How to trade breakouts
The breakout trading strategy is a popular tactic to potentially generate returns by analysing breakouts grounded on chart-based support and resistance levels.
A breakout is when an asset price moves outside a defined support or resistance level with increased volume. A breakout strategy is a popular trading approach used by active traders to take a position within this trend's early stages.
Breakout trading strategies have some principles in common:
- Identifying an opportunity: Finding stocks with strong support and/or resistance levels
- Waiting for the breakout: This type of trading strategy often requires patience, as you’ll need to wait for the stock price to make a sizeable move
- Setting your target: As with any trading strategy, it’s important to decide upfront what your parameters will be. This includes your entry and exit points on a trade and how you manage your risk. Many traders will choose to trade towards the market close, as it can be hard to tell whether prices will hold at any level when markets open
- Allowing the stock to retest a level: After an asset price breaks a certain level, whether it's a support or resistance level, there is often a tendency for the stock price to revisit or "retest" that level
If the price drops below a support level (a price level where it previously stopped declining), that old support level can become a new resistance level. In other words, if the asset tries to go back up, it might face resistance at this previously broken support level.
The opposite is also true: if the asset price rises above a resistance level (a price level where it previously stopped rising), that old resistance level can become a new support level. If the stock pulls back, it might find support at this previously broken resistance level. This “retesting” tends to happen quite quickly. If the asset price retraces back to the broken level and goes through it in the opposite direction, it potentially indicates a reversal. In this case, you might consider accepting the loss on the trade, as the expected trend change might not be favourable for your position.
Example
Let's say ACME stock's initial trading range is between $50 AUD and $60 AUD. It then breaks the initial resistance level of $60 AUD. The stock retraces and attempts to move back down below $60 AUD (retesting the level) but finds support at the previous resistance level, which has now become a support level.
So far, this is looking good as an entry point for a breakout trade as it seems to indicate the start of a trend. However, if the stock, after bouncing off the broken resistance (now support) level, quickly breaks through it again to the downside (i.e. it goes below $60 AUD again), it may indicate a potential trend reversal. In this case, accepting the loss might be a wise decision, as the pattern or breakout has failed.
False breakouts
False breakouts (or fake-outs, as traders often call them) can occur. This happens when the asset price breaks out of the consolidation phase but then quickly reverses, resulting in a loss.
Types of breakout trading strategies
Continuation breakout strategy
A continuation breakout strategy is where a trader aims to enter the market when there is a breakout of a key level of support or resistance. The basic idea is that the established trend will continue – this breakout trade seeks to capitalise on the momentum.
To combine a breakout and trend trading strategy, you would start by identifying a trend, then look for a consolidation phase. When the price breaks out of consolidation and moves beyond the key level of support or resistance, you will place your trade.
Reversal breakout strategy
While the continuation breakout strategy aims to capitalise on a trend's momentum, the reversal breakout strategy aims to profit from an expected trend reversal. In this type of trading, traders look for breakouts as indications that the current trend may be losing strength.
Try out breakout trading for yourself
1. Using virtual funds in a demo account, pick a forex pair of your choice to try out a breakout trading strategy. For example, EUR/USD, GBP/USD, USD/JPY, USD/CHF or USD/ZAR.
2. Practice using your technical analysis tools to identify potential breakout opportunities, such as studying price charts, drawing trendlines, and identifying key support and resistance levels. If you’re not quite there yet, don’t worry – research and practice are your friends!
3. Look for areas on the price chart where the currency pair has historically faced resistance (upper boundary) or found support (lower boundary).
4. Try to confirm the potential breakout using technical indicators, such as moving averages, Bollinger Bands, or the relative strength index (RSI).
5. Set your entry and exit points. For a bullish breakout, you might set a buy entry slightly above the resistance level, while for a bearish breakout, you might set a sell entry slightly below the support level. Make sure you set stop-loss and limit levels to practice managing your risk.
6. Wait for a confirmed breakout and enter a trade. Avoid impulsive decisions and ensure that the breakout is supported by increased trading volume.
Example
Let’s say you’re looking to trade the EUR/USD currency pair, and you identify a resistance level at 1.1500. You could set a buy entry slightly above this level at 1.1520, with a stop-loss at 1.1480 and a limit at 1.1600. If the price breaks above 1.1500 and triggers your entry, you enter the trade using your established risk and reward parameters.
7. Once your trade is complete, assess its outcome. Consider what worked well and what could be improved. Keep a trading journal to track your progress.
8. Repeat the process several times and implement what you’re learning. Practice is the best way to improve your results.
