Breakout Trading

During our lessons on various kinds of bases, we’ve frequently mentioned the concept of a breakout. Now it’s time to take a closer look at breakouts, the single most powerful stimulus a stock can have for big gains.

I. What Is a Breakout?

A breakout occurs when a stock’s price passes a point of resistance. That point of resistance can come at many different points; wherever it occurs, it’s a sign that sellers are unloading shares around that point. A breakout thus signals that the stock has far more buying power behind it this time, enough to overcome sellers and the resistance they’re previously offered. The stock then shoots higher in heavy volume, launching a new uptrend. 

II. Why Is a Breakout Such a Powerful Indicator of Strength?

It starts with historical precedent. The stock market as a whole as well as individual stocks repeat the same patterns and behaviours, whether we’re in the 1920s or the 2020s. Look at some of the biggest stock winners of all time — everything from U.S. Steel to IBM to Tesla — and you’ll find huge breakouts propelling those stocks higher. 

For a stock to break out, its volume must soar at least 40%-50% above its average daily output. Thus by definition it’s a powerful indicator of strength: Stocks that clear key resistance points in heavy volume are being bought by the big mutual funds and other institutional investors that (with apologies to your auntie and her $500 investment) make the market go.

III. Why Buy at Breakout Points and Not at Other Times?

Buy low, sell high. That’s the common mantra of stock market investing. But that’s easier said than done. Trying to buy a stock on the way down can be like trying to catch a falling knife: You could end up with blood everywhere. 

The theory behind buying at breakouts is that the downward forces that can hold down stocks’ success have departed, clearing the way for a burst of buying by big-money investors. It’s not that it’s impossible to make money while trying to buy dips or slumps. It’s that buying at breakout offers the best combination of price upside and minimizing risk.

IV. So What Exactly Is the Ideal Buy Point During a Breakout?

It’s always 10 cents above the point of prior resistance. Where that point lies depends on the kind of base you’re scrutinizing. 

In a cup-with-handle or saucer-with-handle base, the ideal buy point sits 10 cents above the top of the handle. In a double-bottom base, the ideal buy points lies 10 cents above the middle of the base’s W shape. In a flat base, the ideal buy point is 10 cents above the top of the base.

Moving on… 

You’ve now learned all about the art of breakouts – nice job! Click on the link below to move on to the next lesson, on day trading. Not feeling ready for the next lesson yet? It never hurts to review previous lessons, to make sure you’ve mastered some of the most important concepts in stock market investing.