Signs of an imminent stock market breakout

Find out what a stock market breakout is, what causes it, the different types of breakout and breakout trading strategies.

Trading profitably on the stock market is all about being able to spot trends before anyone else. When the price of a stock changes in either direction, then smart traders can make money, either by buying a stock just as its price starts to rise and selling when it peaks (going long), or by selling stock at a high price and, in some cases, buying it back when the price drops (going short).

Ideally, what traders are looking for is the beginning of a sustained price movement. An upward price movement, described as bullish, where the price steadily rises, is preferable, but as mentioned above, it’s also possible to profit from a downward, negative, or bearish price movement.

The important thing is to get in on a trend as close to the beginning as possible and then to ride it for as long as you can before exiting your position. Investors should understand the basics of technical analysis, including chart patterns, trend lines, and moving averages, and use these tools to identify trends and potential opportunities in the market.

What is the definition of a breakout?

All price movements or trends must start somewhere, and that starting point is usually a breakout. Most stocks or stock indexes have a price that fluctuates between two imaginary fixed points.

The price may go up or go down from one hour to the next, or one day to the next, or one week to the next. But observing these price movements on a chart, you’ll see that the price never drops below a certain level and never goes above a certain level. Until one day it does.

That moment, when the price breaks through one of the imaginary lines, is known as a breakout. The bottom line, which the price usually never falls below, is called the support line, as it seems to hold the price up. The top line, which the price never usually goes above, is called the resistance line, because it suggests pressure or resistance from above which the price is constantly butting against.

Traders are always trying to find the best breakout stocks that will lead into an ongoing trend. Sometimes multiple breakouts occur before a trend is established, which is why traders shouldn’t be too hasty and should look for confirmation before entering a position. 

What causes a breakout?

There are many possible reasons for a stock to suddenly have a breakout moment. All price movements are basically caused by supply and demand, so if a stock price suddenly shoots up, it means more people are buying, and if it drops, it means more people are selling. This also applies to other forms of financial trading, such as forex trading. 

The reasons for these sudden surges can vary. A positive (or negative) news story is one common reason, but sometimes a stock might have been gathering momentum for some time before the volume of trades in a particular direction reaches a tipping point and leads to a breakout.

Signs to look for

A common pattern that appears prior to a breakout is the ‘cup and handle’ formation. The price reaches a high point just below the resistance level, then falls significantly before climbing gradually back to the high point. Drawn on a graph, this movement forms a cup shape. The handle is made by tracking the contracting price swings as the overall price gets higher, anticipating a breakout.

Bollinger bands can also be used to predict a breakout. These technical indicators are lines on a candlestick chart that move with the price, enclosing it in a kind of bubble. When the price is changing frequently and dramatically, the bands will be further apart. When the price is staying steady, the bubble will be tighter. Stable periods followed by large price movements can indicate a forthcoming breakout.

Types of breakouts

There are three types of breakouts to be aware of:

  1. A consolidation breakout is one that forms tentatively but then spikes dramatically as the volume of trades rises. 
  2. A reversal breakout is when a down-trending price movement suddenly changes direction, going into reverse, and then spikes. This kind of breakout can be caused by a positive announcement relating to the stock in question.
  3. A triangle breakout occurs when the support line on a chart rises over time while the resistance line stays level. This forms an ascending triangle. The result is that the price is eventually pushed over the resistance level. 

Breakout trading strategies

An effective breakout trading strategy requires an entry point, an exit point where you have an acceptable return on the risk taken, and a stop-loss point where, if things aren’t going as expected, you cut your losses and walk away. Traders should look for a decisive breakout leading to a sustained trend, rather than a false breakout that quickly returns to the previous pattern. 

Striking the right balance between acting quickly and waiting for confirmation is the trick all traders try to pull off. Some get it right, others don’t. Spotting an imminent breakout is desirable; but knowing when to act on it is just as important.