If you’re looking for a new trading strategy, you may be interested in breakout trading. This strategy helps traders capitalize on an upcoming directional move or trend. By following a few rules and taking a different approach to the way you trade stocks, you can potentially add to your portfolio and earn high returns.
Breakout trading is focused on sudden directional moves in price that extend beyond the current trading range of a market. In order to succeed, a breakout trader must aspire to become active in the market just before or soon after a strong pricing trend starts. It differs from the traditional range, reversal, and position trading approaches, so this type of trading can be challenging.
The breakout strategy of trading can include a variety of factors, but typically will include a few key elements. These elements include:
- Volatility: When participating in a market increases, the volatility of that market goes up as well. Increased buying and selling lead to instability in the market, which can allow for larger fluctuations in price. As a result, the chance of a stronger trend developing increases, which allows breakout traders to take advantage of the shifts.
- Market participation: An increase in the volume of trades in a market is a common characteristic of breakout trading. When a security price changes drastically, moving outside of its normal range, the value debate tends to increase. Those trading in the market are typically more interested in opening both long and short positions to take advantage of the possible opportunity and earn a profit.
- Directional price move: The other two elements, volatility and market participation, combine to produce a directional and pronounced price move. A directional price move is the key characteristic of a breakout, as pricing is what allows breakout trading to occur. Until the directional move in price takes place, a breakout won’t be able to happen.
All three elements are important to the occurrence of a breakout. The conditions of the market will ultimately impact whether a breakout can occur, although it can take place at any time in any market. Catching a breakout at the right time can increase your chances of earning high profits.
Price Breakout Indicator
Before you can trade during a breakout, you will need to understand how to identify this type of market condition. Some traders apply a fundamental analysis, while others use technical analysis to assess the conditions and determine whether a breakout is approaching. Other traders apply a combination of both fundamental and technical analyses.
When learning to identify breakouts, you may want to use some of the most common strategies:
- Chart patterns: As you watch the market charts, you can look for pennants, flags, and various candlestick patterns. These patterns are often indicative of a coming change in the market.
- Periodic news releases: When a company schedules the release of market-related data or an official economic report, this action may serve as a catalyst for a definitive pricing move. Companies in both the public and private sectors can release data that results in increased market participation, which is a necessary element of market volatility that can lead to a breakout.
- Market consolidation: When a market consolidates, some people believe this serves as a precursor to a pricing change due to the indecision. When a security’s trading range gets tighter, the volumes of that security often go down. When the range is compromised, market participation tends to increase, driving the prices up or down.
- Support and resistance: Support and resistance levels change as prices are tested before returning to the control range. These levels are often seen as constraints on pricing, which can cause the market to be contained. If the price extends beyond the set level, a breakout may take place. Some of the most commonly used support and resistance analysis tools include pivot points, Fibonacci retracements, Bollinger Bands, and moving averages. If you prefer a more traditional approach, you can also use value areas and round numbers while examining the order flow.
Traders can apply any combination of these strategies when assessing the market for a possible breakout. Those who stay active in the market at all times may use short-term charts, including those with one, five-, and 30-minute increments, while intermediate-term investors often focus on monthly, weekly, or daily charts to find opportunities for breakouts. The best breakout strategy for you will ultimately depend on your overall trading strategy and how aggressively you want to pursue this type of market shift.
Breakout Trading Rules
One of the key rules to trading in a breakout market is to figure out how to best manage the risk associated with this strategy. You should spend quite a bit of your time on risk management, especially if you are trying to become a more experienced and skilled trader. Managing the risks you take can help minimize losses, as well as optimize the trades that do produce profits.
Another rule of breakout trading is to utilize news reports and data, as the information released drives pricing changes more than nearly anything else. This is particularly true of micro-caps and penny stocks, which many breakout traders focus on when applying this strategy. In order to use the data released through news outlets, you can look at stocks that have increased substantially, and then search news sites to determine what might be influencing that price shift.
Benefits and Drawbacks to Breakout Trading
Regardless of the approach you take to trading, there are a number of factors that contribute to your success or failure. The strategy of breakout trading is no exception, although there are several unique pros and cons to this type of trading. Some of the advantages include:
- Potential for profit: When successful, participating in breakout trading can result in large gains. When you can get in on a stock during a major trend, you can take advantage of impressive profits.
- Limited risk: Breakout traders focus on buying and selling during consolidating phases in the market. As a result, the initial stop losses can be lower based on the price range or compressional pattern used to enter the market. You can also continue to watch the shifts in the market to determine whether the trade could fail, allowing you to exit quickly and limit your losses.
- Management of trades: Entering and exiting the market in a predefined manner can eliminate the risk of errors due to trade management. You can also identify profit targets and stop losses early in the process.
- Aligning with trends: When you’re reviewing breakout trading indicators, the ultimate goal is to make sure your moves align with the upcoming trends. If the market reverses or the trend you’re watching starts to fizzle out, you will hit the initial stop loss and can get out, rather than having to trade against the trend.
Although there are some advantages, breakout trading also has some potential drawbacks.
- False trends: When you are attempting to identify a breakout market through the use of various analysis methods and trend assessments, you could falsely identify this type of market. Regardless of the methodology you use to assess the condition of the market, the participation levels may not increase to what they need to be to trigger a breakout.
- Cost of the opportunity: Optimal trades are infrequent, so spending a lot of time searching for the perfect opportunity could end up costing you more than you expect, especially if you are sacrificing other potential trade opportunities as you wait for a breakout to occur.
- Slippage: In order to successfully navigate a breakout in trading, you must enter the market at just the right time and in a precise way. Increased market activity is necessary to move the prices, but knowing exactly when to enter can be a challenge.
How to Trade Breakouts
Now that you understand what breakout trading is, as well as the pros and cons of this trading strategy, you can start applying the concepts to your own method of trading. One of the best ways to engage in this type of trading is to maintain tight consolidation on the trades you make. Doing so helps lessen your risk while increasing your profit potential.
It’s also helpful to look at the recent behavior of the stocks you are considering buying to determine the objective. Using that pricing action trend allows you to establish a target price, which you can then use to determine when you will exit with a profit. You may also want to calculate some of the most recent swings in price to get an average price target.
In order to succeed in breakout trading, you need to be able to identify a trade that has failed and bounce back. Choosing to engage in this strategy makes it easier to identify failed trades, as resistance levels and support levels become more apparent. By identifying when a trade has failed, you can also set a stop-loss order more effectively, which you can then use to close out a trade that has lost momentum and is no longer performing well in your portfolio.
Learning to apply the necessary strategies to succeed in breakout training is often challenging, especially to new traders. At Raging Bull, we offer webinars and free e-books to give you insights into the various ways to trade and help you maximize your profits.