BALTIMORE (Stockpickr) -- You don't have to know much about trading to figure out that if a stock is in "breakout mode," you probably want a piece of the action. But what exactly constitutes a breakout? And why do they work?
In this technical primer, we're going to take a look at the nuts and bolts behind how how a breakout trading strategy works -- and how to implement it for your portfolio.
If you’re familiar with technical analysis, chances are you’ve at least heard the term “breakout trading” before. As the foundation of the uber-successful trading systems used by some of the biggest Wall Street investment managers, breakout trading is one of the most effective technical strategies out there -- and also one of the most nerve-wracking.
After all, it's one thing to analyze technical charts after the fact to find trading opportunities, and it's yet another to pull the trigger on a real trade. Using a technical strategy has significant advantages. Whether used as a standalone method of analysis or as a timing supplement to fundamentals, technicals can provide significant cues about a stock’s potential price movement.
Must Read: Does Technical Trading Really Work?
Almost any method of analysis seems great in theory, but the money is made where the rubber meets the road. Not surprisingly, applying technical analysis concepts to real-world markets is also where most people (particularly those with fundamental backgrounds) have the most trouble.
What Is Breakout Trading?
Breakout trading is one of the most popular methods of applying technical concepts to live financial markets. In its simplest form, breakout trading is the practice of buying stocks as they “break out” above a prior resistance level or “break down” below a prior support level.
In the below chart, a breakout in this silver ETF occurred when shares made a sustained move above $30, signaling a buy.
The rationale for this strategy is simple: If support and resistance levels act as barriers to share price movement, then the breach of a previous support or resistance level should leave shares free to make a larger move.
That’s a pretty logical approach to trading. Here's another way to think about it: If a resistance level indicates a glut of supply of shares of a stock at a particular price overhead, then a breakout above that price level should mean that buyers have absorbed the excess supply above, and now those sellers are adjusting their ask prices to higher levels (or opting not to sell at all). That clears the way for shares to get bid up to higher prices.
That's the theoretical side of things. As I said earlier, in practice, there are significant challenges to being a successful breakout trader.