Breakout
In the trading world, the concept of a ‘Breakout’ plays a crucial role for those trying to interpret market movements and take advantage of them. Let’s take an example of a stock XYZ. Suppose it has been trading between $ 10 and $ 12 for a while. A breakout occurs when the price of XYZ exceeds $ 12 (an area of resistance) or falls below $ 10 (an area of support). For instance, if XYZ’s price suddenly jumps to $ 13, it’s a breakout above the resistance level. This event is particularly significant when the trading volumes causing it are higher than normal, given the increased likelihood that the price will continue to move in that direction.
So, what does a breakout indicate? It signals that the price, previously held below a resistance level or above a support level, may have started a new trend. Resistance or support levels act as guidelines that traders use to set entry points or stop loss levels. When the price breaks these levels, traders wait for a breakout intervention, while those who do not want a breakout exit their positions to avoid greater losses.
Breakouts are frequently associated with chart patterns such as triangles, flags, wedges, head-and-shoulders formations, and double tops or bottoms. These patterns form when the price follows a specific movement that results in well-defined support and/or resistance levels. Traders observe these levels, waiting for breakouts to open long positions or close short positions if the price breaks through resistance or to open short positions or close long positions if the price breaks support.
After a breakout with high volume, the price may retrace to the breakout point before continuing its movement. This happens because short-term traders try to sell quickly after buying the initial breakout to make a profit, which can temporarily bring the price back to the breakout point. If this is legitimate, the price should then continue in the direction it initially took.
However, it is crucial for traders who use breakouts to open trades to set stop-loss orders if the breakout fails. A stop loss is typically set just below the resistance level for long positions on an upward breakout. A stop loss is typically placed just above the breached support level for short positions.
There are limitations in using these chart patterns, mainly due to false patterns where the price moves just above resistance or support, attracting breakout traders and then reversing direction. The subjectivity of support and resistance levels makes it even more crucial to observe volume, confirming a level’s importance during a breakout.
