What Is a Breakout?
A breakout refers to when the price of an asset moves above a resistance area, or moves below a support area. Breakouts indicate the potential for the price to start trending in the breakout direction. For instance, a breakout to the upside from a chart pattern can signal that the price will start trending higher. High trading volume during a breakout reflects greater market conviction, making it more likely that the price will continue in the breakout direction.
Key Points to Remember
- A breakout happens when the price surpasses a resistance level or falls below a support level.
- The accuracy of breakouts can be subjective since different traders might identify varying support and resistance levels.
- Breakouts offer trading opportunities—an upside breakout signals traders to possibly go long or cover short positions, while a downside breakout signals traders to possibly go short or sell long positions.
- Breakouts associated with relatively high volume increase the likelihood of a sustained move in the breakout direction.
- Low-volume breakouts are more likely to fail, making ongoing trends less probable.
The Significance of Breakouts in Trading
A breakout indicates that the price has moved beyond a defined support or resistance zone, potentially after being contained there for a significant period of time. These levels often become benchmarks for traders to set their entry orders or stop-loss limits. When the price breaches these levels, traders act quickly to capitalize on the momentum, while those who weren’t expecting the break might quickly exit to prevent further losses.
Increased trading activity at the breakout point frequently boosts volume, signifying that a large number of market participants are responding to the breakout. High volume lends credibility to the breakout. Conversely, low-volume breakouts may indicate that not many traders recognize the level as significant, making such breakouts more inclined to fail. An upward breakout that fails will see the price fall back below the previous resistance, while a failed downward breakout will see the price rebound above the previous support.
Breakouts commonly occur within established ranges or other chart patterns such as triangles, flags, wedges, and head-and-shoulders. These patterns create well-defined levels of support and resistance that traders monitor for potential breakouts. If prices breach resistance levels, traders might initiate long positions or close short ones. Conversely, breaching support levels might prompt traders to take short positions or sell long ones.
Even after a substantial breakout with high volume, prices might retreat briefly to the breakout level before advancing once more in the breakout direction. This phenomenon happens because short-term traders might take quick profits, temporarily pushing the price back to the breakout point. A valid breakout will lead the price to resume its initial direction; if it doesn’t, it’s considered a failed breakout.
Illustration of a Breakout
Consider a chart where there’s a significant volume spike as the price breaks through a resistance area within a triangle pattern due to an earnings release. This breakout led to a noticeable price gap, followed by continued upward movement without retracing to the breakout point—a hallmark of a robust breakout.
Traders leveraging this breakout might have entered long positions or exited short ones. For those going long, a stop-loss order would best be situated just below the resistance level (or below the support of the triangle). Given the pronounced breakout, regularly adjusting the stop-loss upwards could help in locking in profits while minimizing risk.
Distinguishing Breakouts from 52-Week Highs/Lows
Breakouts can lead prices to new 52-week highs or lows, but not all 52-week highs or lows arise from recent breakouts. A 52-week high or low tracks the highest or lowest price within the last year, while a breakout is specifically a movement above resistance or below support.
Challenges When Trading Breakouts
Trading breakouts isn’t foolproof and poses two main challenges. One issue is failed breakouts where prices may push slightly beyond resistance or support, misleading traders into entering breakout trades, only to reverse direction. Such misleading signals can happen multiple times before an authentic breakout occurs. The subjectivity of support and resistance levels is another limitation since traders may identify and react to different levels of importance. Observing volume helps mitigate this as an increase in volume underscores a breakout’s significance, while low volume suggests the level may not be important to all traders.
Related Terms: volume, earnings, gap, stop-loss order, 52-week high/low.
References
- Adam Grimes. “The Art and Science of Technical Analysis: Market Structure, Price Action, and Trading Strategies”. John Wiley & Sons, 2012.
- A. Brooks. “Trading Price Action, Trading Ranges”, Chapter 5. John Wiley & Sons, 2012.
