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Ric Cox

pro MEMBER SINCE 2018

Richard has more than two decades of experience in the financial markets and has had his writing appear on CNBC, NASDAQ, Economy Watch, Motley Fool, and Wired Magazine

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25 min read 29th of Jun, 2018
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Breakout Trading Strategy Tutorial

Breakout trading is a financial strategy that allows investors to identify and capitalize on surging market trends while they are still in their earliest stages.  Generally speaking, active traders will use breakout trading techniques as a starting point to establish positions prior to major changes in market prices.  Breakout trading environments are often characterized by rising volatility, which means that stop losses are required in order to minimize risk and protect against unexpected reversals in market activity.

When many people hear the term “breakout trading,” the first thing that comes to mind is a stock trend that rallies higher.  However, these ideas can just as easily be applied to negative market scenarios (i.e. downside or bearish price breakouts) that can be accurately identified before establishing short-sell positions.  Additionally, the technical analysis concepts used in these strategies can be applied in any asset class (i.e. stocks, forex, cryptocurrencies, commodities, etc.) to structure positions and achieve profitability with a high rate of success and relatively little drawdown.

Market Events: What Is a Price Breakout?

A price breakout is generally defined as a change in asset valuations that extends far beyond prior support and resistance levels.  These market events are often characterized by significant increases in trading volume and volatility as new participants aim to capitalize on the emerging developments.  Significant increases in buy/sell interest amongst the majority of the market’s traders is what ultimately propels asset prices to new high/lows.  During breakout environments, this occurs in a relatively short period of time.

Essentially, breakout traders will enter into long positions after the price of an asset moves above (or “breaks” above) clearly defined resistance levels.  Conversely, breakout traders will enter into short positions after the price of an asset falls below (or “breaks”) prior support levels.  Once markets violate these previously established price barriers, traders will typically witness rising volatility and trend extension in the direction of the original price break.  In other words, a strong break of support or resistance tends to generate significant follow-through, fueled by the initial momentum that has developed in the market.

In the chart history shown above, we can see an example of how this phenomenon works in real-time.  On two separate occasions, bullish investors have propelled asset valuations above their prior resistance levels.  In the process, many bearish traders that were already involved in market short-sell positions were forced to trigger stop loss orders and exit their trades.

Remember, a short position that is stopped out ultimately turns into a new long position (as the original trade is reversed and closed).  The resulting transaction flows essentially create new “buy” positions in the market and this activity helps propel further gains in asset prices.  As each of these bullish transactions begins to work in combination with one another, asset prices break through previous resistance levels and markets establish a clear upward trend.  Breakout traders that are able to spot these events in their earliest stages would be able to take long positions at relatively low market valuations and capitalized on all of the positive price moves that follow.

In the next example, we can see how prices might behave in the event of a bearish breakout.  On this chart history, prior support levels are tested on multiple occasions before finally breaking to the downside and sending market valuations much lower.  Breakout traders monitoring this support level prior to the break could have placed short-sell orders just below this price zone and captured significant profits (with very little drawdown) after the trade became active.

One element that traders should note is the fact that price breakouts tend to be characterized by larger candlestick formations (relative to the preceding time periods).  It is quite noticeable that these candlestick patterns tend to have extended candle bodies.  Those familiar with Japanese candlestick strategies might notice that these are also characterized as periods of decisive market action.  In other words, the market is sending a very clear signal that a new trend is developing and that the price momentum that follows next is likely to be forceful.

Market Trends: Importance Of Price Breakouts

Breakout periods represent an important event in the broader behavior in the financial market for a variety of reasons.  Essentially, they project an emerging paradigm in the market’s valuation expectations and signal the possibility of rising volatility in the future.  Unfortunately, a majority of traders actually lose money in breakout environments because the severity of these new price moves is generally unexpected and rapid changes in market expectations often take traders off-guard.  However, breakout scenarios can offer substantial opportunities to profit when successful traders are able to identify potential volatility events before they begin to develop into major market trends.

Early Breakout Signals: Basic Chart Patterns 

Breakouts can occur in any market environment and the most explosive moves tend to become visible as classic price patterns complete according to the rules of technical analysis.  Examples include channel breaks, triangle patterns, flags, trading ranges, and pennants.  For these reasons, breakout traders shouldn’t restrict themselves to individual market scenarios when seeing out new trading opportunities.

