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 – the price “boundaries” within which an asset tends to move over a certain period. The range potentially signals a trend in a particular direction. In other words, breakouts happen when an asset’s price breaks out of a predefined level of support or resistance.

Successful breakout traders are able to recognise patterns and indicators that may suggest the likelihood of a price breakout.

In this lesson, we look at how breakout trading differs from other trading strategies, why breakouts are important and different types of breakouts.w 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.

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.

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 would consider placing 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.

Basic components of breakout trading

Breakout trading strategies include the following elements:

• 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 asset 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 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 and $60. It then breaks the initial resistance level of $60. The stock retraces and attempts to move back down below $60 (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 again), it may indicate a potential trend reversal. In this case, considering accepting the loss might be a wise decision, as the pattern or breakout has failed.

Try it out for yourself

1. Using a demo account, where no real money is at risk, 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 – we’ll touch on some of these in the coming lessons.

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 over the process of this course and implement what you’re learning. Practice is the best way to improve your results.