The Anatomy Of Trading

Breakouts
By Jeff Kohler | February 04, 2008
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Breakout trading is used by active investors to take a position within

a trend's early stages. Generally speaking, this strategy can be the
starting point for major price moves, expansions in volatility and,
when managed properly, can offer limited downside risk. Throughout
this article, we'll walk you through the anatomy of this trade from
start to finish and offer a few ideas to better manage this trading
style.
What Is a Breakout?
A breakout is a stock price that moves outside a
defined support or resistance level with increased volume. A
breakout trader enters a long position after the stock price breaks
above resistance or enters a short position after the stock breaks
below support. Once the stock trades beyond the price barrier,
volatility tends to increase and prices usually trend in the breakout's
direction. The reason breakouts are such an important trading
strategy is because these setups are the starting point for future
volatility increases and large price swings. In many circumstances,
breakouts are the starting point for major price trends. (To learn
more, read Spotting Breakouts As Easy As ACD.)
Breakouts occur in all types of market environments. Typically, the
most explosive price movements are a result of channel breakouts

and price pattern breakouts such as triangles, flags or head and

shoulders patterns (see Figure 1). As volatility contracts during
these time frames, it will typically expand after prices move beyond
the identified ranges.

Figure 1: A triangle breakout

Source: Prophet.net

Regardless of the time frame, breakout trading is a great strategy.

Whether you use intraday, daily or weekly charts, the concepts are
universal. You can apply this strategy to day trading, swing
trading or any style of trading.
Finding a Good Candidate
When trading breakouts, it is important to consider the underlying
stock's support and resistance levels. The more times a stock price
has touched these areas, the more valid these levels are and the
more important they become. At the same time, the longer these
support and resistance levels have been in play, the better the
outcome when the stock price finally breaks out (see Figure 2).

Figure 2: The trading range shows multiple

reactions to support over time.
Source: Prophet.net

As prices consolidate, various price patterns will occur on the price

chart. Formations such as channels, triangles and flags are valuable
vehicles when looking for stocks to trade. Aside from patterns,
consistency and the length of time that a stock price has adhered to
its support or resistance levels are important factors to consider
when finding a good candidate to trade. (For more insight, check
out Analyzing Chart Patterns.)
Entry Points
After finding a good instrument to trade, it is time to plan the trade.
The easiest consideration is the entry point. Entry points are fairly
black and white when it comes to establishing positions upon a
breakout. Once prices are set to close above a resistance level, an
investor will establish a bullish position. When prices are set to close
below a support level, an investor will take on a bearish position.
To determine the difference between a breakout and a "fake out", it
is a good idea to wait for confirmation. For example, a fake out
occurs when prices open beyond a support or resistance level, but
by the end of the day, wind up moving back within a prior trading

range. If an investor acts too quickly or without confirmation, there is

no guarantee that prices will continue into new territory. For
example, many investors look for above-average volume as
confirmation or wait towards the close of a trading period to
determine whether prices will sustain the levels they've broken out
of. (For related reading, see Trading Failed Breaks.)
Planning Exits
Predetermined exits are an essential ingredient to a successful
trading approach. When trading breakouts, there are three exits
plans to arrange prior to establishing a position.
1. Where to Exit With a Profit
When planning target prices, look at the stock's recent
behavior to determine a reasonable objective. When trading
price patterns, it is easy to use the recent price action to
establish a price target. For example, if the range of a recent
channel or price pattern is six points, then that amount should
be used as a price target to forward project once the stock
breaks out (see Figure 3).

