ALL YOU NEED TO KNOW ABOUT BREAKOUTS

Breakouts are a very popular trading technique used by expert traders and investors to make their living out of the stock market. The pattern comes into play after the price consolidates inside a range, over a certain period of time, and then breaks the range in one direction. The reason behind the popularity of this technique is that it not only yields relatively quicker returns but also prevents traders from getting trapped inside the range which might last for longer than one can expect. This article would cover various aspects related to breakout trading with the help of the most recent illustrations.

Anatomy of a Breakout

We all know that any stock or instrument does not move up/down in a straight line. They often pause to regain energy before resuming the next strong move in the direction of the trend. During this phase, many buyers and sellers change hands. The price often squeezes in a range with declining volatility as well as trading volumes. Experts, if still bullish, utilize this opportunity to accumulate more. As soon as there is enough accumulation, the stock breaks the range and expands in the direction of the trend. The price action may constraint itself in a variety of ways during the pre-breakout phase, which partly decides the fate of a successful breakout.

On the basis of pre-breakout price patterns, breakouts can be broadly classified into two types. I like to call them diagonal and horizontal/flat breakouts. The breakouts from a symmetrical triangle, flag, trend channel are the types of diagonal breakouts as the price breaks out the lines inclined to an angle. The breakouts from rectangles, ascending/descending triangles, necklines of head & shoulders, or its reverse or cup & handle patterns are examples of horizontal breakouts as in all these cases the price breaks out of a horizontal line.

In its simpler form when price surpasses a previous swing high or low it is called a breakout (see fig i). But in this article, we will be dealing with those horizontal type breaks where the price faces resistance/support multiple times, at a price level, before it actually breaks out of that level (see fig ii).

Price Action Follow-up

In the following illustration, the price faced resistance at a specific level (red line) multiple times. The price may take multiple attempts before it finally breaks through such resistance. There could be several reasons for such a resistance to developing but let’s not get into those as of now.

One of the important pre-breakout observations should be the type of reaction from resistance. If reactions are sharp and significant, then there are chances that the breakout attempts might fail. On the other hand, if reactions from the resistance are weak then there are more chances for a successful break.

Another important post-breakout observation should be the length of the candles. It is favorable to have wider candles at breakout. Wider candles suggest greater buying interest and hence chances of a successful breakout.

Most of the time post-breakout, the price pulls back to the breakout level for a retest (refer to above figure). If buyers are still interested the stock would rebound from the retest level and resume in the direction of the breakout. I would like to see narrow candles during the pullback which signifies weaker selling.

Reading Volume

It is ideal to have a higher volume at the breakout. You can observe volume at point ‘A’ in the figure. The term higher is relative as there cannot be absolute volume figures which can be used as a rule of thumb for breakouts. If the volume at breakout is higher than the average volume of say 50 candles, then it is considered good but there is no rule of thumb.

During pullback for the retest, the volume should contract (see volume at point ‘B’ in the figure). Low volume along with narrow candles during pullback suggests weak selling and hence a high probability of continuation.

After the successful retest, there should be a continuation with increasing volume (see volume at point ‘C’). This signifies that buyers are back and are still interested to buy the stock/instrument.

Types of Breakouts

In the horizontal/flat type discussed above, the post-breakout price action is of great importance. This price action decides the success or failure of a breakout. I have classified breakouts, on the basis of post-breakout price action, into three types as follows.

Flying-Foot Breakout

The ‘foot’ represents the place of the breakout and ‘flying’ represents the character of the breakout. This type of breakout is seen as the market breaks out of a bottom/accumulation phase. I am illustrating only breakouts but the same is true for breakdowns.

A very common observation near a bottom would be a shakeout; a sharp initial rally; and then retracement towards the low of a shakeout. The market may make multiple attempts to clear the high of the sharp initial rally. This would result in a range well contained within the low of the shakeout (or the lowest low) and the high of the initial rally. After enough accumulation, the price finally breaks out of the upper end of the range.

This breakout is so strong that many investors would not be able to get in. Many traders would have been waiting for a pullback that will never come. This further entices the fear of missing out and traders will have to get in at higher prices only. Therefore, after a strong footing (accumulation), the price flies sharply to the moon and never looks back.

In the following example of RIL, the stock had a strong bear phase which ended with a strong initial rally ‘A’. This level was also a prior resistance zone so we can draw a horizontal red line through ‘A’. The price then retraced towards the bottom again but could not break the prior low. Finally, it broke out of resistance zone ‘A’ and never looked back. Surely a flying-foot breakout.

I have deliberately taken the following example of IOC. It has a flying-foot breakout near the bottom but it also has a flying breakout in the middle of the trend. One that looks like a small consolidation on a daily chart could have a flying-foot structure on a 15 or 30min chart. Many times dropping down our timeframe provide excellent opportunities to pinpoint our entries.

In the following chart of SunTV, the price left the resistance zone near the bottom with a gap up. This would have left many traders on the sidelines who had no better opportunity than to buy at higher prices. Notice three long bullish white candles signaling strong buying by left-out traders.

Retest Breakouts / The Ideal Candidate

You would have often heard that support is once broken may act as resistance and resistance once broken may act as support. This concept works behind our next type of breakouts.

Price often pulls back to the breakout level to check if the breakout was for real and if buyers are still interested in continuation. This gives us our second type that is, retest breakouts. In this type, the price breaks out sharply with wide candles and higher volumes. It then tests the breakout zone once and then resumes in the direction of the break. I would also call this type as ‘ideal breakout’ type.

