A breakout is when the price moves above a resistance level or moves below a support level.
The price movement of a breakout can be described as a sudden, directional move in price that is typically followed by increased volatility and heavy volume.
Traders who trade breakouts live by the motto, “No price is too high to buy and no price is too low to sell.”
Because not all traders recognize or use the same support and resistance levels, breakouts can be subjective.
Breakouts indicate the potential for the price to start trending in the breakout direction.
There are two types of breakouts:
- Upside Breakout
- Downside Breakout (“Breakdown”)
A breakout to the upside indicates that the price will start trending higher. This signals traders to possibly go long or exit short positions.
An upside breakout pattern represents a trading range in which prices move sideways between two parallel horizontal lines.
It’s often a pause or consolidation area within an existing trend, although sometimes the breakout results in a reversal to the prior trend.
In either scenario, an upside breakout through the upper resistance line signals an end to the consolidation period and the start of an uptrend.
Once the resistance level is broken, it reverses its role and turns into a support level if price experiences a correction or pullback.
A breakout to the downside, also called a breakdown, hat the price will start trending lower. This signals traders to possibly go short or exit long positions.
Once the support level is broken, it reverses its role and turns into a resistance level if price experiences a correction or pullback.
Breakouts that occur on HIGH volume (relative to normal volume) show greater conviction which means the price is more likely to trend in that direction.
Breakouts that occur on LOW volume (relative to normal volume) show weak conviction and are more prone to failure. Price is less likely to trend in the breakout direction.
How to Trade Breakouts
A breakout occurs because the price has been contained below a resistance level or above a support level, potentially for some time.
The resistance or support level becomes a line in the sand that many traders use to set entry points or place their stop losses.
When the price breaks through the support or resistance level, two things usually happen:
- Traders waiting for the breakout jump in.
- Traders who had placed their stop losses in this area get stopped out.
This surge in buying and selling will often cause the volume to rise, which shows that lots of traders were interested in the breakout level.
Breakouts are commonly associated with chart patterns, including rectangles, triangles, wedges, and pennants.
These patterns are formed when the price moves in a certain way that support and/or resistance levels develop.
These levels are monitored heavily by traders.
If the price breaks above resistance, traders go long. If price breaks below support, traders go short.
After a breakout, the price may, but not always, retrace to the breakout point before moving in the breakout direction again.
After an upside breakout, the price may retest its previous resistance level, which has now turned into a support level.
After a breakdown (downside breakout), the price may retest its previous support level, which has now turned into a resistance level.
This happens because some shorter-term traders will often buy the initial breakout, and then quickly take profit.
In order to exit their long position, they must sell. This selling temporarily drives the price back to the breakout point.
Fakeouts do occur regularly.
The price will often move just beyond resistance or support. This tricks the gullible breakout traders into entering.
The price then reverses and fails to continue moving in the breakout’s direction.
This can happen multiple times before a real breakout happens.
Trading breakouts is not easy.
Trading chart patterns like triangles, flags, and pennants provide higher-probability breakouts than ranges (or rectangles).
Since ranges are easier to identify, this means ranges attract traders who have opposite approaches:
- Breakout traders
- Range traders
In this scenario, opposites do not attract. They create fakeouts.