(by Jeff Kohler)
Breakout trading is used by active investors to take a position within a trend's early stages. Generally speaking, this strategy can be the starting point for major price moves, expansions in volatility and, when managed properly, can offer limited downside risk. Throughout this article, we'll walk you through the anatomy of this trade from start to finish and offer a few ideas to better manage this trading style.
What Is a Breakout?
A breakout is a stock price that moves outside a defined support or resistance level with increased volume. A breakout trader enters a long position after the stock price breaks above resistance or enters a short position after the stock breaks below support. Once the stock trades beyond the price barrier, volatility tends to increase and prices usually trend in the breakout's direction. The reason breakouts are such an important trading strategy is because these setups are the starting point for future volatility increases and large price swings. In many circumstances, breakouts are the starting point for major price trends.
Breakouts occur in all types of market environments. Typically, the most explosive price movements are a result of channel breakouts and price pattern breakouts such as triangles, flags or head and shoulders patterns (see Figure 1). As volatility contracts during these time frames, it will typically expand after prices move beyond the identified ranges.
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| Figure 1: A triangle breakout |
| Source: Prophet.net |
Regardless of the time frame, breakout trading is a great strategy. Whether you use intraday, daily or weekly charts, the concepts are universal. You can apply this strategy to day trading, swing trading or any style of trading.
Finding a Good Candidate
When trading breakouts, it is important to consider the underlying stock's support and resistance levels. The more times a stock price has touched these areas, the more valid these levels are and the more important they become. At the same time, the longer these support and resistance levels have been in play, the better the outcome when the stock price finally breaks out (see Figure 2).
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| Figure 2: The trading range shows multiple reactions to support over time. |
| Source: Prophet.net |
As prices consolidate, various price patterns will occur on the price chart. Formations such as channels, triangles and flags are valuable vehicles when looking for stocks to trade. Aside from patterns, consistency and the length of time that a stock price has adhered to its support or resistance levels are important factors to consider when finding a good candidate to trade.
Entry Points
After finding a good instrument to trade, it is time to plan the trade. The easiest consideration is the entry point. Entry points are fairly black and white when it comes to establishing positions upon a breakout. Once prices are set to close above a resistance level, an investor will establish a bullish position. When prices are set to close below a support level, an investor will take on a bearish position.
To determine the difference between a breakout and a "fake out", it is a good idea to wait for confirmation. For example, a fake out occurs when prices open beyond a support or resistance level, but by the end of the day, wind up moving back within a prior trading range. If an investor acts too quickly or without confirmation, there is no guarantee that prices will continue into new territory. For example, many investors look for above-average volume as confirmation or wait towards the close of a trading period to determine whether prices will sustain the levels they've broken out of.
