Breakout trading is a popular strategy used by active investors to take advantage of price movements in the early stages of a trend. When executed properly, this strategy can lead to significant price moves, increased volatility, and limited downside risk. In this article, we will explore the anatomy of breakout trading and provide some ideas for effectively managing this trading style.
A breakout occurs when the price of an asset moves above a resistance level or below a support level on increasing volume. This presents a potential trading opportunity for investors.
Breakout traders typically enter a long position when the stock price breaks above resistance or a short position when it breaks below support. Once the breakout occurs, volatility tends to increase, and prices usually trend in the direction of the breakout.
Breakouts can occur in various market environments, but the most explosive price movements are often a result of channel breakouts or price pattern breakouts such as triangles, flags, or head and shoulders patterns. During periods of consolidation, volatility contracts, and it typically expands when prices move beyond the identified ranges.
When trading breakouts, it is essential to identify stocks that have strong support and resistance levels. The validity and importance of these levels increase with the number of times the stock price has touched them.
Additionally, the longer these support and resistance levels have been in play, the better the outcome when the stock price finally breaks out.
Price patterns, such as channels, triangles, and flags, can also serve as valuable indicators when looking for breakout candidates. Consistency and the length of time a stock price has adhered to its support or resistance levels are crucial factors to consider when selecting potential trades.
Breakout trading is a strategy that thrives on volatility. The increased volatility experienced after a breakout can generate strong price movements and provide opportunities for substantial returns.
By following a well-defined trading plan and implementing proper risk management techniques, breakout trading can offer attractive returns while limiting downside risk.
Once a suitable breakout candidate has been identified, it is crucial to plan the trade and determine the entry point. Establishing positions on a breakout is relatively straightforward. When prices close above a resistance level, investors can establish a bullish position. Conversely, when prices close below a support level, investors can take on a bearish position.
Differentiating between a breakout and a fakeout requires confirmation. Fakeouts occur when prices open beyond a support or resistance level but end up moving back within a prior trading range by the end of the day. To avoid false signals, many investors look for above-average volume as confirmation or wait until the close of a trading period to determine if prices will sustain the breakout levels.
Successful breakout trading requires predetermined exit plans. When establishing a position, it is important to determine where to exit with a profit, where to exit with a loss, and where to set a stop order.
To establish a profit target, it is helpful to analyze the stock's recent behavior. Price patterns can be used to set a reasonable objective. For example, if a recent channel or price pattern has a range of six points, that amount can be used as a price target once the stock breaks out. Another approach is to calculate recent price swings and average them out to determine a relative price target.
Once the profit target is reached, investors can choose to exit the position entirely, exit a portion of the position while letting the rest run, or raise a stop-loss order to lock in profits.
It is equally important to know when a trade has failed and to exit with a loss. After a breakout, old resistance levels should act as new support, and old support levels should act as new resistance. These levels provide objective criteria to determine when a trade has failed and where to set a stop-loss order.
By using the old support or resistance level as a line in the sand, investors can close out losing trades promptly and avoid accumulating significant losses.
When setting a stop-loss order, it is advisable to place the stop just below the prior support or resistance level beyond which prices have broken.
This ensures that the stop is within a safe range, protecting the position without exposing it to excessive downside risk. Setting the stop too high may result in premature exits, as prices often retest the levels they have just broken out of.
Now that we have covered the key elements of breakout trading, let's summarize the steps involved in implementing this strategy effectively:
In conclusion, breakout trading is a strategy that can be applied to various trading styles, whether it be day trading, swing trading, or any other approach.
By identifying breakout candidates, planning entry and exit points, and managing positions effectively, active investors can capitalize on early trend movements and potentially achieve significant profits. Remember to exercise patience, adhere to your trading plan, and always stay disciplined in your approach to breakout trading.
GENERAL RISK WARNING!
NOTE: This article is not investment advice for anyone because online trading could be a high risk for all who have a lack of knowledge & experience. 86% of traders lose money in financial markets. we are not your financial advisors who guarantee your profit at all.