Chapter 22

Trading Breakouts
"We must remove the emotional element as quickly as possible in trading. If you can do it before you put on a position, you have
a good start."

As we move forward in the trading course, it is important to address actual strategies to apply to your trading
approach. Most active traders spend countless hours looking for trading strategies or opportunities that offer the
highest returns, without exposing their account to unnecessary risk. As option traders, it becomes even more
difficult to do this. Let’s face it; option buying is a low-probability strategy. To compensate for this, we highly
recommend focusing your efforts on a common technical strategy that offers explosive price swings in most
financial instruments – trading breakouts.

Breakout trading is used by many active investors to take a position within a trend’s early stages. Generally
speaking, this strategy can be the starting point for major price moves, expansions in volatility, and when managed
properly, can offer limited downside risk. Throughout this chapter we will walk through the anatomy of this trade
from start to finish and offer a few ideas to better manage this trading style.

What Is a Breakout?

A breakout occurs when a stock moves outside a defined support or resistance level on its price chart with
increased volume. An investor enters a bullish position after the stock price breaks above resistance or enters a
bearish position after the stock breaks below support. Once the stock trades into the new price level, volatility
tends to increase and prices usually trend in the breakout’s direction. The reason breakouts are such an important
trading strategy is because these setups are the starting point for future volatility increases and large price swings.
In many circumstances, breakouts are the starting point for most major price trends.

Figure 1: A Breakout in RIMM and a Breakdown in AAPL

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Breakouts occur from many environments. Typically, the most explosive price movements are a result of channel
breakouts and price pattern breakouts such as triangles, flags or head and shoulders patterns (see Figure 1). The
pattern is not necessarily as important as the fact that the stock has paused and consolidated ahead of a potential
breakout. Note: as volatility contracts during these time frames, it will typically expand after prices move beyond
these ranges.

As we discuss trading breakouts as a trading strategy, it is important to discuss from start to finish, how to manage
this type of approach. We will highlight entry points, exit points, trade management, and profit targets. At the end
of this chapter, you should be able to develop a complete plan on how to successfully trade breakouts.

Important Points to Consider

Breakouts generate explosive price swings because they trigger supply/demand imbalances that occur outside of
these obvious price barriers. For example, traders that are bullish on a stock will set buy stop orders at or above
resistance to execute a buy order once prices trade through resistance. Traders that are short the stock during this
event will likely have their stop orders in this area as well, to cover a short position as prices trade above
resistance. This event sends a tremendous amount of demand to the market as the bulls enter buy orders to buy
stock, and the bears enter buy orders to cover their short positions to prevent further loss. This excess of demand
sends prices sharply higher.

The opposite would be true for traders that are bearish on a stock. They would set sell stop orders at or beneath
support to short shares of stock as prices break beneath support. Any traders that are long shares of stock at this
time would likely have sell stop orders at or beneath support as well, to take them out of a long position in the
event that the stock broke support. This event sends a tremendous amount of supply to the market as the bears
enter sell orders to short stock, and the bulls enter sell orders to sell their shares to prevent further loss. This
excess of supply sends prices sharply lower.

As you can see, breakouts trigger significant order flow and price action. Traders know that once a stock is done
consolidating, as it moves away from a range, one side of the market will be wrong while the other will be right.
The general public will notice this move as well and will enter the market based on the idea that the stock is
getting ready to trend; similar to the examples in Figure 1. Once prices moved outside the highlighted support and
resistance levels, prices continued to trend for multiple weeks. These moves are more significant than most typical
market fluctuations. This is why we will always be keeping an eye out for these types of situations. We want to
trade stocks that are moving with purpose, not stocks that are just fluctuating randomly with the broad market.

