As we know by now, traders try to profit from day-to-day price fluctuations in stocks. These fluctuations can either occur in a trend -- where the stock price is continuously moving in one direction with minor corrections, or in consolidation -- where prices trade in a narrow range.
Consolidation in prices indicates indecisiveness in the market as neither bulls nor bears have the upper hand. This constant tussle between the bulls and bears results in prices moving in a range.The upper level of this price range is called the resistance level. This level prevents the stock price from rising beyond it. At the resistance level, the demand for that stock is less and the sellers outpace the buyers. The lower level of the price range is the support level. The stock prices generally do not fall below this level due to a flock of buying orders here, limiting further downside. The concepts of support and resistance are covered in detail in chapter 7.3.
Breakout trading strategy
A breakout happens once prices breach a support/resistance level, trendline or form a breakout pattern.In technical analysis, the expectation is that the price will continue moving in the direction of the breakout after the breakout. For example, if the stock breaks the resistance levels, it will continue moving up.This is because breakout (and confirmation) usually leads to follow-up buying (or selling). And as more and more traders jump on the bandwagon, a snowball effect is seen, which pushes prices higher and higher (or lower and lower). Hence, a trend emerges.The longer the stock trades within its price range, the sharper would be the movement of the stock when it breaks out from the consolidation zone. Breakouts provide a good trading opportunity and traders need to proactively identify such breakouts.
Identifying breakouts
Identifying real breakouts from false breakouts can generate higher return on your capital. Here are some factors that you should consider to confirm the breakout.Technical analysis: Traders can take the help of advanced technical charts and various tools to spot the stocks that show the potential for a breakout. These tools also aid in determining a strong trading strategy.Indicators such as Moving Averages, RSI and MACD can be used to measure the strength of the breakout.Volume: An important factor to identify a breakout is the trading volumes of the stock. It is essential that the volumes traded should be high on the day of the breakout. The Higher the volumes, the higher the chances of a strong breakout.Time period: Traders are required to use a longer time period to determine a genuine trend. A general rule is to use a time period of 21 days to wait for the stock to show its momentum.
How to trade breakouts
Successful breakout traders watch out for stocks that are about to break out of or break down from critical levels.The quality of the signal is important. This means that multiple signals (such as a chart pattern formation + spurt in volumes + Indicators) is better than a single signal.Risk averse traders may start with a small position and add to it on the way up. Risky traders typically put on a larger position on breakout.However, traders should have the ability to recognise false breakouts. A false breakout is when a stock breaches a critical support or resistance level, signalling a reversal or continuation of a trend, but then sustains below resistance or above support level.If you repeatedly get trapped in a false break out, the best thing that you can do is to wait for a day or two (if you’re a swing trader) before entering your position. False breakouts typically shake out the weak hands from the marketFinally, it is important for traders to have an exit strategy when entering a trade. They should have a set target price at which they would want square off the trade. A trailing stop loss, which we will discuss later in this module, can also be a good way to protect yourself against false breakouts.
