Breakout Trading

Breakout trading is a trading strategy in which a position is opened when the price of an asset moves outside a level or range that has contained it for some time. The trader buys when the price rises above the upper boundary, or sells short when it falls below the lower one, expecting the move to carry on. It is one of the oldest approaches in technical analysis and is applied to shares, futures, currencies and crypto assets on time frames from minutes to months.

The reasoning is that a long period inside a range reflects a balance between buyers and sellers, and that a decisive move out of it shows the balance has shifted. Breakout rules are simple to state and to program, which has made them a common basis for systematic strategies. They also fail often, and managing those failures is the main difficulty.

There is no single definition. Traders use several kinds of boundary.

• Horizontal levels. A resistance level is a price at which earlier rallies stopped, and a support level is one at which earlier declines stopped. A close beyond either is the classic breakout.
• Trading ranges and chart patterns. During consolidation the price moves sideways in a band. Triangles, flags and rectangles are named shapes of this kind.
• Channel highs and lows. A rule-based version buys when the price exceeds its highest level of the last N days, such as 20 or 55, and sells when it drops below the N-day low.
• Volatility conditions. Some traders act only after volatility has contracted, for example after a Bollinger Band squeeze, on the view that a quiet market is more likely to produce a sustained move.

Many traders ask for confirmation before acting: a close beyond the level instead of a brief touch, a minimum distance beyond it, or a rise in trading volume.

Entry is commonly made with a stop order resting just beyond the boundary, so the position opens only if the breakout happens. A stop-loss order is placed back inside the range. A common way to set a target is the measured move, which adds the height of the range to the breakout level:

A share has traded between $48 and $52 for six weeks. A trader places a buy stop at $52.10 with a stop-loss at $50.90. The range is $4 high, so the target is 52 + 4 = $56. The amount at risk is 52.10 − 50.90 = $1.20 a share, and the possible gain is 56 − 52.10 = $3.90 a share, a reward-to-risk ratio of 3.90 ÷ 1.20 = 3.25. For a downside breakout the range height is subtracted from the lower boundary.

A large share of breakouts do not follow through. The price moves beyond the level, draws in buyers, and then falls back into the range. This is called a false breakout or fakeout, and an upside failure is also known as a bull trap. Obvious levels attract clusters of stop orders, and a brief push through them can trigger those orders without any lasting change in supply and demand.

Entering with a stop order adds to the cost. The order becomes a market order when triggered, and in a fast move it is filled above the trigger price, which is slippage. Filters such as waiting for a close reduce false signals but give a later and worse entry. Some traders take the other side and trade failed breakouts back into the range.

Breakout rules are a standard entry method in trend following. The best-known example is the group of traders trained by Richard Dennis and William Eckhardt in the 1980s, known as the Turtles, whose published rules bought new 20-day and 55-day highs and sold new lows across a range of futures markets. Systems of this type tend to have a low proportion of winning trades. Their results depend on a small number of large gains when a breakout turns into a long trend, offset against many small losses.

A breakout differs from general momentum trading in its trigger. Momentum strategies rank assets by past return over a period, while a breakout strategy reacts to the crossing of one specific price.

Academic tests of simple range-breakout rules have given mixed results. Some studies of historical data found that such rules had predictive value, while later work showed that profits were weaker in more recent periods and often disappeared after trading costs. Chart levels are also partly subjective, so two traders can disagree on where a range lies, which makes discretionary breakout trading hard to test.

Rule-based versions can be tested through backtesting, but the many adjustable settings, such as the look-back period, filter and stop distance, make it easy to fit past data by chance. Results vary widely between markets and periods, and long runs of losing trades are normal even for systems that were profitable over decades. Nothing in the method ensures a profit.