What is a Breakout
A Breakout refers to a security's price movement through a historical resistance level. A breakout typically precedes heavy trading volume and increased volatility.
BREAKING DOWN Breakout
A Breakout can be an incredibly profitable trading opportunity, so adventurous traders who study market performance over time to identify patterns in resistance levels will often attempt to buy a security when it breaks above a level of resistance or below a level of support.
A breakout is most commonly understood as a situation in which the price of an asset breaks through a level of resistance, increasing to an unprecedented price. Once the resistance level is breached, that new top price is becomes the next level of support when the the asset experiences a pullback in price.
The above chart shows a stock that has met a resistance near $37 over the course of a year, followed by a breakout occurring approximately five months after the last time the resistance level was tested. Traders rely on charts like these to visualize patterns in identifying possible resistance price points that are likely to experience breakouts.
The converse of this situation, in which a downward price movement tests the resistance levels of a price bottom, is known as a breakdown.
Causes of Breakouts
A price resistance usually occurs when the supply of a security exceeds demand at a particular price level, creating a glut in the market that impedes further upward movement of the price. The resistance level is usually breached after the market absorbs the surplus, leading to a sharp upward movement in price.
Breakouts occur more often in market conditions in which potential upward movement is expected. For instance, when the market is range-bound and a particular price is approaching its upper end, savvy traders will prepare for a price breakout in order to maximize gains.
Such traders will look to certain chart patterns, including triangles, flags and head-and-shoulder patterns to identify resistance limits near completion, suggesting the potential for further upward price movement through the resistance barrier.
Breakouts are also sometimes a direct result of significant news events, but such breakouts are difficult to predict.
Breakout trading tends to done best when market conditions are trending upwards, or are range-bound with prices approaching their upper end. Investors pursuing this strategy should identify the resistance level of the asset, and closely monitor trading volume.
When the price action approaches the resistance level, and maintains strong trading volume as it surpasses the resistance level, a breakout occurs and a long position trade setup is established. Following the breakout, a small price retrace usually occurs, resulting from the rebalance in supply and demand. Experience investors will often take long positions while the price is retracing, and place a protective stop loss somewhat below the original resistance level of the asset.
Learning More About Breakouts and Technical Analysis
To learn more about predicting breakouts, take a look at Investopedia's Technical Analysis Course, which provides a comprehensive introduction to technical analysis, ranging from basic technical indicators to advanced risk management strategies. This course offers more than five hours of on-demand video, exercises, and interactive content.