What is a Stock Market Breakout?

Breakout in stocks is like a financial roller coaster ride! Imagine you're strapped into your seat, holding on tight as the stock price climbs higher and higher, and then suddenly, it breaks through a significant level and takes off like a rocket! The stock appears to be shouting, "I'm breaking free," and the investors are encouraging it. You might feel the adrenaline rush as you watch your profits soar along with the stock price. But just like a roller coaster, there are risks involved, so it's essential to be prepared and make smart decisions.

So, basically, a breakout refers to a price movement of a stock that breaks through a significant level of support or resistance. The term is often used to describe the point at which the price of an asset moves above a level of resistance (in an uptrend) or below a level of support (in a downtrend), signalling a potential change in the direction of the trend. If a breakout occurs in the opposite direction of a prior trend, the trend is likely reversing and a position should be closed and maybe reversed. If a breakout occurs in the direction of a previous trend, the trend is likely still there, and is likely to be continued.

A breakout above a resistance level suggests that bullish sentiment is increasing and that buyers are in control, potentially leading to a sustained uptrend. Conversely, a breakout below a support level suggests that bearish sentiment is increasing and that sellers are in control, potentially leading to a sustained downtrend.

For example, let's say that a stock has been trading in a range between INR500 and INR600 for several months. Traders may consider 500 and 600 to be support and resistance levels respectively, as the price has bounced off these levels multiple times in the past. A breakout would occur if the price of the stock rises above 600 or falls below 500, indicating that the trend may be changing. In this example, the breakout above 600 and below 500 could be seen as a bullish or bearish signal, indicating that the stock price is likely to continue to move higher or lower, respectively. However, it's important to note that breakouts can sometimes be false signals, and you need to be cautious and use appropriate risk management measures before entering into a position.

Where Do Breakouts Occur?

It is critical to understand where breakouts occur in order to confirm them. Breakouts typically occur at psychological price levels, such as:

• Supports or Resistance
• Trend Lines
• Time Highs or Lows
• Price Channels/Consolidation channels
• Pattern Levels
• Moving Averages
• Fibonacci Levels
• Round Numbers
• Pivot Points

One of the reasons breakouts cause price to move quickly is that many market participants watch the potential breakout areas. When one side is able to push through, the other side will need to quickly cover their losing positions, which will result in sharp price movements after the breakout.

The importance of a retest in a breakout

We now know that a breakout occurs when a crucial level has been established in a price formation and the price actively attempts to break through it. But, there's more to it too. The price typically approaches the level, retests it, and experiences a small bounce, demonstrating that this price level is in fact a reliable key level.

Retest in breakouts refers to a situation where the price of a stock that has broken out of a significant level of support or resistance returns to that level and tests it again before continuing in the direction of the breakout.

For example, let's say a stock has broken through a resistance level and started to climb. However, instead of continuing the upward trend, the stock's price falls back to the resistance level it just broke through. If the stock bounces off this level and continues to climb, this is known as a successful retest. On the other hand, if the stock falls below the retested level, it could indicate a false breakout and the stock may return to its previous trend.

A retest can be a crucial factor in determining the strength of a breakout, as it helps traders confirm that the breakout is valid and not just a temporary fluctuation in price.

Trading breakouts requires plenty of discretion, or it can be a dangerous game. The market can bet on either a complete breakout or a fakeout. The price action confirmation should be used to ensure that the key level's breaking has been well-established in order to keep oneself out of trouble. This enables you to verify if the price has a sufficiently high probability of continuing in the breakout's direction.

To establish a confirmation, it’s a good idea to take the highest peak that the price achieved after the breakout. This is the newly established confirmation level. If the confirmation is broken out after the key level has been satisfactorily tested, the entry is approved. This will serve as the last necessary confirmation before a trade can be executed. The confirmation will demonstrate a better likelihood of the price continuing in the targeted price direction.

How is a breakout confirmed?

Here are some common methods used by traders to confirm a breakout:

1. Price action: As discussed in previous posts, candlesticks tell us a lot about the past and future price action of a stock. For a breakout to be considered valid, the body of the breakout candlestick must cross the support or resistance level and close outside of the support/resistance zone. Sometimes it takes two candlesticks to properly cross the key level for a valid breakout; The breakout is completed by the second candlestick, while the first candlestick stops in the midst of the resistance/support level. Keep in mind that we must take into account the candlestick bodies, not the wicks; i.e., the candle's body should cross the key level and not just its wicks. Therefore, it's crucial to wait for the possible breakout candlestick to fully form before using it to confirm a breakout.
2. Volume: Increased volume of trading often occurs with a breakout. Heavier trading demonstrates that other market players are acting in the direction of the new trend and that there is sufficient power behind the price movement. However, over the years, it is also observed that volume can dramatically decline on a breakout, and the breakout is still valid. But in this case, the volume then increases as the trend develops after the breakout.
3. Time frame: Traders often use multiple time frames to confirm a breakout. For example, if a stock breaks out of a long-term resistance level on a daily chart, you may look to the hourly chart to see if the price action is also confirming the breakout in a shorter time frame.
4. Moving averages: Moving averages can also be used to confirm breakouts. For example, you may use a moving average crossover strategy, wherein you wait for the price to break through a resistance level and then confirm the breakout by observing the moving averages cross over on the chart. You can learn more about moving averages through our previous post.
5. Retest: As we have already learnt in the previous section, a retest of the resistance/support level is a good way to confirm a breakout. This is where the price retraces back to the breakout level and then continues in the direction of the breakout. A successful retest is seen as confirmation that the breakout is genuine and not a false breakout.
6. Trendlines: Trendlines are also a useful tool for confirming breakouts. Traders may draw trendlines connecting the high and low points of the price action, and look for a breakout that occurs above or below the trendline. A breakout that occurs with a strong slope of the trendline is seen as more reliable than a breakout that occurs with a flatter trendline. You can learn more about trendlines through our previous post.

