Disclosure: Day trading is a high-risk investment strategy that requires thorough research and understanding of the associated risks. Please consider Webull's Day Trading Risk Disclosure.‌

What is breakout trading?

In technical analysis, it is believed that a stock/ETF is either trending or consolidating (moving within a range). Each uptrend or downtrend is followed by a consolidation within a range and each consolidation gives rise to a new trend.

Breakout trading aims to enter a trade as soon as the price breaks through a range. This is different from trend trading, which aims to make profits from an established trend. In this way, breakout trading gives more room for profits and losses compared to trend trading.

How to identify breakouts

A breakout may occur when a stock/ETF surges above the resistance line or drops below the support line with increased volume. Therefore, the most basic way of identifying breakouts is to look at the support and resistance level with trading volume.

When the price breaks below the support line with an increased volume, it’s more likely that the downside breakout will remain intact. When the price climbs above the resistance line with an increased volume, it’s likely that the upside breakout will remain intact.

Investors applying the breakout trading strategy would establish a short position when the price breaks below the support line with increased trading volume.

Note: Price can move in a range for some time. You can set a price alert if you’ve identified an important resistance or support level. You’ll be alerted immediately if the resistance or support level is broken.

Be careful of false breakouts

Not all breakouts are successful. The price may seem to break above the resistance level or below the support level to form a bullish or bearish trend but immediately turn in the opposite direction. This is what we call false breakouts.

It may be difficult to identify a false breakout immediately, especially when it’s accompanied by large volume. But we can take measures to avoid trading false breakouts or limit losses from trading false breakouts.

1. Wait for a pullback

Investors could wait for the price to pull back to test the support or resistance line when they’re uncertain about the breakout. If the support or resistance line is still intact, the breakout is valid.

2. Place a stop order

Losses could still be limited even if they’ve entered a trade at the false breakout.

Continuing the example above, if an investor bought the ETF at the false breakout and placed a 2% stop order to stop losses, his position would be closed at the price of about $18.50, before the price dropped further.

Bottom Line

Breakout trading can be profitable if the breakout holds intact. Investors could use technical indicators to confirm if the breakout is valid.

However, there is a great chance that this strategy would fail as false breakouts are common. In this case, investors could wait for a pullback to enter a trade. Most importantly, they should take measures to stop losses.

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