Breakout

A breakout happens when the price exceeds a resistance level or falls below a support level. This movement is marked by a sudden directional change, often accompanied by increased volatility and substantial trading volume. Traders who practice breakout trading follow the belief that "no price is too high to buy and no price is too low to sell." Since different traders may recognize various support and resistance levels, breakouts can be subjectively interpreted. Breakouts indicate the potential for a price trend in the direction of the breakout.

There are two primary types of breakouts: upside breakouts and downside breakouts (also referred to as breakdowns). An upside breakout suggests a possible upward price trend, leading traders to consider going long or closing short positions. This pattern typically represents a trading range where prices move sideways between two parallel horizontal lines, often acting as a consolidation area within an existing trend. However, an upside breakout can sometimes result in a reversal of the previous trend. When the upper resistance line is broken, it marks the end of the consolidation phase and the start of an uptrend. Once the resistance level is exceeded, it may become a support level if the price experiences a correction or pullback.

On the other hand, a downside breakout indicates a potential downward price trend, signaling traders to think about going short or closing long positions. When the support level is breached, it may turn into a resistance level if the price undergoes a correction or pullback. Breakouts that occur with high volume (relative to normal volume) suggest stronger conviction, making it more likely for the price to trend in that direction. Conversely, breakouts with low volume indicate weak conviction and are more prone to failure, making it less likely for the price to continue in the breakout direction.

To trade breakouts, traders often wait for the price to remain below a resistance level or above a support level for a certain period. These levels are crucial for determining entry points or stop losses. When the price breaks through these levels, two main actions typically take place: traders anticipating the breakout enter the market, and those with stop losses in the vicinity get triggered. This surge of buying and selling usually leads to increased volume, reflecting significant trader interest in the breakout level.

Breakouts are often linked to chart patterns such as rectangles, triangles, wedges, and pennants, which form as the price moves in specific ways that establish support and resistance levels. Traders closely observe these levels, and if the price breaks above resistance, they tend to go long, while a break below support prompts them to go short. After a breakout, the price may retrace to the breakout point before continuing in the breakout direction. Following an upside breakout, the price may revisit the previous resistance level, which has now become a support level. In the case of a downside breakout, the price may retest the former support level, which has now turned into a resistance level.

This retracement occurs because some short-term traders often buy the initial breakout and quickly take profits, necessitating selling to exit their long positions, which temporarily drives the price back to the breakout point. If the breakout is valid, the price should continue moving in the breakout's direction. If it fails to do so, it is regarded as a "fakeout" or "failed breakout." Fakeouts are common, where the price may briefly exceed resistance or support, misleading breakout traders into entering positions, only for the price to reverse and fail to continue in the breakout direction. This pattern can repeat several times before a genuine breakout occurs.

Trading breakouts can be challenging, as chart patterns like triangles, flags, and pennants tend to produce higher-probability breakouts compared to ranges (or rectangles). Since ranges are easier to identify, they attract traders with opposing strategies: breakout traders and range traders. In this scenario, opposites do not attract; instead, they create fakeouts.