Figure 3: Measuring a price target

Source: Prophet.net

Another idea is to calculate recent price swings and average

them out to get a relative price target. If the stock has made
an average price swing of four points over the last few price
swings, this would be a reasonable objective.
These are a few ideas on how to set price targets as the trade
objective. This should be your goal for the trade. After the goal
is reached, an investor can exit the position, exit a portion of
the position to let the rest run or raise a stop-loss order to lock
in profits. (For more insight, see The Stop-Loss Order - Make
Sure You Use It.)
2. Where To Exit With a Loss
It is important to know when a trade has failed. Breakout
trading offers this insight in a fairly clear manner. After a
breakout, old resistance levels should act as new support and
old support levels should act as new resistance. This is an
important consideration because it is an objective way to
determine when a trade has failed and an easy way to

determine where to set your stop-loss order. After a position

has been taken, use the old support or resistance level as a
line in the sand to close out a losing trade. As an example,
study the PCZ chart in Figure 4.

Figure 1: A triangle breakout

Source: Prophet.net

3. After a trade fails, it is important to exit the trade quickly.

Never give a loss too much room. If you are not careful,
losses can accumulate.
4. Where To Set a Stop Order
When considering where to exit a position with a loss, use the
prior support or resistance level beyond which prices have
broken. Placing a stop comfortably within these parameters is
a safe way to protect a position without giving the trade too
much downside risk. Setting a stop higher than this will likely
trigger an exit prematurely because it is common for prices to
retest price levels they've just broken out of.
Looking at the chart in Figure 4, you can see the initial
consolidation of prices, the breakout, the retest and then the
price objective reached. The process is fairly mechanical.

When considering where to set a stop-loss order, had it been

set above the old resistance level, prices wouldn't have been
able to retest these levels and the investor would have been
stopped out prematurely. Setting the stop below this level
allows prices to retest and catch the trade quickly if it fails.
Summary
In summary, here are the steps to follow when trading breakouts.
1. Identify the Candidate
Find stocks that have built strong support or resistance levels
and watch them. Remember, the stronger the support or
resistance, the better the outcome. Make sure you understand
this when you shop for stocks to watch.
2. Wait For the Breakout
Finding a good candidate does not mean a trade should be
taken prematurely. Wait patiently for the stock price to make
its move. To be sure the breakout will hold, on the day the
stock price trades outside its support or resistance level, wait
until near the end of the trading day to make your move. Be
patient. (For more on this, see Patience Is A Trader's Virtue.)
3. Set a Reasonable Objective
If you are going to take a trade, set an expectation of where it
is going. If you don't, you won't know where to exit the trade.
This can be done by calculating an average move that the
stock makes or measuring the distance between support and
resistance (especially when trading price patterns).
4. Allow the Stock to Retest
This is the most critical step. When a stock price breaks a
resistance level, old resistance becomes new support. When
a stock breaks a support level, old support becomes new
resistance. In the majority of your trades, the stock will test the
level it has broken after the first couple of days. Prepare for it.
(For more on this phenomenon, read Support And Resistance
Reversals.)

5. Know When Your Trade/Pattern Has Failed

When the stock attempts to retest a prior support or
resistance level and it breaks back through it, this is where a
pattern or breakout has failed. It is imperative you take the
loss at this point. Don't gamble with your losses.
6. Exit Trades Toward the Market Close
You can't discern at the open whether prices will hold at a
particular level. This is why you might consider waiting until
near the market close to exit a losing trade. If a stock has
remained outside a predetermined support or resistance level
toward the market close, it is time to close the position and
move on to the next.
7. Be Patient
This strategy requires plenty of patience. By following these
steps, you will reduce emotion and be more objective about a
trade.
8. Exit at Your Target
If you are not exiting the trade with a loss, then you are in the
trade. You should remain in the trade until the stock price
reaches its objective, or you reach your time target without
hitting your target price.
Conclusion
Breakout trading welcomes volatility. The volatility experienced after
a breakout is likely to generate emotion because prices are moving
quickly and in a volatile fashion. Using the steps covered in this
article will help you define a trading plan that, when executed
properly, can offer great returns and manageable risk.

