Breakout stocks: everything you need to know
Stock breakouts are an essential tool for technical trend traders, helping them to spot when price action might be on the cards. But how do they work, and how do you identify breakout stocks?
What are breakout stocks?
If a stock moves beyond its resistance level, it will often go on to make a sustained upward move. If it moves past its support level, it may be about to go on a bear run.
Support and resistance levels are seen as 'stronger' if a stock hits them multiple times. In turn, stocks that break through these 'stronger' barriers are more likely to then go on extended moves.
Why are stock breakouts important?
Traders and active investors use breakouts to identify trends in their early stages. They are often followed by price action and renewed volatility, making them a fertile area to find profitable opportunities.
The theory behind breakouts is straightforward. If a stock approaches $100 multiple times but always retraces, investors will be unwilling to buy it as they are unlikely to make a return.
If the stock does surpass $100, though, those investors might see it is as a sign to buy – and anyone with a short position on the share might close it to cut their loss. This environment of high demand can see the stock's price leap and potentially lead to a sustained new trend.
Trading breakout stocks: the basics
Trading stock breakouts involves:
Here’s an introduction to all three.
How to identify breakout stocks
To identify breakout stocks, first you’ll need to find a market with a defined area of support or resistance. As we’ve already seen, the more times a stock has bounced off this level, the better.
When a market gets stuck in a channel between clear support and resistance levels, it’s known as consolidation. Various patterns within a consolidation can indicate that a breakout is on the horizon: including head and shoulders, triangles or flags. You can learn more about spotting patterns in IG Academy.
Lengthier periods of consolidation are also often associated with bigger breakouts. A stock that has traded in a set range for a significant length of time often goes on to make a bigger move than one that’s only been consolidating for a few weeks.
Opening your position
If you’re confident that a breakout is on the cards, then it’s time to plan when to open your position.
It pays to be wary of 'fakeouts' at this stage. Fakeouts occur when a market pops beyond its support or resistance level before quickly moving back again.
Patience is usually the answer to avoiding getting caught out by a fakeout. Instead of hurrying to open a position the moment a stock hits a new level, hold back and wait to see if the movement sticks.
A spike in volume can be a sign that the breakout is real. Alternatively, some traders will wait until the end of the trading period before acting.
Planning your exit
Like any strategy, trading breakout stocks requires risk management. That means you’ll need to decide when to:
- Take profit from a successful position
- Cut your losses if a trend fails to materialise
Recent price action can help set a realistic objective for your trade. The range of a stock's previous channel or pattern will often determine the size of its breakout. A range between 100 and 200, for example, might result in a move that peaks at around 300.
Using a stop order at or near the previous level of support or resistance can prevent running losses when a stock doesn't break out. After a successful breakout, previous support levels should become new areas of resistance and previous resistance levels should become areas of support.
Examples of breakout stocks
Standard Life Aberdeen
Standard Life Aberdeen entered a new channel as the merger between Standard Life and Aberdeen Asset Management was completed in August 2017. Over the next several months, it repeatedly failed to move beyond the 390 level, while finding support just above 345.
That low was finally broken on 6 February when the stock opened below 345. This led to a major move lower, with Standard Life Aberdeen shares hitting 220 on 9 February. Throughout this move, the previous support area was repeatedly tested as a new level of resistance.
Melrose Industries was stuck between 43 and 61 for almost four years from the middle of 2012 to 2016. Its subsequent breakout was spectacular, moving above 150 by the end of 2016 and up above 220 in 2017.
Melrose is a clear example of the general rule that a lengthier period of consolidation results in a bigger move – note how the months after it went over 61 contain markedly more volatility than those within the channel.
Royal Dutch Shell
One pattern that can point to a new breakout is the head and shoulders, which is viewed as a reliable indication of a trend reversal. In early 2016, Royal Dutch Shell stock saw an inverse head and shoulders that took it from a long downward trend into an upward one.
An inverse head and shoulders is made of three moves:
- After a bearish trend, the stock's price drops to a new bottom and then rises
- It falls again, hitting a new low beyond the first one. Then the price rises back to its previous resistance level
- The price drops a third time, but only to the level of the first low. It then rises above resistance
Reckitt Benckiser shares dropped below 6000 in February 2018, moving into a channel between 5200 and 5900 for the next few months. The move back above 5900 in June marked the beginning of a breakout, setting a new trend that lasted until October.
Here we see the range of the channel (5900-5200=700) foreshadowing the size of the subsequent breakout. If you had bought Reckitt Benckiser shares at 5900 in June and set a limit order at 700 points higher (5900+700=6600), then your position would have closed at the new resistance level of 6600.
Support and resistance levels aren’t always set at a flat horizontal. When a company trades within a set range, the limits of that range will often offer support or resistance.
In this example, we can see NMC Health repeatedly hitting the upper and lower edge of its 700-point channel – even as it makes a bullish move. When it does break out of that pattern, its momentum reverses in a bearish breakout, giving away almost all of the gains it had previously made.
Auto Trader stock consolidated between 300 and 425 from 2016 to 2019 before breaking out above 600 last year.
The price patterns on the chart offered an indication of the bear run to come. Auto Trader stock didn’t hit the bottom of its channel in 2018. Instead, each subsequent low was higher than the one before it. The top of the channel remained the same, giving us an ascending triangle that technical traders use to predict an upward breakout.
Auto Trader did exceed its resistance level briefly before the breakout, in a mini fakeout in September 2018.
How to trade breakout stocks
- Go to IG Academy and learn all the patterns you need to know to spot breakouts
- Sign up for an IG account to buy and sell thousands of global shares
- Use our suite of technical analysis tools to identify potential opportunities
- Open your position with your chosen stop and limit
Breakout stocks summed up
- Stock breakouts occur when a company’s share price moves beyond an area of support or resistance
- They are used as an indication of a new trend forming
- Trading them requires finding an opportunity, opening your position and planning your exit
- Open an IG account now to get started
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