How to Trade Breakout Stocks

Thu Mar 18, 2021, 12:41 pm | by Caitlin McCormack | No comments

Some traders want to be the first to join the dance when a stock in the market is on the verge of making a huge move. Trading breakout stocks captivates the attention of most rookie traders for its ability to throw up quick profits, but without the right knowledge, it can be as dangerous as it is notoriously easy.

Breakout trading seems flawless in theory, but you’ll only make money when the rubber meets the road. Today’s blog provides insight into how to identify and trade potential breakout stocks as well as how to identify false breakouts.

What is a Breakout Stock?

A stock breakout is a tradable event that you can base your entire strategy around. A breakout is simply when a stock or stock index moves beyond a level of resistance and support that it has struggled to move above or below in the past. Therefore, a breakout stock is a share that moves beyond its support or resistance level.

If a stock climbs above its resistance level, it will typically continue with the sustained upward movement. If it goes below its support level, a bear run might be imminent. The support and resistance levels are often seen as stronger when a stock hits them severally. In turn, any stocks that move through these stronger barriers are more likely to go on extended moves. Volatility often tends to increase while prices will trend in the breakout’s direction.

Remember, stocks aren’t the only securities that can break beyond support and resistance levels. Markets such as forex, commodities, and cryptocurrencies, which are favored by technical traders, can also see breakouts.

When adopting the breakout trading strategy, it’s important that you take into account the underlying stock’s support and resistance levels. The more times a stock price touches these areas, the more valid the levels are and the more essential they become. Similarly, the longer the support and resistance levels have been in existence, the better the outcome will be when the stock price finally breaks out.

As prices continue to consolidate, different price patterns occur as we shall find out below.

Breakout Stock Patterns

The price action within the share market is often affected by the demand and supply, and the sight of a breakout signal implies that buyers have succeeded in pushing the stock price beyond its resistance level. In case of a negative breakout stock, sellers can push the price below the current support level. While breakouts don’t necessarily translate into huge price movements, each price movement has multiple breakouts, often beginning with an initial breakout.

There are several patterns you should recognize for your investment research if you intend to catch the potential stock breakouts early enough. Below are a few patterns that can help you identify breakout stocks.

Cup and Handle Breakout

The cup and handle pattern formation is common for both individual stocks and stock indices. It takes place when the price suddenly falls from a high point and then gradually recovers to that initial level. It must not be an all-time high, it could be a 52-week high or any point that looks significant on the chart. This will form the cup.

When the share price approaches the prior high, the size of price movements will start contracting when the price swings start getting smaller. You may draw trendlines on the swing lows and highs of the price swings, in order to see the cup handle. You may consider entering a buy position if the price moves above the upper trendline.

The cup can spread out from 1-6 months, or probably longer. The handle will form and complete over 1-4 weeks.

AMD Chart Showing Cup and Handle
AMD Chart Showing Cup and Handle

Flags

Flags are often short-term continuation patterns that signify a small consolidation before the previous move resumes. Flags can be detected in any time frame though it often consists of about 5 to 15 price bars, but this isn’t a set rule.

A flag is typically a small rectangle pattern sloping against the previous trend. If the previous trend was up, the flag slopes down, and vice versa. Since flags occur within very short durations, the price action must be contained within two parallel trend lines.

The move that comes before the flag portion of the pattern (pole) should be a sharp move that’s nearly vertical and be significantly larger and quicker than the price moves before it. The swift movement indicates strong buying or selling action. It’s this action that you should look to capitalize on by trading a breakout from the flag formation.

Bull Flag on OPCH Chart
Bull Flag on OPCH Chart

Triangles

The triangle patterns also provide analytical insight into what may be forthcoming, and they come in 3 different types:

  • Ascending triangle patterns are bullish indicators that signify the likelihood of a stock’s price soaring higher. You can create this pattern with two trendlines. The first trendline is usually flat along the top and acts as the resistance point which shows the beginning or resumption of an uptrend should the price successfully break above it.
Ascending Triangle on GLW Chart
Ascending Triangle on GLW Chart

The second trendline (at the bottom of the triangle) forms the price support and acts as a line of ascension formed by higher lows. This pattern indicates that sellers haven’t been successful in their attempts to push prices lower.

  • Descending triangle patterns provide a bearish signal showing that the price will continue to decrease as the pattern completes itself. Two trend lines depict the pattern, except that the supporting bottom line is flat while the resistance line slopes downward. A descending triangle is interpreted as an indication of possible trend change and market reversal. Traders can short sell during the downside breakout while placing a stop-loss order slightly above the highest price attained during triangle formation.
Descending Triangle on ESI Chart
Descending Triangle on ESI Chart
  • Symmetrical triangle patterns occur when the upward and downward movements of a security’s price are confined to a smaller area over time. The price moves create lower swing lows and lower swing highs. Connecting the highs and lows with a trendline creates a symmetric triangle where the two trend lines meet. Eventually, the price may break out in one direction or the other to form a sustained trend. Regardless of the direction, the momentum generated when the price breaks out of the symmetrical triangle is enough to push the market price significant distance.
Symmetrical triangle on AMSC chart
Symmetrical triangle on AMSC chart

Indicators Used to Track a Breakout

  • Clear Patterns. Any of the above patterns could help you identify a stock breakout. Depending on the trend expected, you should always have an entry or exit plan. If the pattern shows an imminent uptrend, then you’ll want to open a trade in a security. If a downtrend is imminent, you’ll want to exercise some short selling.
  • Moving Average Convergence/Divergence. The MACD tool can help you evaluate price changes that take place quickly, thus helping you understand the momentum behind a breakout. By using a histogram, you can see the speed of the price changes as price movements approach a resistance level and break above. You can even identify potential breakouts even before the price gets to the line of resistance.
  • Besides spotting a price breakout, MACD may also help you figure out when to close your position based on the slowing momentum, which could signify an oncoming price reversal.
  • Relative Strength Index. The RSI is an equally important indicator when you’re evaluating an imminent stock breakout. This index used a 100-point scale to analyze buying trends and establish whether a security is oversold or overbought. When these conditions develop, it provides a strong indication for a potential price reversal, which can alert you to potential reversal breakouts arising from a market correction.

How to Identify Fakeouts

A fakeout refers to a situation where you enter a position anticipating a positive price movement or future transaction signal, only for you to see movement in a different direction. Fakeouts can cause considerable losses, that’s why you should always know how to identify them.

First, you need to wait for higher volume to confirm a breakout, but it shouldn’t entirely be about increased volume. Ideally, you want to first see a period of low volume trading before a spike in the volume. Light volume indicates that the market awaits significant information while a volume surge could indicate that the market has now transited into an active phase. And while a volume surge isn’t a rule of thumb for identifying breakouts, it points to better trade quality.

Besides, you shouldn’t act too fast on every piece of information you receive. Take the time to scan for potential breakout candidates and use chart patterns to weed out any weak prospects.

Final Thoughts

Stock breakouts can provide the opportunity to trade on huge price movements once prices break below the support level or above the resistance level. On the flip side, not all breakouts result in profit — prices could move in the opposite direction, leading to losses. It’s important that you learn how to identify stock breakout patterns and leverage any indicators that may guide your entry or exit from positions.