Last Updated on 21 September, 2020 by Therobusttrader
Breakouts occur all the time in the markets, and if used right, they present great profit opportunities.
A breakout is when the market moves above a resistance or below a support level, and indicates that prices may continue in the direction of the breakout. However, while trading breakouts may seem very compelling, most of them end up as false breakouts, commonly called “fake-outs”. This means that the market turns around and that the breakout fails.
In this COMPLETE guide to breakouts, you’ll learn everything you need to know about breakout trading. More specifically, we’ll cover all the following:
- How to spot breakouts
- How some traders approach breakouts
- How to avoid fakeouts
- Our take on breakouts
What Is a Breakout?
As said, a breakout is when the market exceeds a level that we believe is significant, such as a recent high or low. Anything that’s perceived as a significant level for the market to overcome (or go below) can be perceived as a potential breakout level. For instance, the 200-day moving average is often closely watched by a lot of market participants, which means that it may be a good level to watch for breakouts.
In the image below, you see how the market broke above a recent high with a gap to the upside, which acted as a major resistance level. As soon as the market had taken out that level, it continued up for quite some time and proved to be a perfect breakout case setup.
Advantages of Breakout trading:
Here follow the two biggest advantageous of breakout trading:
- With breakouts, there is the benefit of being able to catch every new market trend. And as you might know, riding trends is one of the most powerful ways to make money in the markets.
- Breakout trading works in many markets and is one of the more universal concepts there are in trading.
Still, there are no free profits in the markets. When trading breakouts, the harsh truth is that most breakouts will be false, meaning that the market just goes slightly beyond the breakout level, and then reverts.
What Makes a Good Breakout Level?
Normally, most traders assume that a breakout level becomes better the more times it has been tested, and the more obvious it is.
The reason is that levels like these tend to become places where traders who are short the market place their stop-loss orders. Then, once the market breaks above this level, these stop orders will cause a huge spike in buying pressure, which helps to push the market higher and ensure the success of the breakout.
Here is an example to make it a bit clearer.
As you see, we have quite an obvious resistance level around the three recent highs, that’s been tested several times without failing. As such, most market participants are now aware of this level.
Since the market finds it hard to penetrate a resistance level, some traders will decide to go short as soon as the market approaches that level. And to limit potential losses, many will place their stops right above the resistance level, since a breakout above it will dismiss their theory that prices were going revert around that level.
This means that there might be a huge wave of cover orders, which essentially are buy orders, that get triggered as soon as there is a breakout above the recent high. And this again will help to fuel the breakout, and improve our odds of success.
Also, by analyzing the image above you can tell that the breakout level was taken out with a big positive gap. This often improves the odds, since most market players were taken by surprise and didn’t have time to exit their positions earlier. In addition, the large gap distance increases the odds that many stop-loss orders were hit.
All this combined increased the likelihood that the breakout would play out well, which it did!
What is a Breakdown?
So far we’ve just covered breakouts.
However, in breakout trading, there is one word you should know, which is “breakdown”.
A breakdown simply is a breakout to the downside.
Still, the term “breakout” could be used to describe a breakdown as well and is quite a common usage.
Below you see an example of a breakdown below a previous market bottom
Different Types of Breakout Levels
Now, there are many levels that can be regarded as breakout levels, and the one you choose may have quite a significant effect on the reliability and usability of your strategy.
Let’ s have a look at some of the most common ones:
Market Highs and Lows
Some of the most common breakout levels are those that rely on market lows and highs, and finding them might be as simple as just plotting a 10-bar high or low. Other times you may just take a significant market top or bottom, and use that as your breakout level.
Now, while this is a very simple approach, it can work quite well in many cases. Below you see how a breakout above a 150 bar high started a new trend.
As we mentioned earlier, moving averages could also be used as breakout levels. Being some of the most popular trading indicators, many traders will inevitably use them in their analysis, making them somewhat reliable as support and resistance levels.
Many traders use the most common moving average lengths, since these are watched by the most people. These include:
- The 5 and 10-period moving averages
- The 20-period moving average
- The 50-period moving average
- The 100-period moving average
- And the 200-period moving average
Now, you could also try to experiment with different types of moving averages. For example, we’ve found that adaptive moving averages, like the exponential moving average, tend to work better in most situations, than a plain simple moving average.
In our guide to moving averages, we take a closer look at the different types and how they may be used!
Another quite useful method that you could try, is bollinger bands.
In short, the Bollinger bands indicator consists of a moving average, around which two lines are drawn. The first line is placed 2 standard deviations above the moving average, while the second line is placed 2 standard deviations below the moving average.
This creates an adaptive breakout level that changes with the volatility of the market. In other words, the breakout level will be placed a long distance from the average when volatility is high, and close to the price when volatility is low. This feature will often prove very advantageous and is likely to reduce the number of false breakouts.
Here you see an image of the Bollinger bands. Notice how the width of the bands changes with the volatility of the market, and how the breakout above the upper band preceded the upmove.
Round numbers, like 10, 20, and 100 often act as resistance and support levels (as we cover in our guide to support and resistance levels)
Thus, they may be used as breakout levels as well.
However, first it might be good to see that the market shows some signs of struggling to get past the level. Then it’s more likely that we’re dealing with a breakout level that’s worth watching!
Below you see how a stock tested the $100 level two times before it finally broke out and took off!
