A stock breakout is a technical analysis term defining a price movement that passes a resistance or support level. The movement continues until the next resistance or support level. A breakout will be accompanied by increased volume, which indicates buying/selling demand is in excess of the supply, and the price follows. Breakouts are the beginning of trends in a security’s price. We will explain why breakouts happen, their types and identifying them, and how best to trade them.
What Causes a Stock Breakout?
For our discussion, we will deal only with bullish breakouts. However, there are equal and opposite shorting opportunities with downward breakouts after consolidation. Uptrends will begin with a stock breakout, passing a support level with strong volume leading to higher highs and higher lows on the backs of FOMO buyers and short-sellers covering their bad decisions. The key is the heavy volume as a buying spike spurs new highs. The result is a prior resistance level now becoming a new support level.
How It Might Happen
A smart money trader may short a stock at a resistance level and buy at the support level, staying in a range. The more the range repeats, the more she repeats her moves, but other traders will follow her play. It becomes apparent with some short-sellers continuing their sales slightly above the resistance level as the price just passes it, assuming another pullback that doesn’t come.
As the price continues higher, the volume builds with our smart money investor covering her position to prevent severe losses. At this point, both retail and institutional fence-sitters jump in trying to catch the upward surge. Both the price and momentum bring in volume, with the last of the short-sellers covering their positions. The stock is now hitting intraday scanners, and even CNBC begins talking about the new breakout.
This pushes FOMO buying that continues the upward climb. And you have a stock breakout. It can happen quite fast and you don’t want to be chasing those types of trades.
Identifying A Stock Breakout
Usually, a stock breakout will be an Intraday breakout that happens when scanners and Fox Biz/CNBC/Bloomberg promote a day’s fast-rising stock. Or a 52-week breakout where a company makes a new high and is also discussed on financial news. This, however, may mean that transparency has been fully recognized and profit-taking is likely to happen soon.
These two types can be broken into three categories:
- Reversal Breakout– a down-trending price that reverses and spikes with high volume. Bargain shoppers and buying and shorts cover their positions. This stock breakout is often a result of positive news.
- Consolidation Breakout– A trading range with identifiable and defined support and resistance levels and light volume. The breakout forms tentatively with rising volume and then violently spikes with volume.
- Triangle Breakout– The resistance level is flat with a rising support level (called an ascending triangle). Motivated buyers are increasing their bid price, reducing the pullback range which shrinks to nothing, and the resistance level is broken.
How Do You Buy on Breakouts?
Trading a stock breakout is an eight-step process:
- Identify Candidate- Asset must have strong support and resistance levels; the more robust, the better.
- Wait for Breakout- Don’t jump the gun; look for movement and confirmation(differs from wiggle or head-fake when breakout sustains price above the prior resistance level) outside the resistance level; usually, end of day trading is best.
- Set Profit Objective- set a profit level the same size as the previous support and resistance range’s height, don’t be greedy.
- Allow for a Re-test- With a breakout, the prior resistance level becomes the new support level; it will likely test that again, don’t be surprised.
- Look and Plan For Failure- If your stock re-tests the new support level and drops back to the old range, it has failed. Set a stop loss to close your position, usually around 80% of the previous range height.
- Exit A Questionable Trade Near The Market Close- Much can happen overnight, and the opening can be very different. If you are down below the support level, it is better to close the trade just before the market close; move on and find a new opportunity.
- Patience Is a Virtue– remove emotion from your trading and be objective.
- Exit Trade at Your Target- remain in the trade untill you reach your goal and get out. You may also set a time target to exit as well at the current price.
A stock breakout is an easy to identify trade that can lead to consistent gains. Make sure to monitor them closely and act when necessary. The more experience you get finding and playing them, the better you will become. Like always, never put at risk in one trade more than you can afford to lose, and good luck with all your trades.