Our guide to using the breakout strategy for identifying buy and sell signals
Last week in our trading strategies section we introduced support and resistance levels and how you can identify and trade them. Building on that we now move on to one of the most popular strategies – breakouts. Its premise is that supply and demand have quiet periods for different instruments, but when news, fundamental or technical reasons start pushing it in a certain direction, there is quite often a snowball effect that increases the strength and speed in that direction.
First off we should recap what support and resistance are – these are price levels that are formed when there are at least two occasions when the price reached them and immediately retreated in the opposite direction. They can be observed on all time frames and are based on a mix of technical and psychological factors.
Support and resistances don’t necessarily go together, but when they are found on the same chart, then we have the so-called trading range. This provides the opportunity to look out for breakouts in either direction. The ranges themselves can be either horizontal or angled (in which case there is a trend, something that we will get into more detail in one of our later posts).
Once you’ve found a strong support and/or resistance comes the slightly trickier part – deciding when to enter your trade. Just like the example in the video below, we’ll assume that we’ll be trading a breakout on a horizontal resistance level, i.e. one that is above the current price and has acted as a sort of a ceiling until now (it would be the same for downward movements below a support level).
Depending on different trading styles, risk tolerance, statistics and experience, traders vary quite widely on this issue. Some watch the charts constantly, waiting for the opportune moment. They then prefer to get into the “buy” position immediately after the resistance is breached, hoping to profit from the full upward movement. Although it promises the maximum profit, this approach poses the highest risk, as there is a phenomenon called “false breakouts”. If such a false signal occurs, the price won’t continue upward, it will instead return below the resistance line, without any profit and quite possibly with a loss.
Other traders who prefer not to pay as much attention to constant price fluctuations use pending orders – you can learn more about them here – strategically placed at levels above the resistance. For different currency pairs, stocks, commodities, etc., and their respective circumstances, this level is determined in different ways. It can be placed using indicators like Fibonacci or at a distance that previously signalled a breakout. In any case it should be in line with your personal trading plan. This type of order is less riskier than the previous one, but is still susceptible to mistakes, as pinpointing the perfect position for entering is dependant on many factors. (That said, it doesn’t always need to be perfect, just profitable.)
The third type of entry for trading breakouts is the least risky and respectively happens less frequently. It does involve watching the market more closely as the best possible time to enter the trade can happen at any time. What you should be looking for is the moment when the current Japanese candlestick on the chart closes above the resistance at a new high – and by new high we mean one that hasn’t been reached in the observed period, even by the fakeouts that previously returned to the range. If your risk tolerance is low, we recommend this trading style.
Trading breakouts is one of the most widely utilised trading strategies, as its conditions and set-up are not hard to identify once they are understood. Still there are risks related to the strategy, as fakeouts or big fundamental shifts can happen, overriding the suitable conditions for the trade. This doesn’t happen extremely often, but always has to be kept in check with reasonable stop losses.
If you have any questions please leave them in the comments, we’ll get back to you. You can also test the breakout strategy right away with our free Practice Account.