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Three Ways Overbought IO Indicator Can Potentially Predict Market Breakouts


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Originally published at: https://optimusfutures.com/tradeblog/archives/three-ways-predict-market-breakout/

The Overbought IO indicator (OBIO) for MetaTrader 5 is a proprietary technical indicator that can be applied in various conditions for an improved analytical understanding of the markets. In this article, we explore how the OBIO indicator, primarily being a momentum-based indicator, can be highly efficient in potentially predicting a market breakout past a consolidation phase.

The Role of the Middle Band

As the market remains within a tight consolidation phase, it is prevalent to find price oscillating at and around the middle band of the OBIO indicator, suggesting the continuation of weak sentiment and confidence from traders.

This scenario, however, poses a subtle change just before the market appears ready to breakout. For the trader who understands market dynamics and the OBIO indicator, this could be a valuable additional tool.

In the chart above, you will notice price consolidating and tightening within a tight wedge pattern. Notice that while the price is within the confinements of the two blue trend lines marking out the wedge pattern, it appears to be oscillating around the middle band. However, just before the breakout, you will see small low volume candlesticks that appear to be consistently tucked above the central band, giving a potential early indication of the weakening grip from sellers and the growing dominance of buyers in the market. Notice also that this happens right at the point where the two trend lines meet, and the pattern appeared most squeezed and constricted – therefore being ready for a breakout.

Here is another example of the same scenario. We have an inverse head and shoulders pattern where the market appears to be consolidating to break above a proven resistance area (marked with the blue line and the pale yellow rectangle). You will again notice that just before the breakout, price seems to be tucked nicely above the middle band and using it as support, indicating that the buyers are getting stronger.

We want to assert though, that while common market breakouts do not always follow this pattern, you may find several occasions when price breaks out through the middle of the consolidation with no clear evidence of the market stalling above (or below – in case of a bearish setup) the middle band. However, in cases where it does, it can be self-evident and straightforward to expect a breakout play.

No Channel Rebound

In times where the market needs to extend the current consolidation phase or retain an existing trend, we will have frequent pullbacks to the outer bands that are met with fierce support or resistance from the bands, bringing price back in line with the existing trend, or in the case of a consolidation phase, essentially back towards the middle band for more indecisive movements.

Breakouts, however, are different in the sense that they mark a clear attempt from the market to ‘break out’ of the existing rhythm. The OBIO, again being a momentum indicator, makes it easier to spot these situations, this time by carefully observing and looking for no channel rebounds.

To start, let’s take a look at what typical channel rebounds look like and what they imply:

The above chart illustrates a sideways range bound market that the bands ensure via violent rejection and rebound every time price tries to violate them.

You will however not see this scenario when the price is aiming for an actual breakout. Let’s look at an example of an actual breakout and how it appears with the OBIO indicator applied on the chart:

The chart above shows a real breakout. Note how the market pierces the upper bands but does not rebound violently. We do get a bearish candlestick and a yellow dot (which is only a weak signal for overbought conditions) but no significant bearish price action or a move that can be characterized as a pullback to suggest the market wants to continue to consolidate. Instead, we see the market rapidly following along the outer band as buyers continue to execute more orders, pulling price further up.

Again, we would like to clarify that every breakout does not typically depict the same pattern and there can be several breakouts that are not sharp enough to remain tightly pegged to the outer bands. However, when you see this scenario unfold, it should dispel important information about the momentum strength and the impact of the breakout.

The Channel Squeeze

For traders already familiar with some conventional indicators, this concept should be straightforward to grasp. The OBIO is revised for potentially faster adaptability, so it’s less lagging and more reactive to price movements, resulting in appropriate signals and information.

When tightening within a consolidation phase or attempting to break out of one, the price will often (again we would like to emphasize on the word often as opposed to always) print smaller candlesticks and narrower price fluctuations prompting the outer bands to come closer to live price action, essentially imitating a ‘channel squeeze’. This is one of the most common and most significant OBIO signals for an impending breakout.

As you can see in the chart above, the more extended price consolidates the bands get closer and closer signaling the tighter trading conditions and the possibility of a breakout.

Here is another example of a market that transitioned from an uptrend into a period of tight consolidation that brought closer together the outer bands signaling the trademark ‘squeeze,’ just before the sharp bearish reversal.

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DISCLAIMER:

Trading indicators on their own do not generate gains. Your experience, discipline and market conditions may prevent you from having any financial benefits. The Overbought IO method’s goal is to assist traders in developing an approach that can potentially build a foundation for trading that is not based on hunches, gut feel or intuition. We do not claim that the overbought IO components are the only tools necessary for successful trading. Your experience, skills and your developed method can potentially help you.

All statements in this publication is our opinion. These are our own interpretation of the markets and could be the opposite of other experts who build their own method. Our opinion is not a universal truth, rather interpretation of the markets the way we view it.

Risk Disclaimer: The development of Overbought IO method is based on what we considered some of the essential elements in trading, but we cannot possibly encompass all the variables necessary, especially when each trader finds different variables for trading based on his/her risk tolerance.

Trading futures and options involves substantial risk of loss and is not suitable for all investors. Past performance is not necessarily indicative of future results. The risk of loss in trading commodity interests can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition.

USE ONLY RISK CAPITAL. You should never put yourself or your family in a position of risk and trade capital you cannot afford to lose.

The placement of contingent orders by you or broker, or trading advisor, such as a “stop-loss” or “stop-limit” order, will not necessarily limit your losses to the intended amounts, since market conditions may make it impossible to execute such orders.

The high degree of leverage that is often obtainable in commodity interest trading can work against you as well as for you. The use of leverage can lead to large losses as well as gains. Please consider if trading in leveraged products fits your own risk profile.