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Trading a break of a trend line is one of the oldest technical trading methods around. Like all trading signals, it has its share of false breaks. However, there are a few simple methods to help weed out these false signals.
The S&P ASX 200 (XJO: ASX) has a good recent example of the kind of test that can often occur after a trend line break. These tests often offer a stronger trade set-up and a better entry price. Chart 1 below shows the XJO breakout on 2nd/3rd February 2010 – depending how you draw your trend line.
Chart 1 – XJO Breakout
click to enlarge
Buying this breakout straight away (whether via a derivative, ETF or underlying stocks) would have proven to be jumping the gun as the XJO then traded lower the next day. This kind of initial drifting backwards is typical of breakouts, especially when a price gap also occurs.
The first place to look for support here is at the trend line that was recently broken. Chart 2 shows the test of the trend line after the breakout. A strong indication that support was found (and the test complete) is shown by the close back above the trend line.
Chart 2 – Test After Breakout
click to enlarge
Once a test of support is in motion, lower timeframe charts are useful for confirming that the test lacks momentum and is likely to make way for further gains. An aggressive approach would be to enter at the trend line test itself, while a more conservative strategy is to place entry stops above each daily (or other time frame) bar.
Chart 3 – Rally After Test
click to enlarge
Chart 3 shows the price movement on the XJO after the breakout, which confirms that a reasonable level of support was found. While tests are not always visible on all charts they often occur subtly on shorter time frames. However, charts that show clear tests often build a more solid base, which translates to more significant gains as the new trend unfolds.
Discussion in this article has been limited to bullish patterns; however this approach works equally as well for bearish patterns. For best results, use the most obvious trend lines when looking for tests after a breakout. When in doubt, avoid fitting the trend line to suit the current price action and instead look for other charts. With such easy global access through ProfitSource, there will always be another trade just around the corner.
Happy Trading,
Jordan Craw
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