In many cases, breakouts can be particularly deceptive because they occur as volatility is actually contracting.  Think of it like a coiled spring: all of the major action generally happens after a slow period of contraction.  In the following sections, we will take a look at some of the price patterns that often precede price breakouts.  Then we will assess the ways projected price activity can be used to determine a trading stance once the breakout finally occurs.

Breakout Trading Environments

In the first chart examples shown above, we can see how the initial breakout event might appear on a price chart.  In the following examples, we will look at some of the ways projected follow-through might become visible in the market.

In this example, we can see a Descending Triangle Breakout.  These chart patterns tend to indicate bearish price trends and we can see that this scenario unfolded once prices fell through the previously established zone of support.  Traders might notice that the candles that became apparent during the break are all red.  This is a bearish signal which confirms that market activity is clearly negative.

With momentum focused on the downside, prices continue moving lower after the breakout example occurs.  Bulls eventually make another attempt to send prices higher but this move fails once prices return to the initial breakout point.  Remember, support levels are expected to act as price resistance once they are broken.  The retest (and ultimate failure) at the breakout point confirms the validity of the pattern and traders could establish short positions now that it’s clear market momentum is focused on the downside direction.  Stop losses could be placed just above the bearish breakout point (white line) as shown above.

In the next example, we can see an Uptrend Channel Break.  In this case, bullish investors steadily pushed valuations higher until the uptrend reached its point of completion.  Once this bullish trend was over, prices broke strongly downward.  This move invalidated the channel and suggested a new downtrend was beginning.  Breakout traders could have spotted this trend in its earliest stages and entered into short positions while experiencing very little drawdown as prices moved sharply lower.

Selecting Breakout Trading Opportunities

Whenever an investor is in trading breakout environments, it’s essential to consider the support and resistance levels markets have previously defined for the asset.  Several factors influence the strength and validity of these levels, including the number of times they have been tested and the length of time those important levels have been in play.  Consider the chart Bearish Breakout example below, where a key support level is clearly tested on multiple occasions.

Breakout traders tend to view support and resistance levels as being stronger (or more valid) if they have been tested by the market on multiple occasions.  In the example above, we can see how continued re-tests of support led to a build-up of long positions above this support level (with stop losses likely placed just below).  Once this level was finally broken, the next move to the downside was quite forceful.

To capitalize on this move, breakout traders could have placed an entry order just below this support zone so that a new short position would be triggered in the event of a downside break.  As we can see, short positions established under this scenario could have captured significant gains (with essentially no drawdown in the process).

In our next chart example, we can see how these same rules also apply to trendline support and resistance levels.  Here, price tends are caught in a strong upward move with trendline support tested on several occasions.  Once the market’s buying activity begins to slow, this clearly defined trendline support breaks and investors react by closing long positions and establishing new shorts.  Support trendlines are expected to begin acting as resistance lines once they are broken, and this occurs in the example above.  After the trendline support breaks, markets then re-test the level and the failure here is what ultimately leads to the massive decline in price valuations.

In this case, the bearish breakout (and eventual re-test) initiates an entirely new downtrend.  If closely monitoring the trendline support level highlighted above, breakout traders could have spotted this sharp price move in its initial stages and opened new positions accordingly (once the breakout event confirmed a true bearish trend reversal).

Breakout Strategy Examples 

In this example, we can see prices face resistance on several occasions.  Eventually, the buying activity puts enough pressure on the topside to break through this supply containment zone.  Following this bullish event, markets were able to establish a new upward trend.  The first wave of this trend was followed by a downward re-test of the previous resistance level.

Classical rules of technical analysis suggest that resistance levels are likely to be retested as support in a later time period.  We can see this event in the chart history above accompanied by rising readings from a Momentum indicator.  Bullish indicator readings begin to develop as the price history shows higher lows in the asset valuation.  Momentum indicators provide an objective assessment of the positioning stances traders adopt.

Bullish indicator readings ultimately projected the upward price moves that became visible with the break of resistance, so these would be factors that might lead to buy positions in the asset.  However, since this strategy requires traders to plot positions in advance, buy orders should be placed above the resistance level defining the breakout event.  Market moves following these breakout moves tend to be forceful and volatile.  For this reason, drawdown is often minimal for traders implementing breakout strategies.

In the next example, we can see the formation of a bullish channel breakout.  To the left of the chart, prices trade near long-term highs but quickly fall through shorter-term range trading support levels.  This creates a downtrend channel as markets trade in what is, essentially, a sideways trading range which slopes in a downward direction.

