Challenges of Breakout Trading
The biggest challenges for would-be breakout traders are psychological -- particularly for investors with fundamental value backgrounds. For upward breakouts, waiting for a stock to move higher before buying can feel incredibly unnatural for an experienced value investor. And staying in the game after a string of losing trades can wear away at the confidence of even the most experienced trader.
It's no surprise then that an estimated 90% of retail traders eventually go bust.
But it's crucial to think like a technician if you're going to find success as a breakout trader. Instead of using technicals as a way of predicting where share prices are headed in the future, you're using technicals to define supply and demand characteristics that lead to a higher probability of a move in one direction than a move in the other.
Must Read: How to Measure Market Strength
In other words, you don't want to predict -- you just want to react when a breakout happens.
Breakout traders are basically looking for “high-probability setups” where share prices have moved outside of the price barriers created by support or resistance levels. To fundamental investors, it's enticing to buy shares before a breakout actually happens, but the breakout is the critical element of creating that high-probability setup. As long as there's still a glut of supply overhead, you don't want to be a buyer.
A prominent portfolio manager I know once described breakout trading as a "traffic light system." When you're sitting in your car at a stoplight, you don't try to predict when the light is going to go green. Instead, you just hit the gas when it does.
The chart below is a great visualization of how that "traffic light system" gets put into practice. This chart was showing traders a red light until shares broke out above $9.50 resistance. That's when the light turned green. The key to buying wasn't predicting the breakout -- it was buying when after the signal hit.
On the Lookout for Breakout Trades
The first step toward becoming a breakout trader is to be on the lookout for potential breakout trades. Historically, market technicians have done this by poring over thousands of stock charts to find those that looked primed for a break outside of a previous support or resistance level.
Today, advanced chart screening software can take away much of that work by identifying a watch list of breakout setups in just a few minutes.
Once those setups have been identified, it's time to determine what needs to happen to classify that stock as a breakout; you’ll want to know exactly when the breakout conditions are met. Normally, you can set free trade alerts through your broker's trading platform. By using alerts instead of stop orders, you're able to weed out stocks whose breakouts aren't statistically valid (that is, not confirmed by a material move outside of the support or resistance level) or are just intraday whipsaws.
Factors such as exit points and stop loss levels can vary based on each trader's preferences but should be predetermined before entering any trade.