A breakout is defined as a stock price movement beyond a predetermined level of resistance or support with increased volume. Breakouts show the potential for the price to move in the breakout direction.
If there is a breakout to the upside, there is a high chance that the price will go higher, and similarly, if there is a breakout to the downside, the price will probably go further down.
The reason for the breakout to occur is that the stock’s price has been contained below a resistance level or above a support level for some time. When the breakout occurs at a high volume, the price is more likely to move in that direction.
Breakout trading can be used for intraday trading as well as short-term (one week to a month) and long-term (more than a month) trading using different time frame charts.
Several chart patterns can be used for breakout trading; however, the most commonly used pattern is the triangle pattern.
There are three types of triangle patterns: ascending, descending, and symmetrical triangle patterns (as shown below), which can be identified in the chart for trading.
Let’s discuss these patterns one by one.
Ascending triangle pattern:
This breakout pattern is a bullish formation and occurs when the stock price breaks the upper horizontal trend line with surging volume.
This upper horizontal trend line acts as a resistance. The lower trend line is inclined at an angle and rising diagonally.
The lower diagonally rising trend line shows the higher lows formed in each swing as the buyers slowly increase their bids.
Later, the buyers rush into the stock above the resistance price, triggering more buying as the uptrend continues. The upper trend line acting as resistance until now becomes the support for the stock.
Descending triangle pattern:
This breakout pattern is a bearish formation, which is an inverted version of the previously discussed ascending triangle.
The lows which are formed inside this pattern are almost the same, resulting in a horizontal trend line.
There is a decline in the upper trend line towards the apex, resulting in forming a triangle. The breakdown takes place when the price breaks the lower horizontal trend line, which was acting as a support. Now, this support line works as a resistance.
Symmetrical triangle pattern:
A symmetrical triangle is formed with the help of a diagonally falling upper trend line and a diagonally rising lower trend line.
As the price moves toward the apex, it breaks the upper trend line and uptrend with rising prices or breaks the lower trend line and downtrend with falling prices.
How to use triangle patterns for breakout trading
The steps which are involved in breakout trading using triangle patterns are common to all three patterns discussed:
1. Look for stocks which are trading in a range for sometime, so that this setup can be applied easily.
2. Draw the trend line joining the high and low prices of the stock.
3. An ascending, descending or symmetrical triangle pattern should form after joining these points.
4. More consolidation happening at the triangle’s apex shows that it may give a good breakout.
5. In an ascending triangle chart pattern, a trader should enter a long position after the confirmation, which is given by a green candle above the resistance line. Also, the green candle should show good volume (can be determined using a volume indicator).
The stop loss should be kept at the lowest point of the same green candle. The target should be an amount equivalent to the broadest section of the triangle.
In the descending triangle chart pattern, the trader should enter a short position once a red candle breaks the support line. Stop-loss should be kept at the high point of this candle.
The difference between the entry point and the vertical distance between the two trend lines should be the target price.
In the symmetrical triangle chart pattern, a bullish or bearish trend depends on whether the breakdown is happening from the upper or lower trend line. The stop loss is generally kept just below the breakout point.
What are the limitations of breakout trading?
Every strategy comes with limitations, and so does breakout trading.
When a stock is trading in a range, there are very high chances of false breakouts. A false breakout occurs when the price breaks the support or resistance, but then comes back within the previous range.
The problem of false breakouts can be tackled by avoiding entry immediately after the price breaks the support or resistance. A trader should wait till the candle closes (confirming the breakout’s strength) and then make an entry.
Sometimes, after giving a breakout, the price increases sharply. The trader is pleased to see this; however, the price again comes back closer to the entry point in the next few seconds or minutes.
The trader gets confused by this scenario with a false breakout and exits the trade with a small profit. However, the price corrects and starts moving back in the breakout direction.
Key takeaways from this Breakout trading guide
Breakout trading seems to be a straightforward trading strategy to execute, but there are few limitations to using this method, such as false breakouts and corrections to breakout points. With the right practice and tools, you can master breakout trading in no time!
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