Which Breakout Level Should You Go For?
We recommend that you start by using price-based breakout levels, such as market tops and bottoms, or the n-bar high or low. While being the simplest approach, it does work quite well in the right markets and timeframes!
Adding Distance to the Breakout Level
As we mentioned earlier in the article, one of the main concerns of a breakout trader is to deal with false breakouts. Markets move a lot and break important levels all the time, which often makes it impossible to just pick one breakout level and stick with it.
In these situations, we can often be helped immensely by adding some distance to the breakout level. In theory, you should avoid quite a lot of false breakouts this way, since you’ll avoid those trades that just go slightly beyond the breakout level, and then revert.
So how do you know how long distance you should add.
Well, let´s cover the most common methods!
The simplest method is to just add a dollar distance to the breakout level.
For instance, if you’re watching a breakout level to go long on, you may use $1 as your distance by just adding it to the breakout level.
Now, while this method is simple and could be effective, it’s always important to take into consideration the price at which the market is trading. For example, you wouldn’t want to add a $1 distance to a market that trades at $1. In the same way, $1 would probably be too little for a market that trades at $1000, since it will move greater distances than that with ease.
Now, there is an easier way than the fixed dollar approach, where this is taken care of automatically. We’re talking about using a percentage of the last price.
Some traders just use a percentage of the last price, and add that to their breakout level if their going long, or subtract it from the breakout level if they’re going short.
So, if the market trades at $100, and you decide to add 1% to the breakout level, you would effectively add $1 to the breakout level.
This way you get a breakout distance that adapts to the current pricing of the market, which makes it way more useful than a simple dollar stop!
Average True Range
You may use a multiple of the Average True Range(ATR) as the distance to add to your breakout level. This makes the breakout level dynamic, by ensuring that it adapts to the current market volatility.
This is a feature that may come very handy in markets that have a tendency to experience drastically varying levels of volatility. In such cases, a static approach may mean that the breakout level sometimes is too far away, and sometimes too close if the market is either extremely volatile or very calm.
So, to calculate the breakout level with average range, you first need to get the average true range reading. This is done easily by just inserting the ATR indicator on a chart, and noting the current reading. Then you just add it to the breakout level if you´re going long, or subtract it from the breakout level if you´re going short!
You may also use the range reading of the last bar. This probably won’t generate very different results, but in some cases, it could work a little better!
Which Should You Choose?
We recommend that you go with the average true range solution. This is what we’ve used a lot, and what has proven to work well for us over the years.
Still, we’ve had quite a lot of success with the percentage approach, so you could give that a try as well!
If you want to know how we build trading strategies, we recommend that you have a look at our complete guide to building a trading strategy.
Ways to Improve Breakout Strategies and Avoid Fakeouts
Now, there are several ways you could go about to improve the odds that a breakout you take is going to work out well. In this section of the article, we’ll present some of the approaches that we’ve used, and had good results with. However, keep in mind that every breakout strategy is different, and might need different types of filters to function well.
Having said this, let’s have a look at some of the techniques
Breakouts From Ranges
One way of filtering out unprofitable breakouts is to only take a trade if the market comes from a consolidation. In short, this means that the market didn’t trend in any direction prior to the breakout, but just moved around with no clear goal in sight.
Often times this also means that there is a clear trading range, which the market struggles to get past. In other words, we have some quite clear breakout levels that we may want to watch closely.
Another fact that plays to our advantage, is that markets that go into low volatility trading ranges have a tendency to produce quite volatile breakouts. This means that there may be a greater chance that you get to ride a breakout for quite some time until it’s time to close the trade.
Below you see an example of a market that’s in a consolidation and forms a wedge, from which it then breaks out to the upside.
2. High Volume
One of the perhaps most well-known methods in breakout trading, is to use volume to validate a breakout. Generally, a breakout that forms with high volume is thought to have a higher chance of success, than one that forms with little volume.
This has to do with the fact that volume reflects the number and size of market players that stand behind the breakout as it occurs. And following this, it’s thought to be a positive sign if there is a lot of volume as a market performs a breakout, meaning that there is a greater chance that market players will ensure that the prices continue in the direction of the breakout.
Below you see an example of a successful breakout that forms with high volume.
While all this might sound very logical, we’ve actually found that the oppositive could hold true in certain cases. As always in trading, it’s advisable that you make use of backtesting to ensure that the methods you use work with your market and timeframe. You may read more about backtesting in our complete guide to backtesting.
3. Time Conditions
One quite uncommon way to approach breakouts, is based on the time of day. If you’re dealing with intraday breakouts, there will be quite some occasions where a breakout system won’t work that well during the first or second half of the day.
For instance, we have quite some strategies that enter only the first few minutes of the session, based on certain conditions that only work during those first minutes. Other strategies we have may only enter trades during the first half of the trading session.
There are tons of time-based effects like these to discover, and we definitely recommend that you have a closer look at it!
In this guide to breakout trading, we’ve covered what breakouts are, and how you may go about to find setups that show some merit.
However, while we’ve covered a lot of great things in this guide, this is when it’s up to you to put in the effort that’s needed to come up with a trading strategy that’s profitable and will make you money.
If you’d like to speed up the learning curve, we highly recommend that you consider taking a trading course. Then you’ll save yourself a lot of valuable time, that could instead be used trading the markets and making money!