Breakouts & Breakdowns: What Are They?

Breakouts and breakdowns are strategies indicating a direction of trade as and when it breaks above the resistance level or breaks down the level of support. It is used to capture price trends of stocks at an early stage.

The upper line indicates the level of resistance while a lower limit indicates the level of support. Now if a stock’s price crosses the level of resistance it is known as a breakout. Breakdowns are just the opposite of this. Both breakdowns and breakouts are essential for technical analysis and hence, they are used in various trading strategies.

What Is the Meaning of Breakouts in Trading?

Breakouts refer to that situation when the price of a stock or commodity moves beyond a certain level of support or above its resistance level. This indicates that this stock is about to make a major move. 

A most common behaviour noticed among traders is that they usually buy a company stock if the price moves above and breaks through the level of resistance. Traders usually sell a company stock whenever its price moves below the support level and breaks the level of support. Whenever a breakout takes place, it symbolises a big move in the market.

Pros of a Breakout Trading

The following are some benefits of breakout trading:

• In a breakout, you will never miss a big price movement or big trends in the market. 
• A breakout trading will allow you to get into a trade with momentum backing it.
• Traders can easily identify exit or stop loss levels by studying the breakout range.
• By entering the market at new bullish or bearish trends, you can make more profits.

Cons of a Breakout Trading

The following are some limitations of breakout trading:

• If you are unable to figure out a false breakout from the pattern then you might end up losing heavily.
• Sometimes the breakout happens not far enough from the range for you to make a decent profit. Moreover, if you follow very active risk management, you may not realise profits before the trend reverses.

Steps Involved in a Breakout Trading

The following are the steps to follow to make profitable trades by identifying breakouts:

Step 1: Firstly, you should figure out a breakout stock candidate i.e. try to identify and keep an eye on the stocks with strong support or resistance. The stronger the level of support and resistance more will be the price movement.

Step 2: Secondly, you should wait patiently for the stock price to trade outside its resistance or support level.

Step 3: Thirdly, you must set a reasonable objective of where the price should go; not having a clear idea about the exit point may lead to sudden and unforeseen losses.

Step 4: Be prepared for the stock to retest i.e. whenever a stock price breaks the resistance level, it becomes the new support whereas when it breaks down the support, it becomes the new resistance.

Step 5: It is important to understand that when the pattern has failed.

Step 6: Lastly, take an exit once your objective of the stock price is reached.

What Is the Meaning of Breakdown in Trading?

In simple terms, breakdown trading is a strategy where you identify a downward movement in a security’s price. In a breakdown, prices may move sideways but cannot climb higher than the support level. It indicates a further decline in trends which is high volume in nature, quick in duration and severe in magnitude.

Traders can identify breakdowns using technical tools like moving averages and chart patterns. Typically, breakdowns are accompanied by heavy volumes and subsequent price movements that are quick and significant. 

Steps in a Breakdown Trade

Here are the steps to follow to make profits from breakdowns: 

Step 1: Firstly when the security price breaks down the level of support, a trader should take a short position in that situation.

Step 2: Put in a sell stop loss just below the support level, there will be further decline as these stop-loss orders will trigger more selling pressure.

Step 3: Wait for a counter-trend to enter the market.

Breakouts and Breakdown Patterns

A breakout pattern can indicate a trend or change in volume; it is the most appropriate starting point while scanning for a breakout stock. 

Some breakout and breakdown patterns traders should be able to identify are:

• Cup-and-handle
• Triple Top
• Descending Triangle
• Falling Wedge
• Inverse Head-and-Shoulders
• Flag Formation
• Double Top
• Symmetrical Triangle

Breakout vs Breakdown: What Are the Differences?

A breakout happens when the price of a stock or commodity moves beyond a certain level of support (breaks below the support) or resistance (breaks above the level of resistance). On the other hand, a breakdown takes place when the price movement goes below the level of support. It then continues a downtrend followed by a halt or sideways trend.

There is a common practice of breakout trading prevalent among traders, as it can generate a good amount of profit over a short period. Both breakouts and breakdowns can provide a huge amount of profit if followed rigorously with proper risk management. However, false signs of breakouts and breakdowns can do the opposite and you might have to bear a significant amount of losses.

Final Words

Breakouts and breakdowns are quite common in the market and take place almost all the time. Experienced traders often take advantage of this to make profits. There are several key aspects to consider when trading with breakouts and breakdowns like signs of ascending and descending triangle formation, trading direction, previous trends and waiting for the retest.

Frequently Asked Questions