What is Breakout Trading?

This article was written by Ipek Ozkardeskaya, Senior Market Analyst at FCA regulated broker London Capital Group Holdings plc (LON:LCG).

Thin volumes, hence higher price volatility, usually characterise trading in summer months. The choppy market conditions in currency and indices often generate interesting trading opportunities. A tactical method to cash in short-term profits is to chase the breakout occasions.

Ipek Ozkardeskaya, LCG

Ipek Ozkardeskaya, LCG

Breakout trading is one of the most popular technical trading strategies but also one of the most nerve-wracking ones.

In its simplest form, the breakout strategy consists of buying an asset as the price breaks above a resistance level, or selling it as the price breaks below a support level, assuming that clearing an important technical level could lead to a further directional move.

The breakout strategy is sometimes viewed as unnatural. Buying a stock while the price is already higher than a prior resistance, or selling it below a prior support carries the risk of a trend reversal. Therefore, it is important to apply the breakout strategy when the probability of a correction is seen relatively weak, and/or, there is a great chance of surfing on stops.

Although there is no guarantee that a breakout would lead to a larger directional price action, several tips and tricks could maximise chances of being successful.

Defining a support, or a resistance level, is the core of a breakout trading strategy. Unfortunately, there are no set rules. The support or the resistance levels depend on the historical price pattern of an asset. The most common mistake is to look for a technical level that is too complex. You should keep in mind that the most popular technical levels are usually the best strategic levels.

Horizontal support and resistance levels, psychological levels as 1.50, 100 or 2000, most commonly employed moving averages as 50, 100 and 200 period moving averages and trend lines are good candidates for a successful breakout strategy.

The entry decision is given as the break above, or below the pre-defined support and resistance levels. Breaking an important technical level could usually be expected to hit the stops and to gain further momentum. Therefore, breakout traders react as soon as an important technical level is broken. In this respect, LCG Trader offers the functionality to implement an automatic buy, or sell limit order, which is a very useful tool to avoid missing opportunities.

Breakout strategies are generally best when they are short-lived, as a price breakout is often followed by a correction. Therefore, traders using the breakout strategy intend to take profit on the getaway move and close their exposure to avoid a potential price correction.

Entering a breakout trade is risky as it carries the risk of a correction as mean-reversion traders could fight back the extension of directional gains above, or below, the solid support, or resistance levels. Hence, it is crucial to place a stop loss to limit losses in the alternative scenario of a price correction.

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