When looking for opportunities to trade, here are a few key points to consider:

A prior trend must exist – This will help you determine direction as prices get set to leave a point of
consolidation. If continuation or reversal patterns show up after trending move in price, this will help you
better anticipate a new directional price move for aggressive trade timing and entries.
Watch for the first sign of strength/weakness – The ultimate goal is to get good at reading and

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 anticipating price swings. Many stocks will give clues as to when they will leave a range, and whether they
will move up or down. By constantly watching prices, you can see whether prices are strengthening or
deteriorating in their respective ranges, which will help you in taking anticipatory entries.
Prices fall faster than they rise – It’s important to remember that stocks “take the stairs up and the
elevator down.” Since downward price movements trigger anxiety, emotion, and eventually sell orders,
the market falls much faster than it rises. Knowing this is important as prices trend beyond their
breakouts.
The larger the pattern, the bigger the potential move – As it pertains to measuring breakouts from price
patterns, the bigger and more dynamic the pattern is, the more significant the outcome will be. If a
continuation pattern measures 10 points wide at its widest point, then you can anticipate setting a profit
target 10 points beyond the point of the breakout.
Volume is a confirming indicator – Volume levels should increase as prices break beyond a support or
resistance level. This confirms the execution of order flow, and if the stock remains outside its prior range,
than it is said that the stock is “accepting” these new prices. Volume should always confirm a breakout.
Time frames - Regardless of the time frame, breakout trading is a great strategy. Whether you use
intraday, daily or weekly charts, the concepts are universal. You can apply this strategy to day trading,
swing trading or any style of trading.

Finding a Good Candidate

When trading breakouts, it is important to consider the underlying stock’s characteristics aside from just its price
pattern or support and resistance levels. Most traders develop preferences of the types of stocks they like to trade.
Every stock has particular characteristics that make it good to trade, or not good to trade based on each individuals
preferential biases. For example, Trader A prefers stocks that move fast and in large percentages, while Trader B
prefers highly liquid stocks that are not quite so volatile. These qualities can be used to dial down the large number
of available stocks out there to a smaller, more manageable list. As we’ve discussed in prior chapters, this is why
tracking a watchlist is so important.

A few simple characteristics you’ll want to define are:

Volatility – Stocks that are more volatile can generate bigger returns, but also bigger losses.

Liquidity – Liquid stocks will typically offer liquid options, and are more actively traded in general.

Options – Always double check to see that the options are liquid enough to trade.

Aside from the stocks characteristics, the next thing to check will be the technical set-up. Support and resistance
levels should be inspected, as should the price pattern before entering a trade. The more times a stock price has
touched these support/resistance areas, the more valid they are and the important they become. At the same
time, the longer these support and resistance levels have been in play, the better the outcome when the stock
price finally breaks out (see Figure 2).

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 Figure 2: A Triangle Breakout in BIDU

Looking at the chart above, what defines this as a “price pattern” is the consistent touch points that form the
shape of a triangle.

As prices consolidate, various price patterns will occur on the price chart. Formations such as channels, triangles
and flags are valuable vehicles when looking for stocks to trade. Aside from patterns, consistency and length of
time a stock price has adhered to its support or resistance levels are important factors to consider when finding a
good candidate to trade. All of these elements were discussed in greater detail in our Price Patterns module.

Entry Points

After finding a good instrument to trade, it is time to plan the trade. The easiest consideration is the entry point.
Entry points are fairly black and white when it comes to establishing positions upon a breakout. Once prices are set
to close above a resistance level, an investor will establish a bullish position. When prices are set to close below a
support level, an investor will take on a bearish position. This is where many traders will use buy stop orders to put
them into a long position once a particular price is reached. For example, in Figure 2 the resistance level at the
apex of the triangle pattern was $140. A trader can simply issue a buy stop order to put them into shares of BIDU
once prices hit $140.

Anticipatory Entry Points

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If a stock is in a consolidation pattern, or a trading range, there is no guarantee as to which direction it will break.
This is why many traders opt to wait for the breakout to occur and take on a position immediately as prices start to
break either up or down. However, anticipating a price move can be a very rewarding task, if done correctly.

Going back to Figure 2, let’s assume you were bullish on BIDU. The stock had been in an upward trend, the market
had been bullish, and with the triangle pattern being a continuation pattern, you were anticipating a breakout to
the upside.

Knowing where support and resistance are located on the chart, you simply look for opportunities to buy at
support if you are anticipating a bullish breakout. Conversely, if you were anticipating a bearish breakdown, you
would look to short shares or buy puts when the stock reaches resistance.

