Breakout Trading Explained

Struggling to know when you should buy and sell stocks? 💭

You aren’t alone. Even some of the best day traders still struggle to develop the perfect trading strategy. And not all strategies out there work for all traders. Sometimes it can be important to be sure that you find a strategy that works for you and your portfolio. 

Breakout trading is a specific investment strategy that can help you to make better stock trading decisions. It relies on monitoring the prices of various assets and watching for the moment when the price of an asset moves above or below a predetermined price range. 

Although this may sound easy, this strategy is not always foolproof, and it takes a significant amount of information monitoring to be able to do it well. But if you have the correct information, this can be a successful strategy, as it was for Jerome Powell who was able to time the sale of his stocks perfectly in October 2021 using breakout trading (and maybe insider knowledge, but that’s another story).

Regardless of whether or not you have deep insight into the inner workings of the economy, breakout trading is a strategy that anyone can use to trade stocks. Here, we will explain how it works, as well as the risks and rewards that are associated with it. 

What is Breakout Trading? 🤔

Breakout trading is possible when a specific movement in the price of a stock has occurred. This can either be an upward movement, indicating that the asset has moved above the resistance area or a downward movement, indicating that the asset has left the support area. 

Traders generally believe that when the price of an asset suddenly spikes, that this is the beginning of an upward trend. This is why they will buy a stock or asset when it rises above the resistance line. 

Of course, the volume of a breakout is important when gauging whether or not the asset is worthwhile to buy. For example, a price breakout that is only a few cents is probably not significant enough to spark trades, as this small change is probably still within the resistance area. But a spike of a dollar is definitely sufficient enough to draw interest. 

This brings up another issue with breakout trading, as how do you know what constitutes as sufficient enough of a breakout for a particular trader to make an investment? While a dollar might be sufficient enough for most breakout traders, there are some that will still skip the trade because they don’t see the change in price as significant, this makes breakout trading a very personal trading strategy.

An example of a breakout trade can be seen when evaluating the movement of Ethereum’s price in October 2021. The price was fluctuating in small amounts around a certain amount until October 20th when the price suddenly shot up, driving demand as more and more traders entered the market in response. 

What Do Breakouts Tell You? 🧠

A breakout is a movement in the price of an asset or stock beyond a cost where it has held steady for a few days or weeks. Basically, it starts with the end of a stagnant price period for a particular asset. 

But this doesn’t mean that it indicates anything positive or negative about an asset, but rather it gauges the market interest in the terms of supply and demand in the asset and the possibility of a future trend. The thing about breakouts is, a very small price breakout could be because of something insignificant, and usually it is. But if there is enough interest in the asset, the breakout will quickly grow. 

This happens because if there is a lot of interest in a particular stock, let’s say, even a small change in price could cause a bunch of traders to jump on the opportunity to purchase or sell the stock. And, according to the laws of supply and demand, the moment more than a few traders attempt to trade the breakout, this will drive the price up even more, making the breakout more significant, and attracting even more investors.

If there aren’t many traders interested in the asset, the ‘breakout’ will not be all that inspiring. It will occur, perhaps spike for a minute or two, but because of lack of interest, the price will quickly settle back to where it started. 

Many try to take advantage of this momentary market increase in demand, by purchasing the asset just as the breakout begins and selling before it ends. This is not always successful however, and we will discuss this more later. 

Finding a Breakout 💡

Think breakout trading sounds like the solution you’ve been looking for? Time to take a look at just how you should go about executing your first breakout trade. 

The Asset Will Have a Long-Term Trend 📈

The first thing you will want to look for is an asset that has well-defined resistance and support levels. You can find this information by looking at stock charts. 

This means you should see a nearly straight line in the direction of the trend when looking at the stock chart and it should be in the same direction for an extended period of time. 

This is because a long-term trend in a stock chart indicates that there are lots of big investors (lots of demand) in the space. This increases your chances of having a successful breakout trade because it is unlikely that these big players behind the asset will suddenly decide to abandon the asset. Basically, you will be trading with the trend, rather than against it which makes it more likely for you to profit from breakout trading. 

