Trading stocks, commodities, or currencies can be a lucrative way for an individual to generate returns. There are various strategies and indicators one can use to benefit from price movements in the markets. The breakout strategy is one such strategy that helps traders capitalise on the price momentum once a financial security breaks through an important level. Let’s take a closer look at what the breakout strategy is and how to trade it.
Breakout strategy or breakout trading refers to when a trader buys or sells a financial security once it breaks an important support or resistance level. In a breakout trading strategy, traders identify financial securities that have been trading in range or consolidating for a while. Traders mark key support and resistance levels along with trend lines to identify potential breakouts.
In a breakout trading strategy, one may use indicators such as moving averages and also study candlestick patterns that can help in gauging the direction of the breakout. Traders also pay close attention to the volume of the security to confirm the breakout.
Breakout trading can be applied to various assets such as stocks, indices, commodities, and currencies.
Let’s look at an example of a breakout trade:
Stock ABC had an impressive rally from Rs.50 to Rs.100. However, the stock has been trading in a range of Rs.100 and Rs.110 for the past few months.
A trader notices that the stock is consolidating and trading within a range. The trader then marks the key support level of Rs.100 and the resistance level of Rs.110.
Eventually, ABC’s price crossed Rs.110. The trader confirms the breakout by checking the volume of the stock.
After confirming the breakout, the trader enters into a long position in the stock and places a stop-loss order at a predetermined level.
Since the breakout was genuine, the stock price rallied from Rs.110 to the trader’s take profit level of Rs.150.
Breakout trading strategies can also be applied when a trader has a bearish view and expects the price of a security to decline.
A breakout trading strategy can prove to be useful as traders can capitalise on different types of breakouts.
A horizontal breakout takes place when the price of a security has been trading within a range. The range is marked by a support and resistance level. The price may either give a breakout either on the upside or on the downside. The breakout ends the consolidation period and the price moves significantly in either direction.
A trend line is used to mark the prevalent trend of a security by connecting the highs or the lows. A price may often take support or face resistance at the trend line. If the price gives a breakout above or below the trend line, it signals a reversal of the ongoing trend.
A triangle breakout can be identified once the price of a security breaks through the upper or lower trend line of a symmetrical, ascending, or descending triangle. Depending on the underlying trend, the breakout can signal a trend reversal or continuation.
A breakout from the flag or pennant patterns usually occurs after the price has moved in one direction and has consolidated for a while. Once the stock price breaks out from the pattern, traders can expect the trend to continue.
A head and shoulder pattern or an inverted head and shoulder pattern has a neckline. Once the stock price breaks below or above the neckline, it signals a reversal of the trend.
A breakout strategy can prove to be a useful strategy for the following returns.
A breakout strategy allows traders to capitalise on the momentum with which the price moves after consolidating or breaking out from a pattern. As a result, traders can benefit from a higher potential upside.
Breakout strategies are suitable for various asset classes. A trader can identify breakout patterns and enter into trades across stocks, indices, commodities, or currencies.
Breakout strategies are easy to understand and implement with predetermined criteria that need to be met. As a result, breakout trading strategies are suitable for beginners as well as experienced traders.
Just like any other trading strategy, a breakout trading strategy has certain limitations as well.
One of the key disadvantages of the breakout trading strategy is that breakouts may fail. At times the price may break out from a particular level but quickly reverse resulting in many traders getting trapped in the trade.
While trading keeping emotions aside is vital. In a breakout strategy, it is important to have a grip over your emotions to prevent any early entry or any impulsive trades.
Market volatility can negatively impact a breakout. Although the price may have broken a level with volume, in volatile conditions, the price may reverse suddenly and result in losses.
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While trading a breakout or breakdown, traders should keep an eye on several things.
Trading breakouts can prove to be a rewarding trading strategy and is applicable across various asset classes. Correctly identifying and confirming a breakout are key aspects of a breakout trading strategy. Similar to another trading strategy, following sound risk management principles can help traders preserve their capital.
Disclaimer: This content is solely for educational purposes. The securities/investments quoted here are not recommendatory.