Chapter 22. What Is a Breakout?

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1 Chapter 22 Trading Breakouts "We must remove the emotional element as quickly as possible in trading. If you can do it before you put on a position, you have a good start." As we move forward in the trading course, it is important to address actual strategies to apply to your trading approach. Most active traders spend countless hours looking for trading strategies or opportunities that offer the highest returns, without exposing their account to unnecessary risk. As option traders, it becomes even more difficult to do this. Let s face it; option buying is a low-probability strategy. To compensate for this, we highly recommend focusing your efforts on a common technical strategy that offers explosive price swings in most financial instruments trading breakouts. Breakout trading is used by many active investors to take a position within a trend s early stages. Generally speaking, this strategy can be the starting point for major price moves, expansions in volatility, and when managed properly, can offer limited downside risk. Throughout this chapter we will walk through the anatomy of this trade from start to finish and offer a few ideas to better manage this trading style. What Is a Breakout? A breakout occurs when a stock moves outside a defined support or resistance level on its price chart with increased volume. An investor enters a bullish position after the stock price breaks above resistance or enters a bearish position after the stock breaks below support. Once the stock trades into the new price level, volatility tends to increase and prices usually trend in the breakout s direction. The reason breakouts are such an important trading strategy is because these setups are the starting point for future volatility increases and large price swings. In many circumstances, breakouts are the starting point for most major price trends. Figure 1: A Breakout in RIMM and a Breakdown in AAPL Trading Breakouts Page 1

2 Breakouts occur from many environments. Typically, the most explosive price movements are a result of channel breakouts and price pattern breakouts such as triangles, flags or head and shoulders patterns (see Figure 1). The pattern is not necessarily as important as the fact that the stock has paused and consolidated ahead of a potential breakout. Note: as volatility contracts during these time frames, it will typically expand after prices move beyond these ranges. As we discuss trading breakouts as a trading strategy, it is important to discuss from start to finish, how to manage this type of approach. We will highlight entry points, exit points, trade management, and profit targets. At the end of this chapter, you should be able to develop a complete plan on how to successfully trade breakouts. Important Points to Consider Breakouts generate explosive price swings because they trigger supply/demand imbalances that occur outside of these obvious price barriers. For example, traders that are bullish on a stock will set buy stop orders at or above resistance to execute a buy order once prices trade through resistance. Traders that are short the stock during this event will likely have their stop orders in this area as well, to cover a short position as prices trade above resistance. This event sends a tremendous amount of demand to the market as the bulls enter buy orders to buy stock, and the bears enter buy orders to cover their short positions to prevent further loss. This excess of demand sends prices sharply higher. The opposite would be true for traders that are bearish on a stock. They would set sell stop orders at or beneath support to short shares of stock as prices break beneath support. Any traders that are long shares of stock at this time would likely have sell stop orders at or beneath support as well, to take them out of a long position in the event that the stock broke support. This event sends a tremendous amount of supply to the market as the bears enter sell orders to short stock, and the bulls enter sell orders to sell their shares to prevent further loss. This excess of supply sends prices sharply lower. As you can see, breakouts trigger significant order flow and price action. Traders know that once a stock is done consolidating, as it moves away from a range, one side of the market will be wrong while the other will be right. The general public will notice this move as well and will enter the market based on the idea that the stock is getting ready to trend; similar to the examples in Figure 1. Once prices moved outside the highlighted support and resistance levels, prices continued to trend for multiple weeks. These moves are more significant than most typical market fluctuations. This is why we will always be keeping an eye out for these types of situations. We want to trade stocks that are moving with purpose, not stocks that are just fluctuating randomly with the broad market. When looking for opportunities to trade, here are a few key points to consider: A prior trend must exist This will help you determine direction as prices get set to leave a point of consolidation. If continuation or reversal patterns show up after trending move in price, this will help you better anticipate a new directional price move for aggressive trade timing and entries. Watch for the first sign of strength/weakness The ultimate goal is to get good at reading and Trading Breakouts Page 2

