The breakout trading strategy is for those spontaneous traders who wish to earn profits from sudden market volatility.
With an effective breakout trading strategy in your hand stating clear exit and stop-loss points, you can make good money from market.
As a newbie, you need to first understand the basic breakout trading strategy and related basic concepts. This will help you identify how to curate your breakout strategy as per your particular swing trading or intraday trading goals.
This guide will go into the depths of breakout trading to help you master the skill efficiently.
What is a breakout?
A breakout is when the stock price moves either below the support trend lines (where falling prices stop falling and start rising) or above the resistance level (where rising prices stop rising and start falling).
Breakout trading is a technical analysis term that depicts price graph movement beyond these two levels. It signals the traders that the graph will adopt a specific momentum in the coming days and help them place trade orders accordingly.
Trading breakouts usually happen when there is a sudden change in trade volume at the support and resistance levels. It shows that the graph will soon follow a significant upward or downward trend.
When the stock price breaks below the support level, it provides traders with a short, sell or exit signal and when it breaks above the resistance leave, it provides traders with a long or buy signal.
For traders, breakout trading isn’t only helpful for making huge profits but also for predicting future price volatility, major price moves, and new price trends in the market.
Key factors of breakout trading
Breakout trading strategy comes with its share of risks. If you do not act quickly, you might lose the opportunity and incur losses.
If you falsely identify a breakout trade and act impulsively, you might fall into the trap of huge losses.
To avoid these losses and only incur limited downside risk, make sure that you identify the breakout before it occurs and place a trade order as per the future market direction.
Patience is the key to a solid breakout strategy. Minutely study the volatility cycles, and focus on volume surges to correctly predict a breakout.
If you are unsure about the trading breakouts that are currently existing, you can avoid the first one and wait for the prices to come back to the original breakout point to place an order in a confirmed trend.
You can study how the price reacts and get confirmed resistance and support levels. Thereafter, you can enter again when the price breakouts with substantial stop-loss and exit points to maximize profits and minimize losses.
Say NO to Breakout chasing
Never chase a breakout. Investing in a market trend is wise but chasing the market trend, not so much so. You might be chasing the breakout with no clear exit trades plan and end up losing trade and all related profit points.
Even experts advise you not to chase the breakout when it has already happened. You fail to set logical stop loss and exit points when you chase a breakout.
With no reasonable stop loss and exit, you are lost in the trend when the market makes a complete reversal or pullback.
Chasing a non-confirmed breakout can also lead to trading a fakeout, which is a false market signal that can negatively impact your high-probability breakout trades.
As an intelligent trader, you should identify the breakout just before it happens. It is when the price graph repeatedly consolidates on the resistance level before breaking out above or below the resistance trend line or support level.
Do not only buy low and sell high
The conventional trader mindset of buying at low and selling at high fails in a breakout. You need to understand that breakout is a phase of higher highs and higher lows. You are buying at high and selling at higher.
Such cases can be risky but profitable if you can correctly identify the price charts, and patterns, predict the graph momentum and act quickly with a strong strategy.
Wait for a strong breakout trade signal with a confirmed surge in volume and strong price chart patterns.
How to find out breakout stocks as a breakout trader?
Breakouts can be subjective as not all traders use the same support and resistance levels to identify them. Your support and resistance levels can be different from other traders in the market.
The important factor is who has efficiently analyzed the historical data and come up with well-defined support and resistance levels.
To identify a successful breakout, you must be able to identify not only these levels but also the behavior of the stock.
Generally speaking, a stock breaks out when it is crossing a moving average either from above or below and also trading at a higher volume than it usually does.
If the financial assets or stock breaks crosses the simple moving average from above, it is most likely going to trend upwards and hence send a long or buy signal to the traders.
If the stock crosses the simple moving average from below, it is most likely to trend downwards and hence send a short or sell signal to traders.
Key components that will help you find breakout stocks
Significant support or resistance level
Often traders misinterpret support and resistance levels which results in identifying false breakout opportunities What you think as confirmed resistance and support levels might be a random point in the price movement.