Can a breakout be anticipated?

We have so far focused on methods of verifying a breakout after it has already happened. Is it feasible to predict when a breakout will happen before it actually happens? Yes, sometimes it's feasible to predict when a breakout will occur. Often, volume is a clue that a breakout is about to occur. In other words, the trend formed after and during a breakout is mainly supported by a volume rise that is consistent with it. Thus, when prices oscillate beneath a resistance zone, for example, and volume increases on every price fluctuation or minor correction,  the odds favour the price breaking through the resistance or support zone.

Prices can also provide information about their potential future direction. For example, in a trading range, if prices begin to retest the resistance level and then reverse downward right at the resistance zone, it indicates that buyers are becoming a little more aggressive with every minor correction and are willing to pay just a little more for the stock. If this tendency to have a slightly rising retest price action is accompanied by increasing volume, the probability of an upward breakout through resistance increases.

Bringing it all together

Let’s take the classic example of ITC to illustrate everything we’ve discussed up to this point.

First, we’ll draw our support and resistance levels on the weekly chart of ITC. This is pretty straightforward, as explained in our last post which describes how to define support and resistance levels.

As you can see, ITC oscillated between a resistance level of 250 and a support level of 205 for almost 4 years, from Apr’13 to Jun’17.

The first breakout attempt: The stock tried to breakout of the resistance level with a big green candlestick. But, the candlestick was not supported by an increase in volume that often accompanies the trend. This is the first negative signal.

The price quickly tries to retest, but fails, and moves back inside the resistance level, which is the second drawback.

Though the price tries to breakout again, even in its second attempt, the volume didn’t increase to fuel the breakout, Thus, it retested and falls back within the resistance zone.

Already two negative signals. The breakout is false.

Most novice traders make the mistake of trading these failed breakouts before the close of these potential breakout candles and incur a huge loss.

The final breakout attempt: The stock tries to breakout again in Jun’16 but fails again because of the same reason of low volume. However, on its last breakout attempt from this strong resistance zone, it breaks out of the resistance level cleanly.

Notice that the continuous breakout attempt followed by small retests gives a hint as to the stock’s next directional move. This pattern of breakout and retest with a slight increase in volume is indicating that buyers are becoming a little more aggressive with every minor correction and are willing to pay just a little more for the stock.

We get another positive signal of the breakout with a long green candlestick, followed by a series of green candlesticks. This shows that the bulls are showing strong signs of momentum and eagerness to break free of the resistance zone.

The third positive signal is that there is a significant increase in the volume. This means there is enough volume to fuel the resistance level.

Finally, the fourth positive signal is in the bigger picture. On the monthly chart below, you’ll notice a significant downtrend and a flag and pole pattern to the left. The price finally broke out of the pole, and the uptrend continued. Our resistance breakout, therefore, coincided with the breakout of a strong flag and pole pattern.

These four encouraging signs allowed us to validate the breakout even if the retracement has not yet taken place.

Some tips for trading breakout stocks

After identifying a potential breakout stock, here are some tips that may help you trade a breakout successfully:

1. Wait for the completion of the breakout: After identifying the support and resistance levels, keep an eye out for when they will be broken. Then, wait for the breakout to occur. It is crucial to remain patient and wait until just before market closure on the day when support and resistance have been broken. In this way, you can be certain that the breakout is valid, and that it was not just a false signal.
2. Wait for a retest: Breakouts are as lucrative as they are risky. The most significant source of risk is a false breakout. It is important to wait for a re-test of the broken support or resistance level after a breakout. Price often returns to the broken level after a breakout. For instance, if a support level is broken, it becomes a level of resistance for the next or fresh decline. Finding good entry positions and weeding out false breakouts can be made easier by having the patience to wait for a retest of a support or resistance level.
3. Recognize a failing pattern: The main risk factor in this method is false breakouts. As a result, spotting fake breakouts can reduce your exposure to total risk. A breakout pattern fails when the price returns to the initial support and resistance levels. For instance, if a resistance level is broken but the price falls below it, the breakout is no longer legitimate. In this situation, it would be wise to cut your losses.
4. Exit towards the market close: When exiting a losing trade, it is wise to do so towards market close. This is because, during the market opening, it might be difficult to ascertain that prevailing prices will hold during the active trading hours. But once the market closes, the prices likely reflect the participants' consensus.
5. When your target is met-Exit: When your trade is profitable, it is critical to stick with it until the target is met. You can set a target that is time-based or price-based. A time target will prompt you to exit after a specific duration of time, whereas a price-based target can be determined by the average movement of the stock or chart patterns.

End note

It's important to note that no single method of confirming a breakout is foolproof. One should use a combination of technical analysis tools and their own judgment to confirm breakouts and make informed trading decisions. It's also important to remember that false breakouts can occur, so it's important to have a clear exit strategy in place to manage risk.