What is breakout trading
Breakout trading is a trading strategy that aims to capitalise on significant price movements in a financial market. These price movements happen when an asset’s price breaches its trading range.
An asset’s trading range refers to the price “boundaries” within which an asset tends to move over a certain period. The range potentially signals a trend in a particular direction. Breakouts happen when an asset’s price breaks out of a predefined level of support or resistance. This is when breakout trading strategy comes into play. Successful breakout traders can recognise patterns and indicators that may suggest the likelihood of a price breakout.
In this article, we look at how breakout trading differs from other trading strategies and why breakouts are important.
How is breakout trading different to other strategies?
Trend trading is based on the idea that prices will continue to move in the same direction for some time. In other words, the trend will hold. While trend-following strategies aim to ride existing trends, breakout trading is about identifying the starting point of a new trend as prices break through established levels.
Range trading (also known as mean reversion trading), is a strategy where traders aim to profit from the price changes within a defined price range. In other words, traders assume that prices will return to an average value within an established range. In contrast, breakout trading involves traders attempting to make money when there is a large, sudden price movement that could start a longer market trend.
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At their core, range and trend traders “buy into support” or “sell into resistance.” Breakout trading takes the opposite approach. A breakout strategy focuses on selling once support is lost (entering a long position) or buying once resistance is breached (going short).
Whether you are a position trader or prefer to skim profits off several daily trades, breakout trading can work regardless of your timeframe. Of course, as with any trading strategy, risk management is crucial and returns are not guaranteed. Successful breakout traders generally place limit orders and stop-loss orders.
Why are breakouts important?
Breakouts often lead to substantial price movements, upon which traders will look to capitalise. Because breakouts tend to signal shifts in market sentiment and increased volatility, traders who correctly identify and act on these opportunities can benefit from strong price trends.
Breakouts also provide clear entry and exit points for trades. Traders can set entry orders just above or below key breakout levels, and the breakout itself can act as a confirmation signal. You might also choose to set the breached support or resistance levels as stop-loss points for risk management.
Breakout trading can be applied to various financial markets, including stocks, currencies, commodities, and cryptocurrencies. This means breakout trading is an attractive strategy for traders participating in different markets and asset classes.
Traders who prefer to use technical analysis to inform their decisions may find it helpful that breakouts will often confirm technical analysis patterns, such as triangles/pennants, rectangles, or flags.
Breakout trading is also potentially a good option for traders with limited time available. You can set your automatic orders after conducting your analysis, then leave the market to move without worrying about constant adjustments.
As with any trading strategy, use risk management strategies and tools to help you to prepare for and limit losses. Stop loss orders, diversification and hedging are common risk management practices and can be applied to breakout trading as well.