Just because the market has traded several times on that point does not make it a support or resistance level. Even if there is a significant change of direction at some levels, it does not confirm the levels as viable resistance or support price points.
Support and resistance level needs to be an area where there is a shift in the stock’s supply and demand.
At support levels, buyers get more aggressive, driving the stock price near its lowest. At resistance levels, and sellers get more active and drive the stock price near its highest.
The important factor to identify these levels is volume. You should focus on the surge in the stock’s volume as it picks up significantly at these levels to confirm the support and resistance price points.
You can draw the correct graph pattern and predict a breakout when you spot the correct support and resistance levels. The correct graph pattern and levels will also tell you how the future graph trend after it breakouts.
Breakouts on low volume are mostly false breakouts or fakeouts where a trade fails. This also happens when there is not enough momentum, no ideal exit point and lack go big breakout candle in the market.
A breakout occurs on high volume as high volume indicates that the move drives institutional investors rather than retail traders. Institutions defend their positions by purchasing and selling continuously and very aggressively. This significantly impacts the stock prices.
Institutions and organizations are always acquiring and dispersing shares because of the perpetual requirement for rebalancing due to asset outperformance and new asset inflows.
As a result, if you observe a breakout on heavy volume in the direction of the long-term trend, the stock’s institutional owners are likely in a net-accumulation mode. In other words, while some institutions may be selling, there is more purchasing than selling going on.
A moving average of volume is an excellent approach to determine the volume’s significance. Swing traders often utilize a 50-day average and look for a breakout of at least 150% of the MA to confirm the price swing.
Consolidations play a major role in the early prediction of a breakout.
Consolidation is a lengthy phase where the stock neither continues in the price trend nor reverses. It builds up near the resistance or support level after an immediate trend “rests”.
A trend is said to be strong when there is a solid build-up with repeated or numerous candles on the resistance level. The longer a stock stays in consolidation, the stronger the breakout.
In order to predict a breakout, you need to look out for strong stock consolidations with increased volume in the market.
Types of Breakouts
There are two types of breakouts – upward and downward breakouts.
When the price graph breaks the resistance level and moves in a continuous upward direction, it is an upward or bullish breakout. The stock continues to touch higher prices until a new resistance level is formed.
During an upward breakout, traders receive an ideal entry point or buying signals as the market is expected to continue rising.
When the price graph breaks the support level downwards, it is a downward or bearish breakout. The stock continues to touch lower prices until a new support level is formed.
During a downward breakout, traders receive ideal exit or shorting signals as the market is expected to continue falling.
There are several patterns, technical indicators and tools to analyse the past and present data to determine an upward or downward breakout trend. Let us discuss them in depth as follows –
A chart pattern is a graphical representation of stock prices along with the dates when they traded on these prices. Price data is plotted on charts that occur over a period of time which helps traders identify the market movement and place orders accordingly. Some of the widely used chart patterns are –
The ascending triangle is an upward or bullish continuation pattern that signals traders that markets are going to rise and hence provides them with ideal entry signals.
It consists of a lower trend line that moves in an upward direction and acts as the support level of the stock. It also consists of a flat upper line formed with price highs that acts as the resistance level.
When the price breaks out above the resistance level, the stock prices start increasing rapidly due to the increased and strong buying pressure and not so strong selling pressure.
The descending triangle is a downward or bearish continuation pattern that signals traders that markets are going to fall and hence provides them with ideal exit signals.
It consists of an upper trend line that moves in a downward direction and acts as the resistance level of the stock.
Its also consists of a flat lower line formed with price lows that acts as the support level.
Lastly, when the price breaks out below the support level, the stock prices start decreasing rapidly due to the increased and strong selling pressure.
A flag is a type of chart pattern that occur in periods of tight consolidation and are of two types – bullish flag patterns and bearish flag patterns. As flags are a continuation pattern, a breakout leads to the stock prices continuing in the prior trend’s direction.