Figure 3: Anticipatory Entry Points

One of the reasons we aim to trade at support or resistance levels is because risk is easy to define, and easier to
manage. Going back to our example of BIDU, the apex of this consolidation pattern illustrates resistance at $140,
and support at $135. If you are able to enter a trade at support, you could set a stop just beneath support, in case
prices were to break down. For example, if you entered the trade at $135, you could set a stop at $134 knowing
that if the stock traded down to that price, then the outcome of this price consolidation would be a breakdown,
which would result in much lower prices.

At times you will run across situations where a stock attempts to make a move outside a support or resistance
level, only to fail and trade back into their trading ranges. This is commonly referred to as a “fake-out.” As it
pertains to trading breakouts, always remember “from failed moves come fast moves.” This means that in a fake-
out situation, once a breakout fails, you will see a fast move in the opposite direction. This is why many traders

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choose to wait for confirmation, as opposed to anticipating movements. Many investors look for above-average
volume as confirmation or wait towards the close of a trading period to determine whether or not prices will
sustain the levels they’ve broken out of.

Planning Exits

Predetermined exits are an essential ingredient to a successful trading approach. When trading breakouts, there
are three exits plans to arrange prior to establishing a position.

1. Where to Exit with a Profit

When planning target prices, look at the stock’s recent behavior to determine a reasonable objective. When
trading price patterns, it is easy to use the recent price action to establish a price target. For example, if the range
of a recent channel or price pattern is 12 points, then that amount should be used as a price target to forward
project once the stock breaks out (see Figure 4).

Figure 4: Measuring a Price Target

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As you can see, the range in Figure 4 is roughly $12 points wide (142 – 130 = 12). That means that once prices
break resistance at $140, you would anticipate a $12 point move, or would look to book gains at $152 (140 = 12 =
152).

Another idea is to calculate recent price swings and average them out to get a relative price target. If the stock has
made an average price swing of four points over the last few price swings, this would be a reasonable objective.

These are a few ideas of how to set price targets as the trade objective. This should be your goal for the trade.
After the goal is reached, an investor can exit the position, exit a portion of the position to let the rest run or raise
a stop-loss order to lock in profits.

2. Where to Exit with a Loss

It is important to know when a trade has failed. Breakout trading offers this insight in a fairly clear manner. After a
breakout, old resistance levels should act as new support and old support levels should act as new resistance. This
is an important consideration because it is an objective way to determine when a trade has failed and an easy way
to determine where to set your stop-loss order. After a position has been taken, use the old support or resistance
level as a line in the sand to close out a losing trade. As an example, study the CHK chart in Figure 5.

Figure 5: A Failed Breakout in CHK

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After a trade fails, it is important to exit the trade quickly. Never give a loss too much rope. Remember; from failed
moves come fast moves. As you can see in Figure 5, a low volume breakout in CHK quickly unravels into a 25%
decline!

3. Where to Set a Stop Order

When considering where to exit a position with a loss, use the prior support or resistance level that prices have
broken out of. Placing a stop comfortably within these parameters is a safe way to protect a position without
giving the trade too much downside risk. Setting a stop higher than this will likely trigger an exit prematurely
because it is common for prices to re-test price levels they’ve just broken out of.

Figure 6: A Breakout in RIMM

Looking at the chart in Figure 6, you can see the initial consolidation of prices, the breakout, the re-test and then
the price objective reached. The process is fairly mechanical. When considering where to set a stop-loss order, had
it been set above the old resistance level, prices wouldn’t have been able to re-test these levels and the investor
would have been stopped out prematurely. Setting the stop below this level allows prices to re-test and catch the
trade quickly if it fails.

Summary

Breakout trading can be a packaged trading system by itself. As discussed in this chapter, so long as you are able to
consistently identify opportunities, if is very straight forward on how to enter a trade, set a profit target, and set a
stop order. At that point, the only thing left to do is to let the trade work.

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Trading these set-ups can offer significant returns, but they also bring about riskier trading conditions. Prices are
moving fast and there can be a considerable amount of volatility. As with all trading systems, the most important
element is understanding what risks are involved and properly managing those risks.

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