What is breakout trading?

What is a breakout?

A breakout is when a security’s price moves above or below an established support or resistance level, often leading to a significant bull or bear trend. Identifying and entering a breakout early is an attractive strategy for traders because it utilizes periods of high volume and volatility to return sizable profits.

Breakouts themselves occur due to a shift in the supply and demand of a security. Once the price of a security moves beyond a set boundary, more traders become involved in the movement, either actively as day traders or passively through various order types.

What is breakout trading?

Breakout trading is a strategy that capitalises on the potential price action during a breakout. Essentially, you try to predict when a breakout will occur and then profit from the resulting trend.

Breakout traders consist of three parts: spotting the breakout, entering the trade, and closing at the correct moment. Spotting breakouts is the key element and is done by identifying consolidated ranges formed when a price is trading within levels of support and resistance.

TIP: How do breakout trades gain momentum?

The longer it takes for the price to break out of the consolidated range, the stronger the resulting trend will be. A driving factor of this phenomenon is the traders’ actions around the levels of support and resistance.

When a security trades between support and resistance levels, many traders will set buy and sell stop orders right beyond these levels to capture the breakout. So when a breakout occurs, these orders are triggered and give further momentum to the breakout.

How to spot breakouts

To spot breakouts, you’ll need to follow two steps. First, you identify the support or resistance levels a market is struggling to break beyond. Second, you wait for a signal that indicates the breakout may be imminent.

As mentioned above, support and resistance ranges can take several shapes, but they all indicate impending or possible breakouts within the price action. Let’s look at a few key examples of consolidation patterns.

Rectangle and channels

Rectangles patterns occur when the price moves between horizontal levels of support and resistance, causing the entire price action to move in a sideways box. Channel patterns are like rectangles except they are angled up or down and indicate a bullish or bearish range trading. Like horizontal rectangles, angled channels maintain parallel levels of support and resistance.

Triangles and flags

Triangle patterns are characterized by converging trendlines connecting a series of highs and lows; they can be ascending or descending or symmetrical. Symmetrical triangles feature two converging trendlines and feature a neutral pattern; the breakout after the formation of a symmetrical triangle typically continues in the direction of the existing trend.

In an ascending triangle, the upper trendline is flat while the lower trendline narrows upward making higher lows. This formation indicates buyers are more aggressive than sellers, and the breakout is likely to occur on the upside.

A descending triangle is the inverse of an ascending pattern. The lower trendline remains flat while the upper trendline slants downwards from the price making lower highs. Typically, in descending triangles the price eventually breaks through the lower trendline. 

Flag patterns, or pennants, are short-term patterns that have less dramatic trend line convergences compared to triangles. They have a ‘flagpole’ at the beginning of the pattern created when price action spikes or dives sharply in the direction of the current trend. Prices then consolidate into a flag pattern before breaking out again in the same direction as the initial flagpole.

Head and shoulders

Head and shoulders patterns form as a baseline with three peaks, in which the middle peak is highest and the first and third peaks are near equal height. This formation often precedes a bullish-to-bearish reversal that occurs as a breakout.

Cup and handle

The cup and handle pattern forms when price action creates a u-shaped cup and then a handle drifting downward. This pattern is a sign of a bullish continuation, wherein the price will break above the resistance level at the rim of the cup after a short downtrend.

Once levels of support and resistance have been established, it’s time to look for a breakout signal. Most traders do this using indicators, which can also help you evaluate the strength of impending breakouts.

As well as indicators, many traders will keep an eye on a market’s volume as they watch for a breakout. A spike in volume can be a solid indication of a strong breakout that leads to a lasting trend.

MACD

The Moving Average Convergence Divergence (MACD) indicator uses several moving averages to evaluate recent price changes, allowing you to gauge momentum as price movement nears or breaks through lines of support and resistance. Conversely, traders can also use MACD to spot slowing momentum in a trend, letting them know when to exit a trade after entering the breakout.

Bollinger Bands

Bollinger Bands use lines of standard deviation and a 20-day simple moving average (SMA) and can be used to determine when price movement is swinging into a trend. When the price’s SMA moves above or below lines of standard deviation, a reversal breakout may occur. You can strengthen this signal by combining Bollinger Bands with the MACD to see the strength of possible reversals indicator by the Bollinger Bands. 

RSI

The Relative Strength Index (RSI) determines when a security is overbought or oversold, indicating its price may be ready to pivot in the other direction. The stronger the price reversal, the more likely a breakout will occur.

You can also use a volume RSI chart, where the changes in price are replaced by up-volume and down-volume for the formula.

How to trade breakouts

Once you’ve spotted an impending breakout, it’ll be time to plan your entry point.

There are three places to enter a breakout: prior to the breakout, on the breakout, and after the breakout. Each comes with varying levels of risk and reward.

How to close your breakout trade

Planning your exit is just as crucial as your entry when it comes to profiting from breakout trading. Before you open your position, you should look to establish a reasonable profit objective and set stop and limits appropriately.

Establishing a profit objective

There are several ways to establish your profit objective. For example, one method is to look at recent price action and determine an objective based on the range of price movement exhibited before the breakout. If the support and resistance levels were six points apart, a reasonable objective could be six points in the direction of the breakout. For non-parallel ranges like descending triangles, you can take an average of the price swings and set that number as your objective.

Exiting with a loss

Another advantage to the breakout trading strategy is the relative speed at which you can identify when the breakout is false. In a regular breakout, old support levels should operate as new resistance, and old resistance levels should become the level of support. If the price crosses back over one of the original levels, it’s a sign of a false breakout. You can set stop-loss orders at these original levels once you’ve entered the trade to protect yourself or exit the trade quickly once the failed breakout is confirmed to curb losses.

How to trade a breakout in forex

Trading breakouts in forex works exactly like any other market – although you’ll have to rely exclusively on volatility because you won’t be able to assess volume.

An easy way to time volatility when trading forex is to wait for the start of a new trading session, such as the London or New York section (the two busiest in forex trading). During the start of the sessions, related majors will experience higher volatility and are more likely to breakout from the consolidated ranges they traded in during slower sessions.

A prime example is the European Opening Range breakout strategy. Here, you would focus on EUR/USD, or any European major, at the start of the London, or European, trading session.

Breakouts are one of the most popular forex trading strategies. You can start trading breakouts with City Index in a few quick steps:

1. Open a City Index account or log in if you’re already a customer
2. Search for the currency pairs you want to trade, preferably ones that are experiencing strong support and resistance levels
3. Identify levels of support and resistance, set your stops and limits
4. Wait for a breakout, which you can confirm with the indicators mentioned below, and enter your trade at the beginning of the trend

How to identify false breakouts

Sometimes the price of a security can momentarily break through a support or resistance level, only to fall or rise back into the channel it was previously trading in. This is known as a false or failed breakout and often occurs when traders misidentify levels of support and resistance.

As we’ve covered, high volume can indicate the difference between a real breakout and a false one. A volume indicator will signal if a breakout is strong or not, and how established levels of support and resistance are. Volume should pick up when the price reaches levels of support or resistance, if not, any breakout beyond these levels may likely be a fake-out.

Unfortunately, you can only identify a breakout as false once it moves back into its original range, which makes stop-loss orders critical to breakout trading. As mentioned in the exits section, setting a stop-loss order at the level of support or resistance involved in the breakout will protect you from running up losses in the event of a false breakout.