What is a breakout trading strategy and how do you trade with it?

What is a breakout strategy in trading?

A breakout is when a stock price moves outside a defined support or resistance level with increased volume.

Following this, a breakout strategy is a popular trading approach used by active traders to take a position within this trend's early stages. This strategy is often the starting point for large price moves and increased volatility – when managed carefully, it can even be low-risk.

A breakout trade involves entering a long position after the stock price breaks above a resistance level or goes short if the stock breaks below the support level. Once the stock trades beyond the perceived 'price barrier', volatility tends to increase. The stock price will then trend in the breakout's direction.

Traders are always looking for strong momentum, and the actual breakout can be a sign to enter a position and profit from the market movement.

Breakouts are common in most markets. Large price movements are typical within channel breakouts and price pattern breakouts, such as the well-known head-and-shoulders, triangle and flags patterns.¹ This pervasiveness is a key reason for the strategy's popularity.

Further, it can be a solid trading tactic. Whether you are a position trader or you prefer to skim profits off several daily trades, the concept tends to work equally well, regardless of your timeframe.

Of course, there are a couple of caveats to be aware of:

• traders taking advantage of breakouts will almost always place 'take-profit' and 'stop-loss' orders to manage their risk
• like all trading strategies, there is no guarantee of returns. Just because a strategy is popular does not mean your trade will be

How do breakouts work?

A breakout occurs when the price of an asset moves above a resistance level or below a support level. Breakouts indicate that the asset price will move further in the breakout direction – but importantly, they require higher than normal volume to sustain themselves. This signifies increased interest and conviction. Low-volume breakout patterns are prone to failure, meaning the asset price will be more likely to retrace.

Breakouts can be a subjective trading term, as traders tend to disagree about what exactly constitutes the support and resistance levels.

What is a support level?

When using technical analysis to support your trading decisions, looking at a chart over an extended period will usually show some support levels – areas where prices are usually supported. These support levels provide a 'floor' for asset prices, as whenever an asset falls to the support level, a wall of willing buyers is there to purchase because they think the price presents good relative value.

What is a resistance level?

A resistance level is essentially the opposite of a support level. On a chart, you can often find resistance levels as areas where prices usually stop (or are resisted) and can't go any higher because asset holders will sell for profit.

There is an element of 'positive feedback' when it comes to support and resistance. Many traders will have limit orders in place at the support level and take-profit orders at the resistance level. This is to manage their risk, which means that both levels remain rigidly in place for some time.

Types of breakout strategies

All breakout trading strategies have some tenets in common:

• Identifying your opportunity – find stocks with strong support and/or resistance levels. The stronger the support or resistance, the better the result
• Waiting for the breakout – most strategies require patience, and breakouts are no exception. You need to wait for the stock price to make a sizeable move
• Setting a profit target – you should be sure of when to take profits before you place your trade. It can make sense to use a combination of limit orders and take-profit orders to manage your risk of loss and lock in a profit. It's usually a good idea to trade towards the market close, as it can be hard to tell whether prices will hold at any level at the open
• Allowing the stock to retest a level – when a stock breaks a support level, the old support becomes the new resistance. When it breaks its resistance level, the old resistance level becomes the new support. Most trades will see the stock retest the broken level fairly quickly, and if it breaks back through it, you should consider accepting the loss

Continuation breakout strategy

The continuation breakout strategy is an approach that 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.

Traders start by identifying a trend, then look for a 'consolidation' phase – the strategy starts delivering returns when the price breaks out of consolidation and moves beyond the key level of support or resistance. This is when you place the trade, with the profit target set by measuring the height of the consolidation phase and projecting it in the direction of the breakout.²

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. The same theories that apply to the continuation breakout strategy remain relevant, as do the general tenets.

How to start trading or investing using breakouts

How to invest in breakouts with us

1. Create an account or log in
2. Search for the stock you'd like to invest in
3. Select 'buy' in the deal ticket (you can only go long when investing)
4. Choose the number of shares you want to buy
5. Open and monitor your position

How to trade on breakouts with us

1. Create an account or log in
2. Choose between spread bets and CFDs and search for your breakout opportunity
3. Select 'buy' to go long or 'sell' to go short
4. Set your position size and take steps to manage your risk
5. Open and monitor your position

Learn more about the differences between investing and trading. Investing in shares directly is typically lower risk, while trading on leverage offers higher rewards in exchange for increased risk. This means you could gain – or lose – money much faster than you might expect, including losing more than your deposit. You should assess your risk appetite carefully before engaging in leveraged trading. No returns are guaranteed.

New to investing or trading? Try out our demo account.

Pros and cons of the breakout trading strategy

As with all strategies, trading breakouts comes with its own unique set of advantages and drawbacks.

Pros of the breakout trading strategy

• Profit potential – breakout trading can be profitable because an asset's price can move rapidly when it goes past the breakout³
• Objective entry/exit points – the strategy takes the emotion out of the trade because there are very clear points to time your trade, both for profit-taking and accepting a loss
• Multi-market usability – breakout trading applies to many markets, including equities, commodities and forex breakout strategies
• Time-friendly – traders can set their automatic orders after they have conducted their analysis, then leave the market to move without worrying about constant adjustments
• Manageable risk – through a combination of tools such as stop-loss orders, total risk can be managed simply to help mitigate potential losses

Cons of the breakout trading strategy

• Rapid pace – traders must usually be able to make rapid decisions as the market moves. This pressure is not for everyone
• Patience – alongside acting quickly, the breakout trading strategy requires traders to be capable of waiting for the breakout and then confirming the direction of the trend. You can spend time analysing opportunities that never end up in a trade
• False breakouts – so-called 'fake-outs' can occur, where the asset price breaks out of the consolidation phase but then quickly reverses, resulting in a loss. You can minimise the chance of this occurring by checking additional confirmation signals, but this increases the risk of missing the opportunity altogether⁴
• Volatility – breakout trading occurs in highly volatile markets, which means that you can do everything right and still suffer a loss. No strategy is foolproof
• Trading costs – the strategy often involves many small trades, which increases platform fees and bites into returns over time

Breakout trading strategy summed up

• A breakout is when a stock price moves outside a defined support or resistance level with increased volume
• The breakout strategy is a popular trading approach used by active traders to take a position within this trend's early stages
• A breakout trader will enter a long position after the stock price breaks above a resistance level or goes short if the stock breaks below support
• Breakout trading can be profitable as an asset's price can move rapidly when it goes past the breakout
• There is a risk of trading on false breakouts, where the asset price breaks out of the consolidation phase but then quickly reverses, resulting in a loss