In the following chart of Eicher motors, price broke sharply out of a resistance zone and then pulled back to the cleared resistance area. Notice how the pullback is associated with narrow candles (pin bars) at the end of the retest. This suggests that the sellers are not much interested so buyers will take over. The stock bounced sharply from the test zone.

Maruti had a similar breakout as the pullback ended with a narrow body pin-bar at the test zone resulting in a sharp bounce back.

In the following breakdown example of IOC, the price first broke sharply below a longer term support zone and then retested the zone once again. As there was more selling interest, the price resumed in the direction of the breakdown.

Multi-Retest Breakouts

This type is similar to the retest breakout type with one difference that the price tests the breakout/breakdown level multiple times rather than just one time.

In the following example of the Tata Steel chart, there was a sharper pullback from the top which halted near a prior support level. So we can draw a line (red) through this support area. Finally, this support was broken but the price still hovered near the zone for many weeks. There were two very clear retests of the breakdown level which eventually resulted in a change in trend.

The next example of HDFC is even better. The price barely managed to close above the resistance zone on the breakout day. The further price action suggested that there was no conviction in this breakout. You would notice bearish pin bars after the breakout. So the level was retested and there was still some buying which resulted in a small rally. It looks like buyers were still not convinced. The stock did a second retest which was sharper but ended in a two narrow Dojis at the breakout level. The stock gained strength after this second attempt and shot off in the direction of the break.

Canara bank’s weekly chart is also a very good example of multiple tests. A sharp breakdown of support but price then built a kind of range below the support zone with three clear tests of breakdown level. This lead to a change in trend.

Trading Breakouts

There are two ways to trade a breakout/breakdown. The first one is aggressive buying at the breakout. Within this type, a super aggressive sub-category would be to buy a breakout as it occurs, that is intraday. As soon as the price breaks few ticks above the resistance, the trader hops in and buys. This would be a low probability buying as most intraday breakouts fail and are therefore not recommended to novice traders.

The less aggressive trade would be to wait till the end of the breakout day. If the candle is going to close strong above the resistance level, then buy just a few minutes before the market close. In this case, stop loss should go right below the breakout candle or the most recent swing low. This type of entry works perfectly in the case of flying-foot breakouts.

The third type of trade would be the least aggressive. The trader, post-breakout, waits patiently for a retest. Entry would be right above a pin bar/narrow bar/bullish candle at the retest level with a stop below the most recent swing low.

Besides price action, the trader should also keep an eye on volume. Ideally, volume should be high on a breakout day. It should be retreating during pullback and increase after retest and continuation.

In the above chart of Axis Bank, retest entry would be on unusual volume retest bullish white candle closing (refer green arrow day).

Following is another example of a valid pullback trade. The stock came out of resistance and then pulled back for the test (refer to Chart I below).

If we zoom in on the above chart we see that there was a strong candle close on the breakout day with the volume on the higher side (refer to chart ii below). Volume retreated as the stock pulled back to redline. In this case, there was no pin bar but narrow candles at the retest. There could be an entry on the first bullish/up candle (green arrow day) that appeared after the narrow candles.

It’s worth mentioning here that the trader might miss some opportunities with retest entries. This is because sometimes there are no retests after breakouts. But that’s perfectly fine to miss a few trades in order to take a high probability trade.

Breakout Failures

The stock market is not a perfect world. Many breakouts would make you money but the others will fail. It is money management and trade management that protects a trader in the case of the latter.

As a rule of thumb, I would like the breakout to be stronger, cleaner with high volume. A strong break means conviction by the traders/investors. I would never like to see the price falling back below the breakout level. If that happens, I would surely close the trade and book a small loss.

Let a trader takes an aggressive entry on the breakout day in TCS. The next day was a Doji, which means lack of conviction. The price instead of going up came down sharply the day after. It was the first indication that buyers are not yet interested. One can think of closing the partial position at this point. A couple of days later the price fell back below the breakout level. A stop loss below the breakout candle (refer to the green line on the chart) would be a good place to close the entire position.

Book Spikes at Top

Although I have added this section at the end yet it has great significance for breakout traders. There is a difference between buying a breakout near a bottom and buying a breakout at the top of a mature trend. I would surely love to keep the former for longer-term and the latter for the short term.

Sometimes breakouts near a top will give you a quick 10-20% in just a couple of days before everything fades out. That spike in price would be the right time to book profit.

In the above LT chart, the stock has a mature uptrend in the background and then a breakout which resulted in a 14% spike in just two days. I would avoid trading such a breakout on pullback/retest as such spikes sometimes lead to a change in trend.

Key Takeaways

Breakouts are highly sensitive patterns obtained as a result of supply-demand imbalance. Various other factors such as fear, greed, and the value of an instrument also work silently behind a breakout. The trader needs to understand the location of a breakout as well as the risk involved. Breaks near the bottom would sustain for a longer period of time and generate healthier returns than breaks near a top which may end up as spikes (as illustrated in LT chart). Also, exceptionally higher risk should be a good reason to skip a trade.

For a high probability of success in breakout trading, always trade the breakouts which are in the direction of the primary trend of the market. This way you will be automatically dodged against many fake breakouts.

Some key points such as the length and character of the candles, the intensity of waves, and volume behavior decide the fate of a breakout. The trader should develop his own/unique breakout system like wide candles at breakout with high volume; narrow candles at retest with retreating volume; and bullish candle(s) at retest as prerequisites for taking a trade. If one of these characteristics is missing, then he should skip the trade. Of course, some other systems can also be designed for aggressive entries. Whatever breakout system a trader adopts he should work on it for the next bunch of trades before reaching any conclusions.

I hope you learned something useful from this write-up. If it was helpful, then please share it with your friends over social media.