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How to Trade Stock Breakouts

 

August 6, 2020 (Investorideas.com Newswire) Price breakouts offer an attractive opportunity for traders of all stripes with relatively little risk. The key to breakouts is that they often represent the start of a larger, sustained price movement - trading the breakout itself gets you in on the ground floor. That said, there are some tricks to know about in order to trade breakouts effectively. In this article, we'll take a look at how you can identify prospective breakouts and how to trade them for maximum profit and minimum risk.

What is a Breakout?

A breakout occurs when it breaks above a resistance line or below a support line. Typically, these levels of support or resistance will have been tested unsuccessfully multiple times prior to the breakout. Once a breakout happens, the stock's price usually begins to trend in the direction of the initial movement.

[Breakouts - Example 1]

Importantly, breakouts can happen on any timescale. Day traders may look for breakouts over 5- or 10-minute intervals, while swing traders may look at hourly or daily charts. Breakouts can also be spotted in weekly or even monthly charts.

How to Identify Potential Breakouts

The most critical part of trading breakouts is identifying potential setups correctly. The most reliable breakouts come from stocks that have been trading in a channel, since these stocks are likely to have tested their support and resistance levels two or more times prior to the breakout. The longer a channel pattern persists and the more support or resistance tests it involves, the stronger the eventual breakout is likely to be.

[Breakouts - Example 2]

With this in mind, you can look for specific price consolidation patterns that typically form ahead of a breakout. Channel, triangle, and flag channels all involve prices bouncing back and forth between support and resistance levels, and triangle patterns in particular give an indication of when a breakout may be approaching. However, since these patterns can be ambiguous, it's important to tread carefully and to use other technical indicators to confirm the start of a price trend.

If you need help finding stock breakouts, you can use stock picking services like Motley Fool to get stock recommendations. You can also use scanners that you may find in services like Stock Rover and Finviz.

Price Patterns of a Breakout

The start of a potential breakout is where the greatest risk is involved for traders. False breakouts, in which the price breaks above a resistance or below a support, but then resumes channel trading or even reverses strongly, are very common. Risk in this situation can be mitigated with carefully placed stop losses, but recognizing the patterns that signify a breakout will be sustained can help you trade more profitably.

First, breakouts should trade on strong volume. This indicates that there is a good base of support traders for the price movement through a resistance band, which is necessary if the breakout is going to be sustained against pushback.

[Breakouts - Example 3]

Second, it's important to watch out for a retest of the broken support or resistance line. In a legitimate resistance break, the broken resistance line becomes a new support; the opposite is true for a support break. That new support or resistance is often tested with a pullback, and the price should bounce off of it if the breakout is going to be sustained. For this reason, many breakout traders don't trade the initial breakout, but rather wait for this secondary test before entering a trade.

[Breakouts - Example 4]

Setting Entry and Exit Points

The entry point is fairly easy to identify, but trade execution requires close attention. For a resistance break, open a long trade after a bar closes above the resistance line. For a support break, open a short position after a bar closes below the support line. To hedge risk, you may prefer to wait until the support or resistance is retested, which typically takes several bars. It's also important to look at trading volume and other technical indicators to provide more information about whether a breakout is legitimate.

Whenever you open a breakout trade, stop losses are critical. You should place your stop loss at or just below the initial resistance line, or at or just above the initial support line. If you open a position after the breakout has retested its prior channel, it's a good idea to set your stop losses at or even above the new support or at or below the new resistance.

Setting a price target is more difficult, as it depends on the stock's recent price action and the pattern that formed ahead of the breakout. Channel, triangle, and flag patterns each have different rules of thumb for determining an appropriate exit point. You may also want to look at longer-term support and resistance levels, as well as at alternate technical indicators. Since the price should be trending after the breakout, you can incrementally move your stop loss level to lock in some profits.

Conclusion

Trading breakouts requires attention and patience. It's important not only to find the best candidates for a potential breakout, but to ensure that a breakout is legitimate before trading on it. The nice thing about trading breakouts is that, when done correctly, it's fairly straightforward to minimize your risk with stop losses and the upside potential is very good. While day traders commonly look for intraday breakouts to trade, this strategy can be used effectively over any timescale.

If you want guidance, you can find services that provide breakout scanners or stock pick recommendations. Make sure to check the reviews on Top Trade Reviews to see if the services are legitimate. You should  always do your research before relying on another company for your investing strategy.

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