7 COMMON BREAKOUT
PATTERNS
(Educational)
If youve been following me for the past 6 weeks, you know that I have
called breakouts almost immediately before they do so. I was asked by
dozens and dozens of people to provide some sort of educational post on
what I lookout for. The primary patterns that make it on my imminent,
potential, and waiting lists are as follows: 1) parabolic
breakout+symmetrical triangle, 2) bull flag, 3) ascending triangle, 4) failed
descending triangle, 5) rounded bottom, 6) flat base, 7) measured move.
Each pattern must utilize price action, volume, moving averages (15, 20,
50, 100, 200-day), and the development of the pattern itself. The entry
point is marked when everything lines up perfectly.
1) Parabolic Breakout and Symmetrical Triangle:

These patterns are the intra-day spikes that I covet dearly. They are
responsible for many of the fastest and largest gains that I have ever
achieved. This pattern utilizes 2 or more continuation or consolidation
patterns to complete itself. They are usually flat bases, flags, and a variety

of triangles. When the pattern goes parabolic intra-day, there will usually
be massive profit taking and the entire move could retrace as much as
50%. Most weakhands would sell in panic when this occurs. However, this
is wrong.
After a large move, the pattern needs to consolidate its gains, shake out
the weak holders, attract the dip buyers, and gather accumulation and
interest for the next run up. Towards the end of the consolidating period,
there will be another breakout, which marks a secondary entry to add
another position.
Volume must be flat and declining prior to the spike, which will be
accompanied by huge volume. In addition, the moving averages listed
above will help guide you to time your entry. My favorite short-term
averages are the 15- and 20-day MAs. 50- and 100-day MAs are
intermediate averages, and the 200-day MA is the big daddy himself the
most important long-term MA.
Whenever you see a symmetrical triangle form after the initial spike, it is
almost a guarantee that the particular stock will breakout again. Failures
are rare, but they do happen.The point is to harvest as many of these
patterns and cut losses on any of the failures.
2) Bull Flag:

Bull flags are usually very small and can last for only one day or several

weeks. The way to tell the entry is by using the appropriate moving
averages. Sometimes, I like to enter a flag regardless for fear that I may
miss the breakout. However, the closer the pattern is to the 15- or 20-day,
the faster the breakout will materialize.
3) Ascending Triangle:

The ascending triangle is one of the most obvious bullish patterns, and
one that is highly reliable. Each trough is marked by selling exhaustion
while the buyers hold their ground. You want to either get in on the
breakout from the pattern or if you are more tolerant to risk, then enter
within the pattern and just sit tight. Do not get shaken out.
4) Failed Descending Triangle:

Sometimes, when a pattern fails, it can be a good thing. A pattern failure

will force holders on one side of a trade to immediately reconsider. A
descending triangle is a bearish pattern but occasionally, it will fail. This
will force short covering and a great time to add longs at the same time. I
like to get in on the breakout on confirmation.
5) Rounded Bottom:

This pattern takes months, even years, to develop. The pattern is created
by a downtrend, followed by a sideways neutral range. When the right side
of this saucer develops, it will be obvious that the stock/market wants to

go up. There should be a massive increase in volume on the breakouts

following the final completing of the right side of the pattern. Shorts will
cover their positions as they realize that they can no longer profit from the
stock.
When the multi-month base is forming, the main moving averages should
catch up to the stock. They should level off and start heading higher and
support the stock as a launching pad for continuous breakouts.
6) Flat Base:

A flat base is basically an over extended flag trading in a neutral range on

low volume. These patterns have one of the most powerful breakouts,
ever. A stock can easily double in a matter of days/weeks. There should
be no evidence of breakdown in this pattern and they should be entered
immediately when you first find them. When the breakout occurs, it its
highly likely that you never see pre-breakout prices for a long time.
7) Measured Move:

The measured move pattern is one of the most beautiful and predictable
patterns. They easily launch from their supporting moving average. The
best part is that several moving averages should provide support below
the stock. They act as back up in case there is a failure.There should be
decreasing volume during consolidation, followed by large volume
breakouts.
I hope this helps.