What is a 'Breakout'
A breakout is a price movement of a security through an identified level of resistance, which is usually followed by heavy volume and an increased amount of volatility. Traders buy the underlying asset when the price breaks above a level of resistance or when it breaks below a level of support.
BREAKING DOWN 'Breakout'
This chart shows a stock that has historically encountered resistance near $37 over a six-month period, followed by a subsequent breakout approximately five months from the last time the resistance level was tested.
In practice, a breakout is most commonly used to refer to a situation in which the price breaks above a level of resistance and moves higher. Once a resistance level is broken, it often becomes the next level of support when the asset experiences a pullback. Most traders use chart patterns and other technical tools, such as trend lines, to identify possible resistance price points that are likely to experience breakouts. Similar price movements to the downside are more often referred to as breakdowns.
Causes of Breakouts
Price resistance occurs when an excess level of supply for a particular security accumulates at a particular price level and creates a glut in supply that overwhelms demand and impedes the upward movement in price. Once the market absorbs the surplus level of supply, resistance is usually breached with a sharp upward movement resulting from the abrupt shift in supply and demand. These sharp upward price movements are considered to be breakouts and normally occur when resistance levels are penetrated.
Breakouts manifest more often in market conditions where potential upward price movement is expected. For example, when the market is range-bound and price action is approaching the upper end of the range, savvy traders prepare for a price breakout above the upper range resistance level.
Technical chart patterns such as head-and-shoulder, triangles and flags that are near completion in their formation and signify upward price movement are also common spots for breakouts. Once price action makes a final movement to confirm the pattern, a price breakout usually follows.
Significant news events may also cause price breakouts. These breakouts are more unpredictable and depend on the effects that the news has on a particular security.
Trading breakout is best done when the prevailing market condition is either up trending, or range-bound with price action approaching the upper end of the range. Once a resistance level has been identified, volume should be monitored very closely. A long position trade setup occurs when price action approaches and decisively surpasses the resistance level with strong volume. A small price retrace usually occurs following a breakout, resulting from the abrupt shift in supply and demand, as it seeks to re-balance. This is the long entry signal. Experienced traders take long positions as price is retracing with a protective stop loss placed slightly below the original resistance level.