A Comprehensive Breakout/Breakdown Trading Guide
Breakout trading is one of the most exciting and most used trading strategies, relying on price action without technical indicators. Some traders prefer to confirm a breakout or breakdown with a technical indicator, but the purest form uses candlestick charts and support or resistance levels. Breakout trading falls under naked trading, referring to a clean chart. Some traders use a 20-DMA to gauge the trend, but the fine-tuning of any breakout trading strategy depends on individual preferences.
We will outline breakout and breakdown trading, discuss how to spot profitable opportunities, show how to avoid false breakout patterns, and discuss the difference between breakout and breakdown trades. Breakout trading can boost your profits if managed correctly, while it can accelerate losses unless traders avoid mistakes.
What are the most significant breakout and breakdown mistakes traders must avoid? We will cover them in our comprehensive breakout/breakdown trading guide below.
The Definition of a Breakout or Breakdown
Breakout trading refers to the general approach of buying or selling an asset as it moves beyond well-established support or resistance levels. The terms breakout and breakdown define the direction of the trade. Both allow traders to capture a trend in its early stage, offer a counter-trend trading opportunity, or capture a volatility spike.
The difference between breakout and breakdown trading:
- A breakout refers to price action pushing through resistance and extending a previous uptrend following a pause or sideways trend
- A breakdown occurs when price action collapses below support and often continues a downtrend following a halt or sideways trend
Some traders exclusively use breakout trading, as it can result in significant profits over a short period, but patience and discipline are mandatory. While a breakout and breakdown provide tremendous profit potential, false breakouts and breakdowns can magnify losses. Penny stocks are ideal for breakout trading, as they include a multitude of breakout stocks to scan each session. The liquidity of the Forex market is also well-suited for a breakout trading strategy.
Breakout Patterns and Trading Examples
Breakout chart patterns present an ideal starting point when scanning for breakout trading candidates, primarily since a pure breakout trading strategy relies heavily on them. While a breakout technical analysis can confirm a trend or volume changes, it begins with breakout chart patterns.
Breakout and breakdown chart patterns:
- Falling Wedge
- Inverse Head-and-Shoulders
- Flag Formation
- Rounding Bottom
- Double Bottom
- Triple Bottom
- Ascending Triangle
- Symmetrical Triangle
- Rising Wedge
- Inverse Flag Formation
- Double Top
- Triple Top
- Descending Triangle
- Symmetrical Triangle
Traders with access to advanced trading platforms or proprietary solutions can use algorithmic chart pattern recognition software to filter for the above patterns. The above breakout chart patterns can go in either direction, and traders must analyze price action and volume to determine the next move.
Manual traders can refine their search to assets with high trading volumes, those trending on social media, or venture into penny stocks if their risk appetite is high. All three provide the most breakout trading opportunities, and the first two are widely available at most brokers. Beginners should stay away from penny stocks until they master breakout trading strategies.
A breakout trading example:
- A trader identified a falling wedge formation, which belongs to common breakout chart patterns
- Price action previously struggled to push above the upper descending resistance level of the falling wedge formation, which helped form the narrowing cone of this pattern
- Once a breakout above the upper descending resistance level occurs, confirmed by an increase in volume, traders should wait for a retest of resistance, which now presents support, and enter their buy orders
A breakdown trading example:
- A descending triangle formed over the past few trading weeks, and price action struggled to move above its descending resistance level while bouncing off well-established support
- The buildup, where candlestick volatility decreases, indicates the potential for a breakout
- After price action completes a breakdown below the horizontal support level of the descending triangle confirmed by an increase in volume, wait for a bounce higher and a retest of its support-turned-resistance level
- Monitor volume during the retest, and if it is below average, sell at resistance
A Breakdown Trading Guide for Profitable Breakout Trading Strategies
Irrelevant to breakout chart patterns and the direction of the breakout, breakout trading has similarities traders should recognize to improve their trading results.
What to look for when scanning for breakout trading candidates?
