The breakout play can be a great setup to trade, but the term itself can be ambiguous and overused, so let me start off by getting everyone on the same page as to what I mean by breakout. Often people just use the term to describe when a stock starts to move up sharply, which isn’t necessarily wrong, but I have a more specific idea of what a breakout entails. If a stock has dipped and crashed for weeks and then finally bottoms out and bounces, you may hear someone say it’s “breaking out”, I call that bouncing. (TIP – Equity Feed is the screener I use to find penny stocks before they break out with high volume, poised to move higher + ignore message boards)
In general, stocks in downtrends are not breakout candidates. I’m looking for stocks that are uptrending or at least flat, and the major component is a break of key resistance (aka breakout point), then ideally there is little or no obvious resistance above that resistance. Just like many aspects of trading, this is not going to be a black and white issue, there will definitely be a ton of gray area to sort through. A good trader is going to need to be able to spot two things, key resistance and recent price action that is conducive to a healthy run.
– Key Resistance: Sometimes this is the highest point the stocks ever traded at, sometimes it’s a six month high, and sometimes it’s just going to be what you happen to determine as key resistance (though there still could be other resistance overhead). You’re basically training your eye to spot those points where you believe that once the bulls break through, the stock is going to rally. A big part of this is just gaining experience and developing your intuition based on price action. Sometimes a break-out can trigger at a point where most people aren’t really expecting it, but because you were so in tune with how the stock was trading, you were able to get in well before the crowd.
– Favorable Recent Price Action: This is an area where I see many traders make costly mistakes. Stocks tend to trade in a pattern that repeats itself over and over, just with a wide range of variations. That pattern is sideways trading (consolidation), which is followed by sharp price movement, followed by sideways trading again, and so on. When you play a break of resistance, you don’t want the stock to already be overbought and overextended in the short term, the ideal situation is playing a break of resistance when it’s also moving out of a consolidation range.
For example, let’s say you spot very obvious resistance on a chart at $1, but the stock is trading well below it at .60. It goes on a big run and closes the day at .90. That evening you’re looking at the chart and you decide that if the stock breaks $1 the next day, you’re going to buy because that’s a break of major resistance. The next day it does break through, you chase a little because the momentum moved the stock up too quickly, and you’re filled at $1.05. The stock goes as high as $1.10, but then closes the day at .85! Big failure. What the heck happened? Why didn’t the rally hold? The answer is not all breaks of resistance are created equal. In the stock market, anything can happen, so there’s always the chance that in this scenario you could still catch a runner, but if you were playing the odds, you wouldn’t have taken that trade. Just the day before it was sitting at .60, so just imagine how mabreakout was enough to absorb those sellers and then some, it’s not going to work out well. Based purely on probabilities, that’s not a soundny traders were already up 50% or more when you decided to take the breakout. You’re buying when a lot of traders were just getting ready to lock in a nice payday. Not a good idea and unless the momentum from the trade.
So when I say you’re looking for recent favorable price action, what I’m referring to is stocks that are trading near major resistance (either at, below, or above), but have traded sideways and consolidated their gains first. This allows the weak hands to bail and for those shares to be put in stronger hands. Using that last example, let’s go over a much better approach. So the stock rallies one day from .60 to .90, but this time you decide that even if the stock does move past $1 (major resistance), it’s up too much in a short period of time for you to take the break of resistance. The same result plays out, it breaks $1, you’re tempted to get in but your discipline won’t allow you to go against your game plan, and when the stock closes at .85 you pat yourself on the back for making the right decision. Now just because it failed to break that key resistance once doesn’t mean you take it off your watchlist.
On the contrary, you should now be on high alert for consolidation in this range. Consolidation near major resistance is one of the best signs to see in potential breakout setup, and this scenario could be setting up just for that. So you watch the action on this stock for a few weeks and the entire time it stayed above .80 but below $1, all the while having a slight bias to the upper end of that range. Now what you have is a perfect setup, where you had the strong move from .60 to resistance, followed by a few weeks of consolidation (near said resistance). At this point, the weak hands have flipped out, and now you have a strong base full of traders who won’t be so quick to sell into a pop. Finally one day after three weeks of hanging out below $1, it ends up breaking through and starts testing prices north of that resistance again. (This is favorable price action to look for) Instead of being overbought and having a mass of traders who are eager to lock in profits right away, you have a nice base of holders who probably won’t be looking to take profits until the breakout has already had a chance to play out and develop. Because of that, there’s also a very good chance that the momentum will then be enough to absorb that initial wave of profit takers, and the break-out even has a chance to really gain some strength and go exponential.
To summarize what you’re looking for is for the trend to be flat or up. One of the keys is the accumulation that precedes the run, and a stock that is falling or crashing doesn’t have an extended period of accumulation. On the other hand though, if the stock is uptrending too sharply or has gone up too much in too little of time, then you’re going to need to wait for the stock to level off first. The ideal scenario is a stock that is trading flat for an extended amount of time, usually the longer the better, with a slight upward bias. If you are looking to take a breakout after a sharp rally, to get the odds back in your favor you’re going to need consolidation of that rally. The more the rally has gone up, the longer the stock should then consolidate before you think of playing it. Once you spot a chart with a favorable overall look to it, then you need to spot the key resistance. There’s not always going to be one and only one resistance point, but you need to decide where you’re looking to enter. That will generally depend on the last factor I mentioned, which is a favorable recent price action. Sometimes you may see some very attractive consolidation setting up below your targeted resistance. In that case, you may decide to jump in when the price jumps up out of the consolidation and not when it actually breaks the breakout point. Sometimes you may get a break of resistance without a nice consolidation base first, in which case you may just pass on it or wait for a better entry post-breakout.
The last thing to mention is a general cautionary warning that really applies to any setup or method you trade. Breakouts have their periods where they work unbelievably well, and they have their periods where they’re few and far between, and the ones that do rally don’t sustain themselves nearly as long. When I first discovered this strategy, I thought I found the holy grail. I was convinced that this was my one method I’d be able to stick with and week after week make great returns. Fast forward to the present and it’s still not favorite and most frequently used method, because I’ve learned that the results will vary greatly and therefore I need to be aware of the environment I’m in, and trade accordingly. Some options to consider depending on how breakouts are performing are aggressiveness, position sizes, when and where you take profits, etc. and sometimes you may just ignore the setups altogether. Even in the slowest of times for these setups, I personally usually never stop scanning for them and playing them entirely, since the potential for profiting is pretty much always going to be there.
I’ll finish up with a quick example.
The most ideal entry I’d recommend in a situation like this is playing a break of the consolidation that takes place near the channel’s resistance. This consolidation may take place under, at, or above resistance, but in this case, it formed on top. Not all breakouts will set themselves up with neat consolidation ranges prior to the rally, but the ideal ones will. I tend to focus on ideal setups and pass up the rest. As a trader I’m not trying to catch every runner I can, I’m merely trying to make money and then not give it back.
I highly recommend everyone get accustomed to playing these and learning the principles behind them. Even if you don’t focus on primarily trading these setups, the fundamentals that make up the strategy can apply to many other methods. Being able to spot support and resistance, spotting the overall trend of a stock, knowing when a stock is in a favorable position to move up, watching for the repeating pattern of sharp movements and consolidation periods, are all things that can apply to your trading in general.