Prices in the stock market fluctuate in many ways. A good trader understands how to use various price movements to their advantage. It helps if you have access to the best trading tools and features available today, like those offered by Samco Securities to users of the Samco trading app.
In addition to these advanced trading tools and tech, however, you need to be aware of the fundamental concepts involved in price trading strategies like breakout trading. This will help you make the most of the tools and facilities at your disposal. So, in this article, we take a closer look at what breakout trading is, how different breakout trading strategies work and what the pros and cons of this type of trading are.
What is a Breakout?
A price breakout is a phenomenon that occurs when the price of a share or security moves beyond the defined range in which it was trading for a while. This range is typically defined by support and resistance levels, which act as price thresholds in either direction. When the price breaks out of a defined support or resistance level, you have a breakout.
For example, say a share has been trading in the range of Rs. 120 to Rs. 135 and repeatedly hitting the Rs. 135 mark, but failing to move beyond it. After a few unsuccessful attempts, the price finally breaks out of this range and rises beyond the established resistance level of Rs. 135. This constitutes a price breakout.
The opposite may also happen, where the price moves below an existing support level. For instance, in the example discussed above, if the price breaks the Rs. 120 barrier and falls below this level, that also constitutes a breakout. As you can see, a breakout can be bullish or bearish. Let us delve deeper into why breakouts occur, so you can appreciate the logic behind breakout trading strategies better.
How Breakouts Work
A breakout is more than just a price movement. To anticipate a price breakout effectively, you must also study the trading volume and momentum using the relevant indicators. This is because a price breakout is often accompanied by changes in trading volume.
Take a bullish breakout, for instance. It occurs when the price surpasses an existing resistance level. A resistance level forms when the selling pressure exceeds the buying pressure and prevents the price of a security from rising above a particular price point. However, over time, if the buyers become more dominant, they can succeed in building more buying pressure than selling pressure. This drives the price upward and ultimately breaks past the resistance level formed by the sellers.
Similarly, in the case of a bearish breakout, the price breaks out of an existing support level. A support level is formed when the buying pressure exceeds the selling pressure. This prevents the price of the security from falling below a specific level. However, with time, if the sellers start to dominate the market and succeed in building the selling pressure enough, the price moves downward and ultimately breaks down below the support level formed.
An Introduction to Breakout Trading
Breakout trading is the practice of taking a new position in the market (or rarely, closing an existing position) based on how and when the price breaks out of a support or resistance level. It may involve taking a long position (or closing a short position) when the price rises beyond a resistance level or taking a short position (or closing a long position) when the price falls below a support level.
For each trade opened following a price breakout, it is crucial to set a stop-loss according to your risk profile and the expected price movements. Typically, for long positions opened following a bullish price breakout, you must set a stop-loss order just below the resistance level. Conversely, for short positions opened following a bearish price breakout, the stop-loss can be set just above the support level. The take-profit levels in both cases can be determined based on an appropriate risk-reward ratio.
Types of Breakout Trading Strategies
Depending on the type of breakout happening, breakout trading strategies can be one of two types — continuation breakout or reversal breakout. Let us explore each of these in more detail.
Continuation Breakout Trading
Sometimes, the price breaks out of the prevailing range and continues to move in the same direction as it was before. For instance, a bullish stock may undergo a brief period of consolidation before it breaks out of a resistance level and rises again. Similarly, a bearish stock’s price may move sideways in a range for a brief period before it breaks down past a support level and falls again. If you want to trade these breakouts, you need a continuation breakout trading strategy.
Reversal Breakout Trading
A reversal breakout pattern typically occurs at the end of a prevailing trend. The price moves sideways or consolidates for a short period before it breaks out and moves in the opposite direction of the previous trend. For instance, the price of a stock may be rising before it consolidates, breaks down beyond the support level and reverses downward. Similarly, the price may be falling before it consolidates, breaks out of the resistance level and rises upward. To trade these breakouts, you need a reversal breakout trading strategy.
Important Aspects of Breakout Trading
Before you implement breakout trades, you need to understand the key aspects of this type of trading strategy. Here’s how you can trade a price breakout effectively.
Identify Potential Opportunities
Before executing a breakout trade, identify potential opportunities by scanning charts for periods of consolidation, ranging markets or key support and resistance levels. Pay close attention to price patterns like triangles, channels and flags that suggest a possible breakout. Also consider factors like volume, market news and economic data that might signal increased volatility.
Look for the Breakout
Once you've identified a setup, monitor the price action closely for a strong breakout beyond the resistance or support level. A genuine breakout is often accompanied by increased trading volume that signifies market interest. You should also ensure that the price closes above the resistance or below the support level instead of just briefly crossing it, which could indicate a false breakout or market indecision.
Set a Stop-Loss and Profit Target
Risk management is a crucial part of any breakout trading strategy. So, ensure you place a stop-loss slightly less than the support (in a bullish breakout) or more than the resistance (in a bearish breakout) to cap potential losses from a failed breakout. Set realistic profit targets based on previous market highs, key resistance levels or a measured move from the range or pattern to lock in your gains.
Look for Instances of Retesting
After a breakout, prices often retest the previous support or resistance level. This retesting phase is critical because it can confirm the strength of the breakout. If the price holds during the retest, it increases the chance of the trend continuing. However, if it breaks back into the previous range, this could signal a failed breakout. In that case, exiting the trade might be a smart choice.
Advantages of Breakout Trading
The key benefits of breakout trading include the following:
- Early capture of market momentum
- Clear entry and exit points
- High potential for profit from sustained trends
- Flexibility across various time frames
- Applicability in all market conditions (bullish, bearish, or sideways)
- Favourable risk-to-reward ratios
Limitations of Breakout Trading
Breakout trading also has a few limitations such as:
- Occurrence of false breakouts
- Need for constant market monitoring
- Increased risk due to market volatility
- Choppy trading in low-volume environments
- Triggering of stop-losses during market whipsaws
Conclusion
Although breakout trading is one of the top trading strategies to leverage specific price movements, it requires a great deal of practice and planning. If you are a beginner, you need to understand why breakouts occur and how to plan your breakout trades smartly. Samco Securities can help you with this.
With exclusive and free access to TradingView charts directly from the Samco trading app, you can study the development of support and resistance levels and monitor technical indicators to determine when the price may likely break out of the existing range. You can then plan your breakout trading strategy accordingly and enter or exit the market as required.
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