- Since breakout trading is ideal for naked trading or charts free of indicators, support and resistance levels form the backbone of each breakout trading strategy
- The most reliable support and resistance levels for breakout trading are those which price action tested before but failed to break
- Higher lows into resistance can indicate a breakout, while lower highs into supports favor a breakdown
- Traders should learn to recognize chart patterns and learn candlestick formations, which provide necessary insight into price action, confirm support and resistance levels, and decrease the risk of false breakouts
- Volatility and volume accompany most breakout patterns, making them primary indicators for breakout trading
- New highs and lows offer another reliable indicator for profitable breakout trading, as price action usually moves into the direction of either to establish new support and resistance levels
The Best Conditions to Buy Breakouts
One of the most reliable breakout trading patterns is the ascending triangle, as it combines a confirmed and tested resistance level and a natural buildup with higher lows into resistance. The absence of selling pressure adds to bullish momentum, and plenty of buy limit orders await above resistance to capture a volatile move higher.
Traders should monitor price action for a high-volume breakout, wait for a retest, and buy the breakout at its resistance-turned-support level.
The Best Conditions to Sell Breakdowns
A descending triangle is the opposite of an ascending triangle and remains one of the most reliable breakdown patterns. The established and tested support level and lower highs into support create a natural buildup and confirm the absence of buying pressure, which increases bearish momentum. Sell limit orders await below support, where traders attempt to profit from downside volatility.
Traders should monitor for a high-volume breakdown, wait for a retest of the support-turned-resistance level, and sell the breakdown.
Mistakes to Avoid in Breakout Trading
The biggest mistake in breakout trading is to buy the initial breakout when price action accelerates higher or lower. Most breakouts reverse shortly after moving above resistance or below support. Short-term exhaustion sets in, and price action retests support and resistance levels, as they have now switched. Confirming them is a healthy sign, giving traders the green light to buy the breakout or sell the breakdown. A bonus is a better entry-level, which increases the profitability of each trade.
Another mistake to avoid is entering low-volume breakouts, as they are most likely to result in false breakouts and reverse. Trading in the direction of the previous trend and with a buildup will limit breakout trading losses. Other mistakes to avoid are allowing losses to accumulate or entering a breakout trade without an exit strategy.
Essential Tips for Profitable Breakout Trading
Learn the below breakout trading tips, implement them into your breakout trading strategy, avoid false breakouts, and increase your profits.
Tips for profitable breakout trading:
- Trading in the direction of the previous trend can lower risk and the likelihood of false breakouts, and while counter-trend trading can boost overall profits, beginners should avoid it until they earn enough experience
- Assets in a prolonged range-bound market provide the most explosive breakout trading opportunities due to an abundance of limit orders above resistance and below support
- A buildup, the narrowing of highs and lows of each candlestick, often precedes a breakout, making it one of the most defining pre-breakout indicators traders should look for
- Volume confirms breakout and breakdown trading, and traders should avoid price action moves on a decrease in trading volume
- Trading during times of high liquidity will lower trading costs, while high volatility periods ensure traders capture a breakout that has the potential to hold while avoiding false breakouts that often materialize during low volatility periods
- A breakout or breakdown usually reverses following the initial move, retesting the broken support or resistance level, which now acts as resistance or support, and traders should remain patient and wait for the retest before entering their positions
- Have an exit strategy before entering the trade, as it is the only time you can approach it emotionless
- Create a list of breakout candidates as you start your trading day and narrow the list to a handful of most promising setups to focus on, avoid overtrading, and keep things as simple as possible
Breakout trading can offer traders an exciting and highly profitable trading strategy. Key aspects to consider are scanning for ascending and descending triangle formation, trading in the direction of the previous trend, confirming breakouts with volume, and waiting for the retest of the breakout level before taking a position.
Is breakout trading profitable?
Breakout trading is a profitable strategy if executed under the right conditions and with an exit strategy before entering the trade.
How do you confirm breakouts trading?
Volume remains the primary confirmation, followed by a successful retest of the breakout level.
When should you enter a breakout trade?
Ascending and descending triangles present the most reliable breakout trading patterns, and traders should enter after a high-volume breakout following the retest of the breakout level.
How do I find my breakouts?
Scanning markets for breakout chart patterns and assets in prolonged trading ranges will provide traders with a list of breakout candidates to monitor.