Breakouts are typically among the patterns least traded by day traders. The characteristics of a breakout are that the price action will stagnate within a fairly narrow price range until that range is broken out of. Once the price range has been breached, the move away from the area of congestion is often quite dramatic. Breakouts within the trading day usually occur toward the end of the day for securities that have not moved significantly during Phase 2 trading. There can be many reasons for this type of price action, the most common of which is referred to as a short squeeze, which we will now discuss.
It sometimes happens that traders see a security fall during Phase 1 trading. They believe this security is moving lower that day and take a short position but it does not fall any further. At some point in the trading day, most commonly near to market close, those short of the security will start to cover their positions by buying the security. Given that the security has not been falling, this buying starts to push the price up. This buying can also attract new buyers of the stock, which pushes the price up further and brings in the remaining short holders to buy the stock to cover their now losing positions. Although this is quite a neat description of market behavior, it is not a terribly common event. The way to catch these happenings is to set alerts on your market data system that will give off audio and, preferably, visual alerts should a security move out of an area of congestion.
A different type of breakout, a gap, is useful in Phase 1 trading. Gaps rarely appear on intraday charts. They typically can be seen only on daily charts, which show the movement from one market period to the next. Moreover, gaps only appear on bar charts, because line charts connect the close of each time period in one continuous line.
Price gaps occur when the price for a given security opens sharply higher or lower than the previous close. During Phase 1 trading, if an opportunity presents itself, we seek these movements and look to trade in the opposite direction. This is contrary to the traditional way to trade gaps, so let's review the traditional way that gaps are traded.
There are three types of gap, and each one indicates a high degree of price volatility, which is what attracts us as day traders. The breakaway gap occurs at the beginning of a new trend, often completing a major reversal or continuation pattern in the daily chart. A characteristic of these gaps is that the price action moves quickly away from the prior area of congestion (that was within the reversal or continuation pattern) and the gap does not get filled. This means that the price action does not move back to the level it was at prior to the gap until the newly formed trend has expired, which is typically weeks, months, or more. Now, suppose you see a security that has moved up significantly in premarket activity. The smart thing to do is look at the daily chart for that security and attempt to determine what type of gap that move represents. Those that look like they might be breakaway gaps are to be avoided for typical Phase 1 trading because the price is likely to continue in the direction of the gap. Trying to take intraday positions in the direction of breakaway gaps does not yield consistent enough profits for this to be a regular activity. It tends to lead to some spectacular gains but many more losses.
The second type of gap is referred to as a runaway, or measuring, gap and typically appears about halfway through an existing trend. This type of gap is partially filled. It is not, however, the type of gap we search for when operating in Phase 1 trading. The third type of gap, the exhaustion gap, is really worth searching for. The exhaustion gap appears near the end of a trend that has run its course. It signifies price action that has run out of momentum. These gaps are always filled by the price action. The exhaustion gap typically is characterized by opening at or near what turns out to be the high at least for Phase 1 trading, and often for the whole day.
The three types of gap are illustrated in the below figure.
