Trading a breakout from price range or consolidation is a common tactic. The risk, of course, is that the breakout may turn out to be false.
So, we look at volume and follow-through to confirm the likelihood that price will continue to move in the direction of the breakout. In other words, if a breakout occurs on high volume, chances are that the breakout might succeed, unless the underlying volume of transactions causing the breakout reverses.
But might there be another strong indication that price might continue to move in the direction of a breakout? There is one, and it comes in the form of a “trading gap.” When a breakout occurs in the form of a trading gap [aka “breakaway gap”], it gives the impression that a high volume of buyers (or sellers, depending on the direction of price movement) are causing price to make a significant move away from its current range.
A breakaway gap looks like this (shown at right):
What characterizes a breakaway gap?
- A relative period of consolidation must occur to form a consolidation base or range; either of which can be narrow or wide.
- A price gap occurs sharply away from the base or range.
- Preferably, you will see strong volume behind the gap, indicating buying (or in the case of a breakdown, selling) pressure.
Pros, cons, and risks of a breakaway gap.
The pro is that a breakaway gap indicates strong support behind a price breakout, enough to make the price “gap” from its consolidation range.
The con is that you may have to enter at much higher price, which can mean a much wider stop loss than you’re comfortable with.
The risks are:
- Price may retest the gap and fail; falling back into the consolidation range or breaking down below the range’s support level. In this case, you have a failed trade.
- Price may retest the gap but continue moving in the direction of the breakout. In this case, you have a volatile trade that may either tempt you to exit your position or that can even stop you out (depending on where you placed your stop loss) only to continue moving in the direction of your initial bias.
How to trade a breakaway gap:
- When you observe a breakaway gap, depending on the size of the move during the breakaway session, note that price may either continue moving in the direction of the breakout, or it may fall back.
- In an upward breakaway, preferably one showing high volume, you can either buy immediately or wait until the end of day to enter your long position.
- Here’s the critical decision: whatever point you decide to enter your position, and however distant your stop loss, size your position in a manner that does not exceed your maximum risk per trade. This may mean taking smaller positions if the distance between your entry and stop is wide.
Canopy Growth (CGC) is a Canadian cannabis grower whose stock trades on the NYSE. Because of recent US legalization (particularly in California) and in anticipation of Canada’s Cannabis Act (which took place in June 2018), investors have been buying Canadian cannabis stocks as their companies have been able to develop infrastructure for a much longer period as compared with US cannabis companies.
On October 31, 2017, Canopy’s stock price exhibited a strong breakaway gap (1) supported by high volume (2). Note the surge in volume correlating with the price movement.
In this particular case, CGC price continued to move upward; a case wherein a trader might have been better going long on the day of the gap. The stop loss would have been more or less $2.00 from the long entry at $9.35.
Remember that whether your stop loss is $1 or $5 or more away, you should size your position so that it doesn’t exceed your risk should your trade fail. The amount you decide to risk is up to you and is determined by your risk tolerance, capital resources, and your overall investment strategy.
Following this breakaway gap, Canopy Growth continued its uptrend until $36.04 on January 10, 2018 as illustrated below.
Caveat: Not every breakaway gap will succeed. Asset prices are driven by fundamentals and market sentiment. Should any of these factors shift during a trade, they can easily render technical setups invalid. Always monitor the fundamental factors alongside the inherent bias of a technical setup.
Please be aware that the content of this blog is based upon the opinions and research of GFF Brokers and its staff and should not be treated as trade recommendations. There is a substantial risk of loss in trading futures, options and forex. Past performance is not necessarily indicative of future results.