Trading breakout stocks is a popular strategy among active investors. This is a form of range trading in which traders are looking for a stock or asset class (e.g. commodity, cryptocurrency, etc.) that suddenly breaks outside of a well-defined range. This is because after an asset has been in a defined range, a move in either direction usually comes with significant momentum, which provides the opportunity for outsized gains.
To identify potential breakout stocks it’s important to understand the concepts of support and resistance. One way to tell that a stock is range-bound is that there will be a price that the stock does not drop below (I.e. a support level), and a price that the stock does not rise above (I.e. a resistance level).
However, to identify the best breakout stocks traders are looking at the frequency at which the price touches its support and resistance levels. The stronger the confirmation of support and resistance, the higher the likelihood that a breakout will be meaningful.
The role of moving averages in determining support and resistance
A moving average (MA) is an indicator used by investors, to get a clearer picture of a trend in price movement. The moving average calculates price movement over a given period. A moving average provides a way for traders to filter out random price fluctuations that are not consistent with a current trend.
A moving average can also indicate where a stock has support or resistance. For example, when a stock cannot seem to cross above a moving average, the stock is said to be at a resistance point. Conversely, when a stock price fails to cross below the moving average it is seen as providing support for the stock price. In this case, the moving average will look like a floor that the stock price will not fall beneath.
Examples of breakout stock patterns
Cup and handle breakout stocks - One of the most common stock chart patterns that indicates a breakout is about to occur is the formation of a cup and handle pattern. A cup is formed when a price falls from a high point but then gradually retakes the high. Traders then look for a handle to form. This occurs as the price swings get smaller as the price begins to reach the previous high. This signals that the price movement is contracting. Therefore, traders often view a break above the trendline as a buying signal.
Bollinger band breakout stocks - Bollinger bands are a technical indicator that clarifies price movement. Bollinger bands move with the price and form an envelope (I.e. a band) around the price. Traders can place each band a specified number of standard deviations away from a specified baseline. The price will often stay within the bands. When the bands contract, it indicates steady price movement. Therefore, if the price breaks above the bands, it can be a buying signal,
Protecting yourself on the downside
Successful breakout stock traders protect themselves from downside risk by putting a stop-loss on their trades. A stop-loss (also called a stop order) is a trading mechanism that automatically issues a market order to buy or sell a stock once its price reaches a predetermined target.
Why do stocks breakout of a range?
There are many reasons why a stock will breakout of a range of support or resistance. A positive or negative earnings report is often a catalyst. This is not just because investors get a look at revenue and earnings, but because a strong earnings report in either direction is usually accompanied by analysts upgrading or downgrading the stock
Another metric to look for, particularly in a market that looks overvalued, is a change in short interest. If a stock suddenly experiences a rise in short interest, it can mean that institutional investors are preparing to short the stock.
Other reasons can be an unusual call or put option volume in comparison to the stock’s normal volume or heavy insider buying or selling. Understanding why a stock is breaking out can help investors to decide if the breakout is likely to have momentum.
The risk of trading breakout stocks
A significant risk of trading breakout stocks is misidentifying a pattern. In this case, traders can lose money because the security moves in the opposite direction of what was expected. This is to be expected. Using this strategy is a form of market timing, and that is always an imperfect science.
However, the reason this strategy is so popular is that when breakout stocks are identified correctly, investors have the opportunity for outsized returns.
A final word on breakout stocks
The proliferation of trading software and charting tools that are available to the retail investor is exciting. But it can also lead to “analysis paralysis.” As with many things in life, when it comes to identifying breakout stocks, the KISS theory (I.e. Keep it Simple Stupid) is good to remember. Whether you use support and resistance level, simple moving averages, or more sophisticated indicators such as Bollinger bands or Fibonacci retracements, the idea is finding the signal that works best for you and acting on it.
