Breakout patterns are typically easy to spot and range breakouts tend to be one of the first trade set-ups that new traders learn
As attractive as they look, there are reasons why you might want to steer clear of range breakout patterns you see.
Momentum after range breakouts is rare
Large moves after range breakouts are quite rare. While there are many potential range breakout trades out there, finding one that has an explosive move is like winning the lottery, the probabilities are pretty slim.
While chartists look for cases where a stock has the potential of a meteoric rise from a breakout pattern, that kind of move isn’t the norm. There needs to be some sort of catalyst before a stock soars, and getting into a stock just simply because it broke slightly out of range — without a catalyst — is having too much faith in breakouts.
If you study charts enough, false breakouts are something you’ll notice often. Fake breakouts occur when the stock rises above the range, but then pulls right back into the range. Check out this daily chart on Facebook Inc. (FB).
If you got into FB on breakouts on the upper end of the range, you would have lost money if you held onto the position. With that in mind, it’s hard to predict when a stock will break out of its trading range, another reason why you must be cautious trading breakouts.
Legitimate breakouts often retreat
Even when you are looking at a legitimate breakout, there are concerns. When there’s a real breakout, traders have to guard against the tendency to stay in too long, only to see the price retreat back to the trading range. This is also known as a correction.
Let’s revisit the FB range example.; notice here that FB actually broke out of its range:
Let’s assume you got into the trade when it broke above. You had unrealized profits, thought the stock legitimately had broken out and could run higher.
Here’s what happened next:
Facebook’s share price corrected and pulled back into range. When you’re starting out, this kind of action can be particularly frustrating. If you stayed in the trade, you could have lost over 4 points in it.
The Bottom Line
Range breakouts are hard to read; it’s hard to predict when a stock is going to break out. When you’re first starting out, you may look for breakout patterns but avoid trading them on their own merits and look instead for them to confirm other, clearer signs of potential price movements.
Petra Hess runs PetraPicks.com. She is a technical swing trader and long-term investor in domestic and Canadian stocks and ETFs.