Breakout trading is a strategy implemented by market participants aimed at capitalising upon an upcoming trend or directional move in price. While there are many approaches that encourage trade execution in response to current price action, breakout trading promotes market entry through anticipating a forthcoming move.
Breakout traders aspire to become active in the marketplace before, or very soon after, a strong trend in pricing begins. The philosophy behind selecting a proper entry point is very different from position, reversal and range trading approaches. Instead of entering the market using retracement or exhaustion levels, a "breakout" scenario is identified.
Elements Of A Breakout
A "breakout" is a sudden, directional move in price that extends beyond a market's current trading range. It eclipses established support and resistance levels, often rapidly with considerable momentum.
Breakouts come in many unique varieties, but typically include several key elements:
- Market participation: A spike in volume is a common characteristic of a breakout. As the price of a security makes an exit from normal constraints, the debate over its value heats up. In turn, market participants are enticed to open various long and short positions in an attempt to profit from the perceived opportunity.
- Volatility: The result of increased market participation is heightened volatility. Heavy buying and selling promotes unstable market conditions, thereby creating pricing fluctuations of greater magnitudes. As volatility increases, the chance of a strong trend developing becomes more probable.
- Directional move in price: The product of increased market participation and heightened volatility is a pronounced, directional move of price itself. This is the defining characteristic of a breakout; without a definitive move in price, a breakout does not exist.
Each element of a breakout is crucial to its presence and sustainability. Increased market participation leads to volatility, which can act as a catalyst for the trend.
An important point to remember regarding breakouts is that they may occur in any market given the proper conditions. Breakout trading is a commonly employed strategy in the forex, futures and equities markets. Although sometimes a formidable challenge, catching a breakout at the right time can produce substantial profits while mitigating some forms of risk.
Identifying A Breakout
The process of identifying a breakout scenario may be rooted in technical analysis or fundamental analysis, or exist as a hybrid of both. In reality, there are countless ways to recognise opportunities using a breakout trading methodology.
A few of the most common signals used to identify an upcoming breakout are listed below:
- Support and resistance: Support and resistance levels develop over time as price "tests" key areas before returning to the control. When established, they are viewed as price constraints, effectively containing the market. Upon price extending past these levels, a breakout may ensue. Support and resistance can be viewed from the perspective of technical analysis or traditional market fundamentals. Fibonacci retracements, moving averages, pivot points and Bollinger Bands are examples of technically derived support and resistance. More traditional manners of identification are round numbers, value areas and the examination of order flow.
- Chart patterns: Chart patterns are a popular method of identifying breakout scenarios. Flags and pennants as well as assorted varieties of candlestick patterns are often referenced as signals of a coming trend.
- Market consolidation: A consolidating market is sometimes perceived to be a period of indecision and a precursor to a move in pricing. As the trading range of a security becomes tighter, volumes typically decrease. Then, upon the extremes of the range becoming compromised, market participants flood into the market and drive price up or down.
- Periodic news release: The scheduled release of an official economic report or market-related data can serve as the catalyst for a definitive move in pricing. Public and private sector data releases may generate the market participation and volatility needed to sustain a directional move in price.
Many breakout trading strategies are built upon support and resistance levels, chart patterns, consolidation or the volatility caused by an economic data release. Perhaps the most significant difference between them is the timeframe upon which they are based.
Scalpers, day traders, swing traders and intermediate-term investors all attempt to capture breakouts utilising analysis based upon different timeframes. For instance, a scalper may use one-minute, five-minute and 30-minute charts to identify and execute a desirable breakout trade. On the other end of the spectrum, an intermediate-term investor may use daily, weekly and monthly charts to identify a breakout opportunity.
No matter the strategy or duration, the objective of the trade remains constant: achieve profit from a directional move in pricing.
The Pros And Cons Of Breakout Trading
There is an array of factors that contribute to a trade's success or failure, no matter what type of approach to the market is being implemented. However, several distinct advantages and disadvantages are unique to breakout trading.
As with any system or discipline regarding the "proper" way to interact with the marketplace, the viability of breakout trading is an ongoing debate with camps of supporters and detractors.
Proponents of breakout trading cite numerous reasons for its suitability. They include:
- Limited risk: In many instances, breakout trades present themselves during consolidating market phases. Initial stop losses may be relatively small according to the compressional pattern or price range being used for market entry. In addition, confirmation of a trade's failure may come rapidly, offering an opportunity for a quick exit.
- Profit potential: If a breakout trade is successful, large gains are possible. Getting in on a strong trend early can be a profitable situation.
- Trade management: Market entry and exit are typically predefined. With stop losses and profit targets being identified before the trade, subjectivity errors regarding the management of an open position are eliminated.
- The trend is your friend: The goal of breakout trading is to align with an upcoming trend. If the trend fizzles, or the market reverses, then the initial stop loss is hit. It is impossible to end up trading against the trend.
- Conversely, breakout trading is seen by many to be an inefficient means of engaging the financial markets. These are several frequently cited disadvantages to the approach:
- Opportunity cost: Optimal trade setups can occur infrequently. Searching for setups can often leave a trader on the sidelines instead of pursuing other opportunities.
- False breakouts: False breakouts are a considerable part of this approach to trading. No matter how sound the methodology used in identifying a breakout is, quantifying market follow-through is largely subjective. In many instances, a signal may appear to be solid but end up lacking the increased participation needed to succeed.
- Slippage: A key element of successfully trading a breakout is entering the market with precision. Because of the increased market participation created by the setup, optimal entry prices may be saturated with resting market orders. Market activity is needed to move price, but it can be a challenge to enter the market efficiently.
There are numerous advantages and disadvantages to implementing a breakout trading strategy. While capitalising upon a strong trend may be lucrative, achieving consistent profits can prove difficult. False breakouts and missed opportunities make strict adherence to this approach a challenge.
The development of a comprehensive trading plan coupled with proper money management is the key to successfully incorporating any approach into a trader's arsenal. Through proper risk management and sound methodology, breakout trading may prove to be a worthwhile endeavour.
Any opinions, news, research, analyses, prices, other information, or links to third-party sites are provided as general market commentary and do not constitute investment advice. FXCM will not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…