Breakout trading is popular among many, but it is harder than it seems. This method looks for price areas that an asset couldn’t move beyond and waits for it to break through these levels, hence the name of the approach — breakout.
Breakouts may indicate the direction the price might be heading next, but to read the signals, traders need to have analytical skills, some practice and a good understanding of how markets function. Often traders use technical analysis or chart patterns to spot the potential breakouts. Let’s have a closer look at this trading method.
How does breakout trading work?
In breakout trading, traders generally look for support and resistance levels on the price chart. These are important benchmarks, which the price might retract from or which it can break through.
The levels are so significant as they act as a jump-start: if the price eventually breaks through the support or the resistance level, this may be considered as a signal that the price may continue moving in the same direction, providing possible opportunities.
A breakout may indicate a buying or selling opportunity, depending on the direction of the breakout. In the example below, the Forex chart of EUR/USD broke through the resistance level downwards, ending a week-long consolidation with a bearish trend.
When the price breaks through the support level downwards and continues its movement in the same direction, it may be perceived as a “Sell” signal. At the same time, if the price breaks the resistance level upwards and continues to move up, it may be a “Buy” signal. However, it is important to note that there is never 100% guarantee of the accuracy of the results.
It is important to note that many traders that exercise this approach, usually do not enter the market immediately after the breakout, but rather wait for a retracement to occur. This may help prevent receiving a false signal — so called “fakeout” — where the price returns to its previous level after a breakout, or even starts moving in the opposite direction.
3 ways of confirming a breakout
Using chart patterns
Chart patterns are commonly used in order to detect a potential breakout. Such shapes as the triangle, rectangles, flags, head and shoulders or the wedge pattern, can all be formed when the price moves in a certain way. A trader sets the support and resistance levels and when the price breaks out of the candlestick pattern, a breakout may be confirmed.
Using technical indicators
Technical indicators can be used in order to confirm a breakout in a security. Some of the popular tools are MACD, Bollinger Bands and RSI. Volume indicators might be considered useful too, since a breakout is often preceded with a period of low volume. After the breakout, there is often a surge in volume as the market enters a new active phase. Applying several indicators that compliment each other might help get a more accurate signal, however, no indicator can guarantee 100% correct results every time.
An example of fundamental data that can be used to determine breakouts may be a company’s earnings report. When the company is doing well above (or significantly below) of what was expected, the price may surge or fall, depending on the news. Catching the right moment is the hardest part of this approach, so it calls for a well-prepared risk management plan to go along with it.
Breakout trading and money management
There are several important risk management rules to be exercised together with the breakout approach. Traders that wish to stick with this style of trading, may want to confirm the following:
- Appropriate stop-loss and take-profit levels. To set these, make sure you know the result you wish to achieve with your trade. The stop-loss and take-profit limitations need to be placed in accordance with the trading plan, in order to avoid excessive risk and to timely exit the trade.
- Several assets to monitor. Finding a market that may be headed towards a breakout isn’t always easy, so looking at several charts at the same time may save traders the time and provide possible opportunities to work with.
- Patience and good trading psychology. Trading breakouts might be a challenging task, so letting emotions take the steering wheel is dangerous. It might be better to miss an entry than make a costly mistake, so always check in with your emotions.
The bottom line
Breakout trading may be an approach that traders want to exercise with the use of chart patterns, technical indicators or economic news. This method may provide traders with indications to enter the market, but as any trading approach, it requires practice and risk awareness. You may try defining support and resistance levels on the Practice account in order to improve your understanding of the breakout approach, but make sure to keep the risk management tips described above in mind!