When we compare this positive outlook with the objective indicator readings in the Relative Strength Index (RSI), we see that similar arguments can be made.  As the price reached the bottom of its downward trend channel, indicator readings in the RSI fell to extreme lows.  As prices would be viewed as heavily oversold at this stage and this lends credibility to anyone looking to establish long positions.

Ultimately, breakout strategies rely on a confluence of events to create position stances that have a high probability of generating gains.  In the example above, we can see a trend scenario that actually turned a downside price event into an upside breakout opportunity.  Some trading strategies might have signaled sell positions as momentum began to indicate further downside strength.  However, short positions would have entered heavy losses and hit stop losses rather quickly.

Real-Time Trading Examples: Breakout Strategy

Next, we will look at a real-time trading example using the price of crude oil.  To the left of the chart, prices are moving higher until valuations begin to fall through a series of important support levels.

As the previous uptrend ends, a slowdown in market momentum causes a sideways trading range to form at lower levels.  However, to the right of the chart, we can see that the initial uptrend has returned.  Breakout events occur as crude oil prices overcome resistance at $53.60 per barrel.

Long trades can be established at $53.72 with a downside stop loss at $53.45 (below the bullish breakout point).

Profit targets should be structured using a risk-reward ratio of at least 3x, which means traders can consider taking gains as prices reach $54.50.  In some cases, traders will move their stop losses to a breakeven point once the initial profit target is reached.  

Trendline Price Breakouts 

In the next example, we have a bullish trendline breakout in the price of oil (at $55.20):

After a long downtrend, crude oil markets have reversed higher.  Traders going long at $55.20 would need to place a stop loss at $54.90 in order to achieve a favorable risk-reward ratio.

This would set the profit target above $56.30, using the risk-reward ratio described in the strategy.  Crude oil markets quickly send valuations higher (after the trendline breakout event). The long trade is able to capture gains with very little drawdown.

Breakout Trades: Managing Risk 

One of the central benefits when using breakout strategies is that it’s often easy to achieve a 3:1 risk-reward ratio in most positions.  The reason for this lies in the fact that breakout strategies have the advantage of added momentum behind each position.  This momentum produces several different positive effects, as most of the volatility should move in the direction of the trade.  For example, if resistance breaks on a sideways trading range, stop losses on open short positions will be triggered (and turn into “buy” positions when they are closed).  If this momentum is strong enough to propel prices into sizable gains, very little drawdown is likely to be incurred during the process. 

Additionally, stop loss levels can be kept relatively tight when using these strategies.  This is another substantial benefit because it means the potential for loss is relatively small when compared to the potential for profit in each trade.  As a general rule, stop losses should be placed below the support level that preceded an upside breakout through resistance levels (in long positions).  Conversely, stop losses should be placed above the resistance level that preceded a downside breakout through support levels (in short positions).  Essentially, price movements back through either of these areas would be enough to invalidate the original logic behind each trade and this would mean that it wouldn’t make sense to continue holding the open position.

Overall, breakout strategies offer incredible potential for gains.  This is the primary reason active traders favor breakout techniques as some of the best trading strategies available in the market.  They can work very well after news releases or major economic reports as these periods often create trading ranges that will typically break in a forceful fashion once the news event is released to the public.  At the same time, breakout strategies also require strict trade management, as increased price volatility has its own potential for loss.

Summary

  • Breakout trading is a market strategy that allows investors to capitalize on emerging price trends while they are still in their earliest stages.
  • Price breakouts can occur on all time frames and in any market environment.
  • Whenever an investor is in trading breakout environments, it’s essential to consider the support and resistance levels markets have previously defined for the asset.
  • Support and resistance levels are viewed as being stronger (or more valid) the greater the number of times they have been tested by the market.
  • The longer a clearly defined support/resistance level has been visible in the market, the better the trading results (based on degree of trend momentum) when the price breakout finally occurs.
  • After a price breakout, prior support levels are expected to act as resistance (and prior resistance levels are expected to act as support).
  • After prices close above previous resistance levels, breakout traders may establish long positions (bullish). When prices close below previous support levels, breakout traders may establish short positions (bearish).
  • Breakout trading environments are often characterized by increased volatility, which is why protective stop losses are critical in preventing unnecessary trading losses.
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