How to Play Breakouts

In the world of trading, there are numerous strategies that you can use, some are good and some will just lose you money. Trading takes discipline and hard work but it can be extremely rewarding. More specifically, trading breakouts can be challenging but with these tips, you should be able to have a good understanding of breakouts and how you can profit from them.

First lets all be on the same page by understanding what a breakout is. A breakout happens when the underlying price of the stock, commodity, forex, etc moves outside its support or resistance parameters. In theory, once a stock breaks support or resistance, the stock will continue to move into that direction until it finds a new trading range. Ideally, when a stock breaks its resistance, you should go long the stock. When support is broken, sell the stock short.

The great news about breakouts are that they can happen during any market condition. That is why some traders only trade breakouts and after getting the hang of it, you will be able to make some good money with it as well.

Getting down to business. There are several types of different breakouts that can occur in the form of different technical patterns: triangles, flags, head and shoulders, reverse head and shoulders, double bottom, double top, etc.

Here we have a chart of Convergys Corporation (CVG). As you can see the stock has moved above the purple line (resistance) and confirmed a breakout to the upside. The ideal place to enter a trade is the bar immediately after resistance has been cleared. Once the price action has cleared resistance, it must confirm the breakout before entering. If the stock opens up the next trading day, you january want to look at a buy. The reason why you need to wait for a confirmation is because of the potential “fake out”. A fake out happens when the stock has broken out but fails to establish a new trading range and selling pressures put it immediately back under the old resistance.

ACE Limited proves a good example of a fake out. As you can see, the stock had a tough time breaking the resistance initially but finally did…only for the price to be pushed back under the resistance line. This is why you must wait for confirmations to determine that the stock is actually breaking out.
It is important to note that the underlying market playing a major role in breakout trading. It is absolutely essential that you know the underlying trend of the market. If the market is rallying and in a bull market, playing upside breakouts is the ideal strategy. When the market is downtrending, downside breakouts are the way to play. Both ways make you money, as long as you do not try to bet against the market’s direction.

After you determine the market’s trend and you find a breakout candidate that you like, it is imperative that you first select your stop price and a sell price. These two will help protect you from yourself if and when the stock breaks out. If the stock breaks out, greed tends to come over us and we lose sight of our goals. If we have a predefined sell price, then greed’s role is limited and you will become a better trader. Next, always use stops. A stop is a limit order given to your broker that specifies a price at which you want to sell. Stops should be placed where you are willing to get out or your maximum risk.

This is just a introduction into breakout trading but there are a lot of important things to remember such as defining your risk up front by using stops and committing to a sell point. Additionally, you must determine where the market is heading first, and then find candidates that work with that trend. Breakout trading can be very rewarding but it takes great discipline to succeed in this world of trading.