By Kristoff De Turck - reviewed by Aldwin Keppens
~ 5 minutes read - Last update: May 4, 2023
Breakout trading is undoubtedly one of the most popular forms of trading for those who are mainly active as a day or swing traders. It is a method by which a position is taken as soon as a certain price level is broken. This can be at the top of a specific price range (long setups) but equally, breakouts can occur at the bottom of an existing price range (short setups).
Price ranges do not always have to be horizontal; price breakouts can just as well be visible at rising or falling trend channels or other typical price patterns such as a breakout from a bullish or bearish flag pattern.
A breakout can result in a new trend or it may be the moment when an already existing trend is confirmed.
Check out the chart of AOSL. The first breakout occurred after the price had moved sideways for a while resulting in a triple bottom. The SMA20 began to rise and the breakout signaled the beginning of a trend change.
The second breakout occurred after the formation of an ascending triangle pattern at the very beginning of the new bullish trend and was the start of a powerful uptrend that sent the price from $35 to $63 (+80%) since November 2021.
Have a look at the chart of RARE. The first breakout occurred after the price formed a double top following a very strong uptrend. A fairly wide sideways trend channel was formed and the first breakout was a confirmation of the changing price trend.
Subsequently, there is the formation of a descending triangle pattern. This is a continuation pattern and the breakout downward again initiated a further downward movement that brought the price to around $73 at the end of November 2021 since the beginning of June 2021 ($100).
Higher than normal volume is a basic requirement with this strategy. It is the ultimate proof of buyer momentum. A breakout that is not supported by increased volume is to be avoided.
Avoid stocks that already had a strong surge just before their breakout occurs. In that case, a lot of the buyer's momentum has already been used to get the stock to that specific price level. The further upward potential will be smaller than stocks that moved sideways until just before the breakout and are at the beginning of a possible sharp increase.
Always be aware of the price levels on the larger timeframe in terms of key support and resistance levels to which there is a significant chance that the price will react.
Take a look at the daily and weekly charts of RNR. On the daily chart on the left, we can see a clean breakout above a rising triangle pattern at the third most recent candle with the closing price slightly higher than the previous top at $170.67 (doji candle in red circle). On the daily chart, which represents about 4 months, there is no price level visible that could cause any resistance.
However, if we zoom out a bit further by also taking the weekly chart into consideration (right chart), we notice that just above the breakout level there is a price top on the weekly chart (+/- $175). Chances are that the price will immediately break through this top but it remains a price level that can provide resistance. Such setups are definitely to be avoided, especially if you notice that your set stop loss is further away than the first resistance.
Always keep an eye on the general market conditions. Trading breakouts work well in bullish market conditions. If the overall market is rather negative, breakouts in individual stocks are much less likely to succeed. A good indication that general momentum is slacking is when you notice that the number of candidates for breakout setups keeps decreasing and it becomes harder to find good setups.
The most common mistake is trying to anticipate the breakout. Inexperienced traders in particular fall into this trap. They see the price rise above the breakout level fairly quickly and begin to fear that they will miss the rise if they wait until the close of the candle. So they enter during the breakout move, assuming that the rise will continue and they will therefore have bought at a better price than those who have yet to take a position after the break.
Waiting for confirmation does indeed mean that you will miss some nice breakout plays, just because the price has already risen (way) too far after the close of the breakout candle. Remember though that missed money is much less of a problem than losing money. Opportunities to trade breakouts will continue to arise, day after day. Lost capital will have to be earned back by yourself, so use it wisely!
So sometimes you can get lucky indeed but remember that the number of fake breakouts you fall prey to will be a lot higher. The chart below shows why it is rarely a good idea to predict an effective breakout.
A Breakout trading strategy can be very lucrative in bullish market conditions. As with all other strategies, patience is an important skill, it pays to wait until the breakout has actually occurred. In this way, you will be able to avoid many false breakouts (and corresponding loss positions). Always check if the breakout is accompanied by sufficient volume and momentum and check the larger timeframe on important support or resistance levels.
In this video, I demonstrate a breakout strategy screen based on volume and momentum.