Short-term volatility provides opportunities for a stock’s breakout.
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What Is a Breakout?
A breakout is part of technical analysis that allows investors and analysts to determine whether a security’s price will move higher or lower after breaching what are known as resistance and support levels. Analyzing a breakout is ideal for intraday trading and during times of volatility—in which there are large up and down swings over a period—in futures and spot price markets on assets including stocks, bonds, foreign exchange, commodities, and cryptocurrency. This article focuses on stocks.
Breakout analysis tends to work better during times of short-term volatility and in the absence of news that might otherwise cause a sudden change in stock price. Breakouts can be found in the use of technical indicators such as relative strength index and moving averages.
How to Spot a Breakout
Before determining whether a stock will move higher or lower, it’s important to understand resistance and support levels. Think of resistance and support as a series of tops and bottoms, or highs and lows, which create ceilings and floors on prices.
When a stock has reached several similar highs over a short period of time, those price levels form a resistance level, and when the price approaches that level, it could be an indication to sell the stock. Likewise, when a stock reaches several similar lows, a support level is established. As the price approaches that level, it could be an indication to buy.
Over the short term, stocks often bounce in a range between their support and resistance levels (this narrow range is called a consolidation) before a breakout takes place.
If a stock’s price moves above an established resistance level, though, there could be a breakout to newer highs, and the same with newer lows if it moves below an established support level. It’s similar in the approach to understanding the head and shoulders pattern, in which the stock has reached a series of peaks and makes new lows leading to the possibility of a breakout.
Note: When a stock breaks through the support level, it’s known as a breakdown. But some investors and analysts tend to use breakout interchangeably with breakdown.
One factor to monitor during a breakout is the volume of trading. A high volume could indicate that the stock is poised to move past a resistance or support level. Another is money flow—an indicator of the amount of money in buy and sell orders toward the end of a day’s trading—and that could show whether a breakout is likely to occur. A series of large trades at higher prices may suggest that a stock is breaking through its resistance level.
New resistance and support levels are created after a breakout.
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Breakout Example: Apple (AAPL)
Above is a candlestick chart of Apple’s stock from late November 2021 to mid February 2022. Apple’s stock formed resistance and support levels from early December 2021 to mid-January 2022 (this period also saw the formation of a head and shoulders pattern). The stock then broke through in mid-January to the downside, just as the 14-day RSI indicated it was close to being oversold. Afterward the stock reached a new low, paving the way for the creation of new support and resistance levels.
Are There Different Patterns for a Breakout?
Resistance and support levels don’t always have to be parallel to the x-axis. They can be angular, and have patterns with names like triangle, rectangle, wedge, flag, and pennant. Exactly how resistance and support levels are used to forecast breakouts depends on an investor’s style of trading.
What Are the Limitations of Breakout Analysis?
Breakout analysis tends to work out better during times of volatility in the absence of major news that could affect a stock’s price. An earnings report or a macro event, for example, could influence the direction of stock price.
In addition, not all characteristics of prices breaking through resistance or support point to a breakout. There could be signals that lead to a false breakout, which would mean a return to the resistance or support level.
