DEFINITION of 'Breakdown'

A breakdown is a price movement through an identified level of support, which is usually followed by heavy volume and sharp declines. Technical traders short sell a security when it breaks below a support level because it is a clear indication that the bears are in control and that additional selling pressure is likely to follow. A breakdown often signals the start of a downtrend.

In the chart below, prices have broken down below the neckline of a head and shoulders pattern.

       Example of a Breakdown

 

Image depicting a breakdown.

BREAKING DOWN 'Breakdown'

A breakdown can be identified by traders using technical tools such as moving averages, trendlines and chart patterns. Traders can draw trendlines on a chart that connect several swing lows to find areas where prices may be susceptible to breaking down. Heavy volume should accompany a breakdown below key support levels, which shows participation in the move lower.

When a security initially breaks down, traders should seek confirmation from several indicators and other chart timeframes to ensure the move is not a head-fake. For example, a breakdown on a 15-minute chart has a higher probability of continuing lower if the daily and weekly charts are in a downtrend. A breakdown is the bearish counterpart of a breakout.

Contrarian traders may look to trade failed breakdowns. (For more, see: Trading Failed Breaks.)

Trading a Breakdown

Traders could take a short position when the security’s price initially breaks down below major support. To do this, a sell stop-limit order would need to be placed just below the support level. Once prices break down, the decline is likely to be intensified as stop-loss orders for long positions are triggered with additional selling pressure coming from breakdown traders. The extra volatility caused by the breakdown may result in a mediocre fill due to slippage.

Alternatively, traders can wait for a retracement to enter the market. They could place a limit order where the security’s price initially broke down from; that area has now become a resistance level. Entering the market on a retracement is likely to result in a better fill than trying to catch the breakdown early. The flipside is the security may not retrace back to the trader’s limit price. (To learn more, see: What are the best ways to Identify Retracements on a Stock?)

Once in a short position, traders could use a trend following indicator, such as a moving average as a trailing stop. For example, when the price of the security closes above the moving average, the trade is exited. If traders believe the breakdown is the start of a new downtrend, they may want to use a longer-term moving average to try and catch the majority of the move.

RELATED TERMS
  1. Double Top

    A double top is a chart pattern, characterized by two consecutive ...
  2. Asset Class Breakdown

    An asset class breakdown provides the percentages of core asset ...
  3. Failed Break

    A failed break occurs when a price moves through an identified ...
  4. Above The Market

    Above the market refers to an order to buy or sell at a price ...
  5. Neckline

    A neckline is a level of support or resistance found on a head ...
  6. Retracement

    A retracement is a temporary reversal in the direction of a stock's ...
Related Articles
  1. Investing

    Apple Levels to Watch After Earnings (AAPL)

    Apple needs to trade above 115 or below 90 to escape magnetism created by technical conditions in place since a 2015 breakdown.
  2. Trading

    Microsoft Stock Falls Toward 50-Day Moving Average

    Microsoft shares moved sharply lower following a broader tech sell-off, but traders will be closely watching these key levels.
  3. Trading

    Short Natural Gas As Winter Ends With a Whimper (SWN)

    Natural gas futures fell more than 10% on Tuesday in reaction to a mild winter weather forecast and could be headed into a test of the downtrend low.
  4. Trading

    Disney Stock Nears Bearish Technical Tipping Point

    Disney's stock dropped after-hours Tuesday on disappointing results, approaching a key support level.
  5. Trading

    Bank of America Stock Could Enter Steep Decline

    Bank of America stock is testing seven-month support and could break down, entering an intermediate downtrend.
  6. Investing

    Rules and Strategies For Profitable Short Selling

    Short sales work well in bull and bear markets but strict entry and risk management rules are required to overcome the threat of short squeezes.
  7. Trading

    AT&T Stock Near Major Sell Signal

    AT&T has rallied into new resistance following an October breakdown and could turn sharply lower, testing long-term support near $31.
  8. Trading

    Stocks Fall Amid Rising Geopolitical Risk (SPY, DIA)

    International markets were mixed over this holiday week. (SPY,DIA,IWM,QQQ)
  9. Trading

    Stocks Edge Lower as Trade Tensions Grow

    With threats of additional tariffs raising the prospects of a trade war, the major U.S. indexes moved lower over the past week.
  10. Trading

    Gold Bulls Need to Defend These Support Levels

    The gold fund has reversed at the underside of 200-week EMA resistance and needs to hold 116 to 118 or risk a much larger-scale decline.
RELATED FAQS
  1. How should orders be placed when trying to buy a bounce on a stock?

    Buy stocks on a temporary pullback in price to acquire them at a price level that should be profitable when the stock resumes ... Read Answer >>
  2. What are the most common strategies to place retracement levels?

    Find out how traders place Fibonacci retracement levels, and learn what it means when a price retracement seems to reverse ... Read Answer >>
  3. Why is the 50-day simple moving average so popular among traders and analysts?

    Learn the various purposes the 50-day simple moving average (SMA) serves, and understand why it is commonly used by traders ... Read Answer >>
  4. What Does It Mean When There Is 'Price Action'?

    Price action refers to the day-to-day fluctuation in the price of an asset. Read Answer >>
Trading Center