Stock breakouts create a ton of different trade opportunities for day traders, swing traders, and even investors using both long and short strategies. Still, they can also be pretty high-risk setups and many times cause inexperienced traders to buy at the very top of a move before it reverses back down. In this post I'll be explaining one of the proper ways to trade stock breakouts, which will help you avoid buying the top and will reduce risk when buying a breakout!
First… what exactly is a breakout?
A breakout is a move above a defined level of resistance. It's essentially the exact opposite of a breakdown, which is a move below a defined level of support. Unfortunately, many traders are taught to trade breakouts in a much less accurate way that creates a lot of unnecessary risk. This involves them buying immediately when a stock makes a new high over a past level of resistance. The problem with this breakout trading strategy is that it often leads to traders buying the top.
The reason for this is because of what are known as false breakouts. A false breakout is simply a short-term, temporary breakout over resistance that fails to continue upward. Any trader looking to immediately buy a breakout over resistance ends up buying the exact top of a move when it happens to be a false breakout. The breakout trading strategy that I'll be explaining in the rest of this post will help you avoid buying any false breakouts!
Instead of immediately buying a breakout to new highs, you can substantially reduce your risk by waiting for the past breakout level, or resistance, to turn into support. As explained in past posts, broken resistance can become support, and broken support can become resistance. When a stock breaks above resistance, by waiting for that past resistance to become a level of support you're ensuring that you're not chasing the stock at its high during a false breakout. By trading breakouts this way you also now have a level of support to use for risk management. You can enter the trade knowing that your risk is limited because you'll cut losses if the stock comes back below its new support level.
As you can see in the real life example below with the stock symbol $AMD, there was a breakout over a past high/past resistance level, and a long consolidation period over that past resistance, which then became a key level of support. There was plenty of time in this example to use that support as an opportunity to buy before it started its run to new highs. This happens much more commonly than you may think and can offer some incredible trading opportunities!
Again, using this breakout trading strategy will reduce your risk and will definitely reduce the amount of time that you catch yourself buying into a false breakout. The example of stock symbol $IMBI below shows you how dangerous it can be to buy into these false breakouts. $IMBI had resistance at $5.40 from the market's open, briefly broke above that resistance by only $0.03, came straight back down, and ended the day more than 20% lower than its early morning breakout level! By waiting for support to form over that $5.40 resistance, you'd be able to avoid buying into this false breakout trap.
I hope this post was helpful for any new traders that find themselves buying the top of a move too frequently! This strategy should prevent that from happening and should greatly help you improve your accuracy when trading stock breakouts!