What Is a Breakout Trader?
A breakout trader is a type of trader that uses a breakout strategy. This strategy looks for levels or areas that a security has been unable to move beyond, and waits for it to move beyond those levels (as it could keep moving in that direction). When a price moves beyond one of these levels, it is called a breakout.
Many breakout traders use technical analysis to identify these areas, often using trendlines or price patterns. A breakout trader looks for patterns; for example, instances where the price of a security has been resistant to moving above or below a specific price level or price area. Then, the trader attempts to profit by entering a trade in the breakout direction, assuming that the price will continue to move in that direction.
- A breakout trader looks for price, a technical indicator, or a data point to move beyond a support or resistance level.
- A breakout trader can use price, a technical indicator, or fundamentals to trigger them into a breakout trade.
- Most breakout traders use technical analysis, entering trades when the price moves outside of a chart pattern or trendline.
How a Breakout Trader Works
A breakout trader seeks out stocks or other financial assets that have been confined to trading below a specific level (resistance) or above a specific level (support), despite multiple attempts to breakthrough.
To the breakout trader, this confinement of the price is acting like a coiled spring. If the price eventually breaks out of the confined area, it may run in that direction—providing a profit opportunity. The same concept can be applied to a technical indicator. If a technical indicator is getting squeezed and/or can't penetrate through a certain area, when it does, it may present a breakout opportunity. The breakout signals an opportunity to buy or sell the security, depending on whether the breakout is bullish or bearish.
Types of Breakout Patterns
There many different types of breakout patterns that breakout traders look for.
Chart patterns are a common type of breakout. Chart patterns include triangles, wedges, channels, rectangles, head and shoulders, cup and handle, and expanding ranges. These patterns occur when the price moves in a specific way. The trader will typically draw trendlines on the pattern to indicate where the support/resistance levels are. When the price breakouts out of the pattern, they enter in the breakout direction.
A technical indicator works in a similar way, and may even form some of the same patterns mentioned above. For example, a relative strength index (RSI) indicator may form a triangle pattern. If the price breaks out of that triangle to the upside it may be a signal to buy the security, or if it breaks lower, to sell the security.
Breakout trading can even be applied to fundamental data. Assume that a company has been stagnant and reporting similar earning each quarter for the last three years. Then, one quarter, they blow away estimates and report much higher earnings, with projections for even higher earnings in the future.
This company may have developed a new in-demand product or found a way re-invent an old one. Their earnings are breaking out of the old pattern, and that may signal an opportunity to buy. A company could also report much worse earnings than they have in the past. They have broken out of their old pattern. In this case, it may be a signal to sell.
A breakout trader will typically enter a trade when the price moves beyond the support or resistance level they have identified. They go long above resistance and short below support. Managing risk on a breakout is important, because not all breakouts succeed. In fact, many will fail. The price may move slightly above the breakout level and then move back through it, or it may breakout for some time, but then move back through the level at a later date. These are called failed breakouts.
Before entering a trade based on a breakout, consider how long you wish to hold the trade for. If the breakout fails, consider exiting the position as the original premise for the trade has disappeared.
Example of a Breakout Trader
The following chart of Shopify Inc. (SHOP) shows two cup and handle chart patterns.
The price made a high and then moved lower. As the price recovered and moved back toward the prior high, it moved sideways, forming a handle. The price then broke above the handle, signaling completion of the pattern and a potential long trade.
To manage risk, a stop loss is often placed below the low of the handle for this particular pattern.
For a profit target, the height of the cup (in dollars) is added to the breakout point (the price at the upper trendline of the handle). The height of the cup is added to the breakout point. A sell order is placed at this total to lock in profit.
What Is the Difference Between a Breakout Trader and a Trend Trader?
A breakout trader is identifying what they view as important areas or data points and using that area to trigger a trade if the price moves through it. A trend trader looks for securities that are already moving up or down and then attempts to profit by jumping on board by going long or short, respectively.
Limitations of Being a Breakout Trader
Breakout trading requires discipline to act when a breakout occurs and to cut losses when the breakout fails. This will happen frequently. Therefore, to make money over time with a breakout strategy, the trader must also be willing to hold onto their winners. The breakouts that do work well and produce large price movements will hopefully more than compensate for all the losers that occur when a breakout fails.
Focusing solely on breakouts eliminates a wide array of securities that are already trending, and presenting profit opportunities based on those trends.