Look For a Popular Asset 💰

Another important aspect of finding a breakout trade is looking for an asset or stock that is in high in demand. This is because breakout trading is based on the laws of supply and demand, and if the interest simply isn’t there, the price breakout will likely begin, but settle back to where it was very quickly. This is known as a failed breakout trade. 

The best way to gauge the popularity of an asset, and to see if it is significant enough to consider a breakout trade is by looking at the moving average in the volume of trades in a particular asset. Most day traders look at the 50-day averages, searching for an asset that has at least 150% of a moving average when picking their breakout trades.

High Volatility ⚡

Usually, in the world of trading stocks, volatility doesn’t make things easier. But when it comes to breakout trades, you should be looking for shifts in the volatility of a particular asset. This is because high volatility tells you there is more of a likelihood that the price will continue to shift as you trade the breakout–hopefully in the direction you are wanting it to go! 

Look For Stock Trending Into the Resistance 🛡️

The number one way you can gauge the possibility of a stock having a breakout is if there has been increasing interest (gauged by a price increase) in a particular stock as of late, but it keeps stopping at a very specific price close to the resistance level. This indicates that demand is about to begin to outweigh supply, causing a breakout in the price level. 

This is characterized by a chart with many small ups and downs in price that are very close together, and growing closer all the time. These price variations should also be getting smaller as they continue on towards the resistance price. This is a sign that the stock is trending into the resistance and a breakout could be imminent. 

As you can see in the above chart, this stock is increasing in popularity, indicating it may be ready for a breakout above the resistance line. You can see this by the differences in price growing smaller and the changes in price happening closer together.

How to Enter a Breakout Trade 🏦

Ready to try your hand at breakout trading? Let’s take a look at how you would go about entering a breakout trade.

Find an Entry Point 📍

Once you think you know what asset is ready to experience a breakout, it’s time to find an entry point into the trade. Your entry point should be just above the resistance level, or just below the support level depending on the type of trade you are looking to engage in. 

If you are looking to short a stock, or make some other bearish trade, this is when you should enter below the support level. If you want to enter above the resistance level, this would be a bullish trade where you would believe the price was set to rise. 

For example, if many Wall Street day traders are placing bullish investments on healthcare assets, you would want to watch for when your favorite healthcare stock approaches the resistance line to set up a bullish trade. 

You would do this by looking for a build-up (area of price fluctuations right along the resistance line) or an ascending triangle indicating a trend into the resistance on the stock charts. This will tell you that a breakout is imminent. Place your entry point (a.k.a. purchase your stock) somewhere along this level. 

Wait for Confirmation ✅

Trading a breakout can be exciting, after all, you are about to be part of all that supply and demand-changing action! But after deciding your entry point into a breakout trade, you need to hold your horses for a moment and be sure it is a real breakout and not a fakeout.

A fakeout is where the price of an asset might open at your entry point, but within a few hours or days, it will go back to where it was before. This is why you may want to consider waiting a little bit to see where a breakout goes before setting up your trade. This way you can be absolutely sure the breakout is actually happening. 

Manage Your Risk ⚠️

Although you may be ready to bet it all on a breakout, remember to set limits on how much you can lose before entering the trade. Review how much of your funds you will be placing on a certain stock, and at which point you will exit the market if the breakout trade doesn’t work to minimize your losses. The most popular brokers for stock trading will allow you automate much of the process.

How to Exit a Breakout Trade 📉

You would never enter a room you didn’t know how to exit.

And the same goes for breakout trading–you should never enter a breakout trade without your planned exit point in mind because sharp upward spikes in price tend to turn around just as sharply after their momentum is exhausted.

So before you start placing your buy orders at your planned entry point, you’ll need to pick one of the following exit points for your breakout trade. 

A Reasonable Profit Level 📊

As fun as it would be to ride the wave and see how high of profits you could amass, this is a very dangerous strategy. Instead, you look for a price point where you would make a decent profit on your breakout trade and set your sell point for here. 

Remember to keep the target price you plan to sell at within reason. For example, the asset you are trading should have already demonstrated the ability to move in this direction during its pre-breakout price swings. Most traders choose the average of the price changes of the recent swings to get their sell out point. 