Bullish flag pattern
A bullish flag occurs during a stock’s uptrend and are formed with an initial drastic increase in prices that continue in the upward direction thereafter. Once prices move beyond resistance level, the prices continue moving upwards and provide traders with strong entry signals.
Bearish flag pattern
A bearish flag occurs during a stock’s down trend and are formed with an initial drastic decrease in prices that continue in the downward direction thereafter. Once prices move below the support leave, the prices conus moving downwards and priced traders with strong exit signals.
A wedge pattern is a reversal pattern that is represented with tight price swings that occurs between the support and resistance range. Wedges are also of two types- a rising wedge and a falling wedge.
A rising wedge is formed during an uptrend after a drastic increase in the stock price. It is formed by connecting higher highs and higher lows. Once the price breaks out in a wedge, it reverses in the opposite direction and provides traders with an exit or short signal.
A falling wedge is formed during a downtrend after a drastic decrease in the stock price. It is formed by connecting lower highs and lower lows. Once the price breaks out in a falling wedge, it reverses in the opposite direction and provides traders with an entry or long signal.
Technical Indicators for Breakout Trading
Technical indicators are signals that are based on the stock’s prices, momentum and volume to predict the future market direction. The two main technical indicators that help predict a breakout are as follows –
Moving Average Convergence Divergence (MACD)
Moving average convergence/divergence (MACD) is a continuation pattern that determines the relationship between a long and a short moving average of a stock’s price.
It helps in analyzing price changes that occur quickly and aids traders in understanding the momentum behind a breakout.
Traders can examine the speed of price changes when price movements approach and break above a resistance line using a histogram that works in contrary to the stock’s prices.
A bullish MACD divergence occurs when the stock market prices are making a lower low but the MACD is indicating a higher low. This sends traders a signal to enter the trade.
On the other hand, a bearish MACD divergence occurs when the stock market prices are making a lower high but the MACD is indicating a higher high. This sends traders a signal to exit the trade.
Bollinger Bands help in determining the ideal entry and exit levels for a trade. They are a price reversal signal and are plotted two standard deviations above and below a simple moving average line based on which you can place successful trade orders.
It comprises three lines: a 20-day simple moving average (SMA) also called as the middle band, an upper band that is two standard deviations above the SMA and a lower band that is two standard deviations below it.
When stock prices break above the upper band, it indicates an overbought market and signals traders to exit the trade due to a downtrend reversal. When prices break below the lower band, it indicates an oversold market and breakout trader enters the breakout trades due to an uptrend reversal.
Example of breakout trading strategy
Let us have a look at a prominent example of a breakout trading strategy.
Suppose you are trading an ABC stock which is currently trading at INR 1000.
Two days later the stock surpasses its resistance of INR 1500 and the stock price trades at INR 1650, indicating an upturned breakout.
The stock continues trading between INR 1650 and INR 2050, indicating a confirmed uptrend breakout.
At this point, as a trader, after you have noticed that the stock is trading near to this trade, you enter the trade due to the expected market continuation in the upwards direction. R
If you look closely at the price graph from that time, you will see an ascending triangle or a rising wedge forming just before the breakout. This is where you identify the entry price level to make the most of the breakout.
Right before the stock price crosses its resistance level at INR 1500, enter the trade to maximize profits.
The graph will continue to surge higher, touching higher price levels. Opening a trade position at this time will enable you to trade the stock with a newly formed resistance level that will exist in the uptrend.
How to avoid a false breakout?
A false breakout is when the graph goes beyond resistance or support level but fails to sustain its trend and reverts. It is also called a fakeout or a failed break.
The solution to this issue is to have patience and study the graph closely. Rather than impulsively acting on a trade right away when the price breaches a crucial level, you should wait until the candle closes to validate the strength of the breakout.
After the candle has closed, and the breakout is confirmed, we can open our position, which has a better chance of succeeding.
You can choose to set a price alert which will analyze each candle’s closing prices to confirm the market breaks.
The moment it goes beyond your set price and breaks the resistance, you will receive an alert on your phone. You can then login and put your strategy into action to avoid a false breakout and instead trade an actual breakout in the market.