Breakout trading depends on buying a stock just as it finishes a downtrend and before it starts a new uptrend. Every rally in a downtrend has the potential of turning into a breakout that signals the start of a new uptrend.
Understanding the difference between a rally and a breakout is significant as only a breakout signals the start of a new trend. Identifying a rally from a breakout in real time is difficult.
Now, what is a rally? A rally is a short term price action in which the price of the stock increases. However, in a downtrend, a rally might be desperate attempt to stop the downward slide in the stock price and it is soon overwhelmed by the sellers who are not duped by a short term rally. The fundamentals are more in favor of a downtrend. Now rallies are short and are mostly caused by some breaking news with no fundamental signifance that might excite the market for sometime or rumor that might cause the stock price to go higher.
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Many inexpericed traders often mistake a rally with a breakout. It is true that breakout rallies are difficult to identify by even experienced traders. Now, many traders just trade rallies. These rally traders are not frustrated trend traders, they are content with the limited profit potential of a rally and trade in accordance.
Some traders read about rallies in the financial sections of the newpapers or hear about them on CNBC or Bloomberg and try to trade rallies. These traders are least effective in trading rallies. In actual reality, rally trading is short term trading having fixed price targets.
Some rallies are immediate candidates of a downtrend reversal. These rallies get traded in the expectation of a new uptrend developing. If you can get the entry right is such rallies, you can make substantial profit.
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Rally trading is part of the breakout trading. Some indicators that are used to identify the nature of a rally is the price and volume searches, identification with the resistance levels and their strengths. Confirmation with volume behavior. There are some rally search formulas too that experienced traders use.
Breakout rallies at the end of a downtrend are found with price and volume searches, confirmed break of the down trendlines, confirmed volume behavior on failure and re-test. A 10 day and 30 day moving average combination is also used to identify the trend change. Chart reversal patterns like the ascending triangles, descending triangles, rectangle, flags, wedges and parallelograms.
Breakout trading can be higly profitable. If you want to become a breakout trader than you need to master how to identify a rally from a breakout. However, distinguishing a real breakout from a false breakout is the real challenge for many traders. In this regard, mastering chart patterns mentioned above can help in knowing when a real breakout is about to take place.
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