Your Maximum Loss 🪙

Even though you are making all the best assumptions when it comes to breakout trading, there is still a chance you could be wrong and experience a loss. Thus, you should have an exit point at your maximum loss.

It is critical that this exit strategy is close to your original entry point in order to minimize your monetary losses in the event that the breakout was false. You will want to exit as quickly as possible if this is the case.

Use a Stop Order 🛑

The third breakout trade exit strategy is to place a stop-loss order when you enter the trade. This will help you to better minimize your loss before the trade even begins. It is common, however, for a price to fluctuate during a breakout before it really takes off. So you will need to be careful not to set your stop order too close to the resistance price.

Rather, you should try to place your stop order just below the resistance line. While this does mean you will experience some losses in the case of a failed breakout, it also ensures you won’t accidentally miss out on gains by selling too soon either. This is what makes it different from the maximum loss strategy above. 

For best results, you will want to use a combination of the above strategies to maximize your profit while also minimizing your losses at the same time. For example, you could have an order to sell at your reasonable profit price as well as a stop order to control your losses. 

Failed Breakout ⏹️

A failed breakout is a price change that had all the signs of a potential breakout, but after momentarily breaking the support or resistance level, the price quickly settled to where it was. This typically happens because humans are always looking for patterns, and as a result, will see patterns where they may not exist.

This means that what you may have thought was a significant price level really meant nothing when it came down to it–the supply and demand just isn’t shifting as you thought it would. 

It can be difficult to spot a failed breakout. But one of the major signs is a stock that was trending in the opposite direction making a sudden change in the opposite direction with no explanation. This is usually simply a sign of a large purchase order, or perhaps a company reconsolidation but there is no actual change in demand–therefore the breakout will not be supported at the price will quickly return to where it was before. 

One example of a company that keeps experiencing failed breakouts is General Motors, which—despite investors best hopes—keeps barely surpassing the line of resistance, only to settle back to around the same price point it has held since before the COVID-19 pandemic. 

Another example of common false breakouts is the company Lucid. The stock kept approaching the resistance level, but each time it breaks out towards it, it quickly falls back to where it was before without breaking the $28 resistance. Investors kept trying to place a bullish position on the stock, but it took a few false breakouts before a real one occurred. 

Breakout Patterns 🏛️

When breakouts really do occur, there are a few patterns that they tend to follow. Knowing what these are can help you to better trade a breakout and know when you should enter or exit a certain trade. 

Triangle 🔺

This pattern was mentioned above, but when you are looking for a potential breakout, one of the shapes or patterns you should look for is a triangle. This happens when a stock is experiencing price fluctuations but they are getting smaller and smaller as time goes by and the price of the stock approaches the resistance. 

There are both ascending and descending triangles depending on the trend of the price of the stock. There’s also the so-called symmetrical triangle—neither if its sides is a horizontal support or resistance line. 

Flag ⛳

The flag breakout pattern can often be confused with the triangle break out pattern, but there is one major difference–the flag breakout pattern has a pole before it goes into a triangle shape. This pattern usually indicates a major shift in the price of an asset, followed by a period of stabilization, before the price may begin to move again. 

The price may also experience several highs and lows after the flagpole portion of the pattern, but they should be such that the resistance and support lines are, for the most part, parallel to each other. You can see a real life example of this breakout pattern by taking a look at Clorox stocks during the 2020 COVID-19 pandemic. 

Wedge 💸

The third most common breakout pattern is known as a wedge. Like triangles, wedges can be bullish or bearish, and if you can spot these on charts, you will likely have at least a little luck when it comes to breakout trading. But unlike triangles, wedges take a long time to form, making them a long-term strategy when it comes to breakout trading. 

A quality stock scanner can help you to spot wedge break out patterns more easily than your naked eye because of the long time they take to form. However, if you do spot it, chances are you can enter a position that will pay off tremendously once the breakout happens. 

False Breakouts 💵

The only thing worse than a failed breakout, is something called a false breakout. A false breakout is where the price does experience a breakout, but then lots of investors begin to dump their stock very fast. 

