Breakout Trading

Breakout trading refers to taking an early position whenever a stock price manages to break out of its price range. A trader spots the right breakout point and enters a trade because these breakouts are usually observed as the starting point of major price movements, but for this, an authentic price breakout must come along with increased volume.

For beginners, breakout trading may seem like a simple technique for entering the market at the right time, but this is not true. The biggest pitfall with breakout trading is that there are too many false breakouts in an asset’s price movement. To spot the authentic breakout, technical indicators and strategies come into play.

A breakout trading strategy is employed by traders anticipating an asset’s price to fluctuate outside its price range so that they can either enter or exit the market, making the maximum profits. Every stock has a price range which is made up of a support and resistance level. In simple terms, the support level is the floor for the underlying stock price; conversely, the resistance level is the opposite.

When the stock price goes beyond its resistance level, it is a sign for a trader to enter a long position. Similarly, when the stock price declines below a support level, it indicates a good time to enter a short position. Once the stock has gone outside its price barrier in either direction, it increases the volatility, and the price movement continues to trend in the breakout’s direction. At the same time, a trader must confirm the authenticity of a breakout to eliminate the risk of operating on a false breakout strategy. It is done by checking for the volume-weighted moving average indicating an upward trend.

These price breakouts are common in all types of market environments and establish a beginning point for future volatility. The most dynamic price shifts come from price patterns and channel breakouts such as flags, triangles or head and shoulders patterns. The steps to induce a breakout trading strategy begin with any stock’s price chart. First, the trader must mark the price level on the breakout indicator and spot support and resistance levels in the underlying asset’s price chart. After this, the trader patiently waits for a breakout, and once the price moves outside the set levels (above resistance or below support), the trader enters the trade. It is up to the trader to close the trade above the resistance or below the support level to earn returns.

A trader must avoid using a breakout trading strategy without confirming a tight trading range and when it is against outside pressure. It shall only be induced with natural breakouts. This strategy helps investors and traders earn good returns, but they should also check for false breakouts and trading volume before implementing any trade.

The strategies used for breakout trading are -

• Support and resistance breakout - This is the most important strategy as it usually offers a signal of a major change in market equilibrium. Traders closely follow the price chart to focus on moments when there is a clear close past the support and resistance levels.
• Opening range breakout - Given by Arthur Merrill in the 1960s, it uses the price range formed at the beginning of the trading session. It helps identify the breakout when the underlying asset moves up or down its prior days’ peaks and troughs.
• Volatility breakout - Stock market traders with a volatility breakout mindset seek a surge in market volatility. It simply indicates an unusual variation very different from typical market conditions or patterns. This mostly helps in short-term trading. This surge occurs due to some major social or global event that triggers the volatility, and traders use it as an opportunity.
• Breakout gap - As the name suggests, in this technique, traders are more interested in the spaces between the abrupt price movements. These gaps work like an indicator of market momentum.
• Moving average breakout - In this strategy, when the asset's price goes beyond a moving average, it indicates a possible trend change.
• Trendline breakout strategy - In this strategy, trendlines are drawn that replicate the historical market movements and also assist in predicting future trends. When the price crosses the critical trendline, the trendline breakout trading strategy is based on considering a significant event, irrespective of whether it is an uptrend or downtrend.
• Breakout volume - This strategy revolves around trading volume. The trader is more concerned about market sentiment, which is signaled by the hike in trade volume at the breakout time.
• Momentum breakout - The entire strategy relies on the market momentum and acting quickly both in entering and exiting the trade and taking the benefit of the momentum shift.

Below are two examples of breakout trading -

Example #1

Suppose Tulip is an ace investor; over time, she has learned about technical indicators and fundamental analysis of companies and knows about ratios and metrics. Recently, she has been interested in a particular oil stock and decided to enter the trade using a breakout strategy. She sets up the support and resistance level in the breakout indicator of the oil stock’s price chart.

Now, since she is investing for the first time, she is interested in taking a long position for this Tulip waits till the price breaks beyond the resistance level. She checks for the increased volume using a weighted-moving average to confirm a breakout and immediately takes an early long position. She closes the position as per her perspective and earns a good profit.

This is a simple breakout trading example. If Tulip wanted to enter a short position, she would have waited for the price to dip below the support level.

Example #2

In the first week of March 2024, Gold (XAU/USD) recorded its highest weekly gain for 2024. Gold has shown a potential bullish breakout scenario. This means the asset will likely go beyond its resistance level. As per charts, there are multiple resistance levels marked. The price action of Gold is expected to grow within short to medium-term bullish configurations. Once it touches the $2090 mark, which is a bullish range breakout level. The next resistance levels are $2117 and $2149, which is an all-time high printed as of 4 December 2023 in the short term.

Gold, in a two-week time frame, managed a weekly gain of 2.33%. This also registers its best weekly gain not only for this year but for the last three months. For Gold, there have been five attempts on the major range resistance zone, and the weekly RSI momentum indicator has given a higher low above the 50 level. These observations indicate a medium-term upside momentum.

The advantages of breakout trading are -

• Traders can use it to make a profit from quick market shifts and asset price movements.
• The strategy works both ways, allowing a trader to make entry and exit from their positions.
• Once a trader has identified a high-quality breakout with increased volume, the results can be predicted.
• Breakout trading is usually automated; hence, it eliminates the possibility of human error in interpretation and execution.
• There are many breakout trading books a trader can refer to learn about it. The whole strategy is mostly based on price action.

The disadvantages of breakout trading are 

• An analyst or trader interested in breakout trading must be swift with their decisions, or else they will lose the opportunity.
• - Breakouts are a common phenomenon; hence, there are high chances of catching false breakouts without confirmation.
• It requires constant monitoring of price charts to identify patterns and interpretation skills.
• A trader may employ additional confirmation signals, but again, it will reduce the odds of catching the right entry or exit point.