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
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.