This results in a complete reversal and the price of the stock begins to plummet after the breakout. And this can lose a trader a lot of money very quickly if the proper stop orders aren’t in place. 

How to Avoid False Breakouts 💴

It is impossible to avoid false breakouts completely, but with due diligence, you can at least decrease the chance of falling into this trap significantly. 

First and foremost, you need to know that you can’t just rely on the stock charts. While breakout patterns are a great way to predict a breakout, they are not foolproof. This is because there are many exterior factors that the laws of supply and demand rely on.

Just look back at the stock market crash of 2008. So many investors were so sure that the housing market was going well because the charts said it was, but when one investor, Micheal Burry, looked at the information behind the housing loans being given out, he found a different story. This just goes to show that the information driving the change in a chart is just as important as the chart itself.

To add to this point, many people are currently breakout trading on cryptocurrencies. But Micheal Burry sees the hype differently, warning people that these breakouts may not have the support that they think exist behind them. Thus he warns people that there could be many false breakouts and advises everyone to always research any asset before buying it.

So before you go all in on a particular asset, ask yourself why that asset is breaking out. This is a good opportunity to check the news for current events, or take a look into a company’s financial dealings. The time it takes to do this could save you the loss of thousands of dollars. 

Breakout Trading Tips 💡

As you navigate the tricky world of breakout trading, there are a few breakout trading tips you should keep in mind. This will help you to always make the best and most informed decisions possible given the risky nature of these types of trades. 

You Don’t Always Need to Find the Biggest Breakout 💶

Most breakout traders are analyzing stock charts for days on end trying to find out what commodity will have the next big breakout. But this isn’t always the strategy you should focus on. It might be worthwhile for you to look for smaller possibilities to take advantage of.

This is because a small breakout may be less risky than a larger one, and can be easier to predict. And if you are focusing on finding a small breakout, even if it doesn’t take off, you still may make a little money just by buying and selling a stock at a few cents difference.

Try to Profit Off Failed Breakouts 💳

If you are talented at spotting a failed breakout, or if you have a feeling a certain commodity is experiencing a failed breakout, then set up your trades to profit off this. Trading failed breakouts is a strategy all it’s own and can be just as profitable as breakout trading itself. 

No Big Break? Trade Ranges or Secondary Breakouts 💷

Remember, everyone is looking for that one big breakout. But there is money to be made in breakout trading even if “the big one” doesn’t happen or if the price crashes soon after. 

Consider trading within a range caused by a breakout, or holding and waiting for a secondary breakout after the first. Either of these is a trading strategy that can help you to minimize your losses while still engaging in breakout trading. If you wait for a secondary breakout, this could take some time and patience, while trading the range is a more immediate solution (but will likely still take some time to trade at the top of a range).

Always Set an Exit Point 📌

No matter what breakout strategy you are going for, or what commodity you are trading, you need to set an exit point for every breakout trade you attempt. This is the best way to minimize your losses with the risky nature of breakout trading. 

Just remember not to set your exit point too close to the resistance line and approach breakout trading knowing you may lose a small amount of capital. 

The Advantages and Risks of Breakout Trading ⚖️

If you haven’t noticed by now, breakout trading can be risky business. But like anything in the stock trading world, for some people, the risks outweigh the rewards. Of course this will depend on your personal preference, as well as the amount of risk you are willing to expose yourself to while day trading. 

Overall, the upside to breakout trading is that if it is done properly, you have the potential to make quite a bit of capital–and quickly. The problem is, with high risk comes high reward, not to mention that breakout trading requires a lot of research, and a high level of discipline. 

Conclusion 🎬

Hopefully reading this article has taught you a little something about breakout trading. And if this seems like a strategy you can handle within your portfolio, you now have all the tools you need to trade breakouts with success. 

Just remember that breakout trading is highly risky, so there is a chance you could invest in a false or failed breakout. But don’t panic right away, as there are many ways you can still make money off a failed breakout trade. Just stay calm and collected then consider some of the alternative ways mentioned in this to minimize the losses on your breakout trade. Happy breakout hunting! 

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