3 anticipating price swings. Many stocks will give clues as to when they will leave a range, and whether they will move up or down. By constantly watching prices, you can see whether prices are strengthening or deteriorating in their respective ranges, which will help you in taking anticipatory entries. Prices fall faster than they rise It s important to remember that stocks take the stairs up and the elevator down. Since downward price movements trigger anxiety, emotion, and eventually sell orders, the market falls much faster than it rises. Knowing this is important as prices trend beyond their breakouts. The larger the pattern, the bigger the potential move As it pertains to measuring breakouts from price patterns, the bigger and more dynamic the pattern is, the more significant the outcome will be. If a continuation pattern measures 10 points wide at its widest point, then you can anticipate setting a profit target 10 points beyond the point of the breakout. Volume is a confirming indicator Volume levels should increase as prices break beyond a support or resistance level. This confirms the execution of order flow, and if the stock remains outside its prior range, than it is said that the stock is accepting these new prices. Volume should always confirm a breakout. Time frames - Regardless of the time frame, breakout trading is a great strategy. Whether you use intraday, daily or weekly charts, the concepts are universal. You can apply this strategy to day trading, swing trading or any style of trading. Finding a Good Candidate When trading breakouts, it is important to consider the underlying stock s characteristics aside from just its price pattern or support and resistance levels. Most traders develop preferences of the types of stocks they like to trade. Every stock has particular characteristics that make it good to trade, or not good to trade based on each individuals preferential biases. For example, Trader A prefers stocks that move fast and in large percentages, while Trader B prefers highly liquid stocks that are not quite so volatile. These qualities can be used to dial down the large number of available stocks out there to a smaller, more manageable list. As we ve discussed in prior chapters, this is why tracking a watchlist is so important. A few simple characteristics you ll want to define are: Volatility Stocks that are more volatile can generate bigger returns, but also bigger losses. Liquidity Liquid stocks will typically offer liquid options, and are more actively traded in general. Options Always double check to see that the options are liquid enough to trade. Aside from the stocks characteristics, the next thing to check will be the technical set-up. Support and resistance levels should be inspected, as should the price pattern before entering a trade. The more times a stock price has touched these support/resistance areas, the more valid they are and the important they become. At the same time, the longer these support and resistance levels have been in play, the better the outcome when the stock price finally breaks out (see Figure 2). Trading Breakouts Page 3

4 Figure 2: A Triangle Breakout in BIDU Looking at the chart above, what defines this as a price pattern is the consistent touch points that form the shape of a triangle. As prices consolidate, various price patterns will occur on the price chart. Formations such as channels, triangles and flags are valuable vehicles when looking for stocks to trade. Aside from patterns, consistency and length of time a stock price has adhered to its support or resistance levels are important factors to consider when finding a good candidate to trade. All of these elements were discussed in greater detail in our Price Patterns module. Entry Points After finding a good instrument to trade, it is time to plan the trade. The easiest consideration is the entry point. Entry points are fairly black and white when it comes to establishing positions upon a breakout. Once prices are set to close above a resistance level, an investor will establish a bullish position. When prices are set to close below a support level, an investor will take on a bearish position. This is where many traders will use buy stop orders to put them into a long position once a particular price is reached. For example, in Figure 2 the resistance level at the apex of the triangle pattern was $140. A trader can simply issue a buy stop order to put them into shares of BIDU once prices hit $140. Anticipatory Entry Points Trading Breakouts Page 4

