Major technical breakouts may be used for trading purposes, but they can also be used to determine the overall trending direction or when a trend direction changes. This type of analysis helps with determining which direction to trade. For example, if an ETF has been moving sideways but then has a massive surge to the upside, this indicates that a likely uptrend is under way, and therefore only longs should be considered. A trade does not necessarily need to be taken at the breakout point, but it can be taken at an opportune time (based on a strategy) in the direction of the trend.
Similarly, a major reversal to the downside indicates that short trades (or selling) is favored over buying. Until there is a significant reversal, traders should stick to trading in the predominant price direction. Here are two exchange-traded funds (ETFs) that have witnessed a major breakout recently, along with what this says about their trend direction. (For more, see: The Anatomy of Trading Breakouts.)
This ETF was in uptrend since early 2016. It had a relatively small pullback in August through November, but this was minor compared with the strong prior rally. In November, the price rallied again, but it was only able to move marginally above the 2016 high. This was the first warning sign of a correction, but it would not necessarily constitute a signal to get short since the overall trend remained up. Since February, the price has continued to fall, and in June, it dropped below the November low of $11.77.
That was a major reversal. In an uptrend, after the price has made a significant move higher (to a new high, November through February), it should not fall back below a major swing low. If it does, it warns that the trend is reversing, or at minimum that a more ranging price movement could be forthcoming (if it stalls at the prior low). In the case of AMLP, the price has continued to decline aggressively, below the November low, signaling that a downtrend is in play. Short trades and sells are favored over longs. Moves to the upside are likely selling or shorting opportunities, not buying opportunities. Until the price once again makes a higher swing low and/or a higher swing high, it is best to avoid the longs. (See also: 3 Ways to Invest in Energy Infrastructure.)
XBI was trending higher in 2016, until that trend was drawn into question in October 2016. There was a major sell-off that saw the price drop below the prior swing low, and that was followed by a lower swing high. However, the downward momentum didn't last, and the price began making a series of higher lows and higher highs again, signaling that the uptrend was back in play. For trading purposes, longs could have been taken when the uptrend was intact and avoided between October and February when the trend was in question.
Since March, the trend is still up (no major signs of a reversal), but the price was struggling to break definitively through the $72.50 region. On June 19, it did, and the price has continued to push higher as of June 21. The strong surge through resistance, in an uptrend, helps confirm the uptrend. A trade does not necessarily have to be taken at the breakout point (which can be hard to pinpoint and prone to false breakouts). Knowing that the price is in an overall uptrend is still beneficial, since traders can buy on the next pullback, for example. Long trades are favored until the price drops below a major swing low or fails to make new highs (creates a lower swing high followed by lower swing lows). (For more, see: Biotech Funds Could Break Out.)
The Bottom Line
Trade signals are best combined with the overall trending direction. If traders can spot when a trend is in play and also note when it is weakening or reversing, they stand a much better chance of taking trades in the right direction. Look for pivotal areas on the charts, such as major swing highs and lows. During uptrends, the price shouldn't drop below major swing lows, and it should also be making new swing highs. When the opposite happens, that is a warning sign to get out.
Stick to trading in the predominant price direction. Trading based on price action is a constant task. New price action may indicate that the trend is changing in the future, and traders need to be alert to that. (For related reading, see: Are You a Trend Trader or a Swing Trader?)
Charts courtesy of StockCharts.com. Disclosure: The author does not have positions in the ETFs mentioned.