5 If a stock is in a consolidation pattern, or a trading range, there is no guarantee as to which direction it will break. This is why many traders opt to wait for the breakout to occur and take on a position immediately as prices start to break either up or down. However, anticipating a price move can be a very rewarding task, if done correctly. Going back to Figure 2, let s assume you were bullish on BIDU. The stock had been in an upward trend, the market had been bullish, and with the triangle pattern being a continuation pattern, you were anticipating a breakout to the upside. Knowing where support and resistance are located on the chart, you simply look for opportunities to buy at support if you are anticipating a bullish breakout. Conversely, if you were anticipating a bearish breakdown, you would look to short shares or buy puts when the stock reaches resistance. Figure 3: Anticipatory Entry Points One of the reasons we aim to trade at support or resistance levels is because risk is easy to define, and easier to manage. Going back to our example of BIDU, the apex of this consolidation pattern illustrates resistance at $140, and support at $135. If you are able to enter a trade at support, you could set a stop just beneath support, in case prices were to break down. For example, if you entered the trade at $135, you could set a stop at $134 knowing that if the stock traded down to that price, then the outcome of this price consolidation would be a breakdown, which would result in much lower prices. At times you will run across situations where a stock attempts to make a move outside a support or resistance level, only to fail and trade back into their trading ranges. This is commonly referred to as a fake-out. As it pertains to trading breakouts, always remember from failed moves come fast moves. This means that in a fakeout situation, once a breakout fails, you will see a fast move in the opposite direction. This is why many traders Trading Breakouts Page 5

6 choose to wait for confirmation, as opposed to anticipating movements. Many investors look for above-average volume as confirmation or wait towards the close of a trading period to determine whether or not prices will sustain the levels they ve broken out of. Planning Exits Predetermined exits are an essential ingredient to a successful trading approach. When trading breakouts, there are three exits plans to arrange prior to establishing a position. 1. Where to Exit with a Profit When planning target prices, look at the stock s recent behavior to determine a reasonable objective. When trading price patterns, it is easy to use the recent price action to establish a price target. For example, if the range of a recent channel or price pattern is 12 points, then that amount should be used as a price target to forward project once the stock breaks out (see Figure 4). Figure 4: Measuring a Price Target Trading Breakouts Page 6

7 As you can see, the range in Figure 4 is roughly $12 points wide ( = 12). That means that once prices break resistance at $140, you would anticipate a $12 point move, or would look to book gains at $152 (140 = 12 = 152). Another idea is to calculate recent price swings and average them out to get a relative price target. If the stock has made an average price swing of four points over the last few price swings, this would be a reasonable objective. These are a few ideas of how to set price targets as the trade objective. This should be your goal for the trade. After the goal is reached, an investor can exit the position, exit a portion of the position to let the rest run or raise a stop-loss order to lock in profits. 2. Where to Exit with a Loss It is important to know when a trade has failed. Breakout trading offers this insight in a fairly clear manner. After a breakout, old resistance levels should act as new support and old support levels should act as new resistance. This is an important consideration because it is an objective way to determine when a trade has failed and an easy way to determine where to set your stop-loss order. After a position has been taken, use the old support or resistance level as a line in the sand to close out a losing trade. As an example, study the CHK chart in Figure 5. Figure 5: A Failed Breakout in CHK Trading Breakouts Page 7

8 After a trade fails, it is important to exit the trade quickly. Never give a loss too much rope. Remember; from failed moves come fast moves. As you can see in Figure 5, a low volume breakout in CHK quickly unravels into a 25% decline! 3. Where to Set a Stop Order When considering where to exit a position with a loss, use the prior support or resistance level that prices have broken out of. Placing a stop comfortably within these parameters is a safe way to protect a position without giving the trade too much downside risk. Setting a stop higher than this will likely trigger an exit prematurely because it is common for prices to re-test price levels they ve just broken out of. Figure 6: A Breakout in RIMM Looking at the chart in Figure 6, you can see the initial consolidation of prices, the breakout, the re-test and then the price objective reached. The process is fairly mechanical. When considering where to set a stop-loss order, had it been set above the old resistance level, prices wouldn t have been able to re-test these levels and the investor would have been stopped out prematurely. Setting the stop below this level allows prices to re-test and catch the trade quickly if it fails. Summary Breakout trading can be a packaged trading system by itself. As discussed in this chapter, so long as you are able to consistently identify opportunities, if is very straight forward on how to enter a trade, set a profit target, and set a stop order. At that point, the only thing left to do is to let the trade work. Trading Breakouts Page 8

9 Trading these set-ups can offer significant returns, but they also bring about riskier trading conditions. Prices are moving fast and there can be a considerable amount of volatility. As with all trading systems, the most important element is understanding what risks are involved and properly managing those risks. Trading Breakouts Page 9