How to identify breakout stocks

A stock market breakout or a breakout in a specific share is a tradable event that some active investors can base an entire strategy around. A breakout is when a stock or stock index moves beyond a level of support and resistance​ that it has struggled to move above or below in the past. Learning how to identify and trade potential breakout stocks gives traders one more tool that they can use to generate profits within an often-volatile market. Breakout stocks are shown on price charts, in particular, using candlestick trading​ to read price action.

Price action​ within the share market is affected by supply and demand, and when a breakout signal occurs, this usually means that buyers have succeeded in pushing the stock’s price above the resistance level. In the case of a downside or negative breakout stock, sellers have pushed the price below support. While not all breakouts lead to big price movements, every big price movement will have multiple breakouts, typically starting with an initial breakout.

There are certain patterns that traders should recognise for their investment research if they wish to catch these potential stock breakouts early in the process. Below are some of examples of how to identify breakout stocks.

Trading a breakout stock is not quite as simple as buying or selling when a breakout to the upside or downside occurs. Making the entry is only one part of a robust strategy: you will also need a stop-loss, which controls the initial risk of the trade. A breakout strategy for stocks also requires an exit point if the trade turns profitable. Unlike long-term investors, breakout traders nail down their profits periodically.

Each of the breakout methods discussed below involve both a stop-loss and a way to take profit. A stop loss should be placed on every trade so that no single losing trade will erode your account substantially, whereas the profit target is more flexible. You can use a profit target or calculate the risk/reward ratio to see if the trade is worth it, or a trailing stop loss, like in the Bollinger Band example above.

Before placing a trade, you must know what your entry, stop loss, and exit methods are in order to increase your chances of making a profit over time. Read more about execution and order types​ here.

So, what happens if you miss the initial breakout? Say a stock bumped up against a resistance level multiple times and then finally broke above it, but you did not spot it right away. Often, there will be a second chance to trade when the price falls back to re-test the breakout area. Assuming that the breakout had critical signals of an effective breakout, we can assume that that re-testing can be used to enter a trade.

In the below chart, the Euro 50 index tried three times to climb above the trendline resistance area. On the fourth attempt, it finally broke through. At first, it moved up only a small amount, then re-tested the breakout area. It then proceeded to re-test the breakout trendline two more times, rallying after each re-test.

Once you identify breakout stocks, you need to look for a decisive movement, whether it be the candle or price bar where the breakout occurs that must move convincingly through the breakout area. If it moves just above and then the candle closes below the breakout point, this is not as effective as a stock that surged and closed the period well above the breakout point. A decisive breakout is more likely to follow through in the expected breakout direction.

Consider the Euro 50 index example, above. The price decisively broke above the trendline on a long candle that closed near the high of the period. Even though the index re-tested the breakout area, the former area held.

Another signal of a good breakout is if the breakout area holds on re-tests. If the price falls right back through the resistance level, this is not a good sign and traders could look to exit the trade. If there are no positive signals, a trend reversal in the opposite direction is more likely.

On a breakout, if you notice that volume has increased above average levels, this is a positive sign. It helps to affirm that the price trend is more likely to keep moving in the breakout direction. The bigger the increase, the better. A 50% increase over average is good, but 100%, or double the average volume, is even better.

If the price breaks out on lower-than-average volume, this means that few people are interested in buying the stock above the breakout point. This means the stock is less likely to hold above the breakout point and run higher.

Penny stocks​​ tend to have big percentage moves, even though they do not move much in the way of price. For example, a penny stock may trade between $0.04 and $0.05 for a long period of time. Although it is only an increase of a cent, this also represents a 25% leap in value.

Because penny stocks do not move as much in dollar terms, their support and resistance levels are often well defined and easy to spot. For example, Gold Standard Ventures is a penny stock in the mining industry. For almost a month, its share price could not move above $0.74. When it did finally break above this level, it did so in an aggressive manner. Traders interested in the stock could have placed a buy order at $0.75, just above the resistance level.

View a list of UK penny stocks​ to trade.

The examples above look at buying a stock when it breaks out above a specified level. There are also potential trades when the price drops below a support level. This is called a downside breakout. The concepts for a short trade are the same as discussed prior, except everything is flipped upside down.

Consider Macy’s stock chart below. It had already been declining before it found support just above $14. It bounced off this level three times before finally plunging below. A short trade could be entered on the breakout. A stop-loss can go above a recent swing high, near $16.75, or near the gap lower prior to the breakout at $16. If shorting just above $14 and risking $2 per share, a target could be placed at $8. This is $6 below the entry point and provides a 3:1 risk/reward ratio.

Breakouts in the stock market can provide the opportunity to trade on large price movements once the price breaks above the resistance level or below the support level. Traders first look for potential breakout stocks, followed by a decisive breakout on a strong price movement that is accompanied by above average volume. Since these signals occur in both shares and share indices, and one index encompasses many stocks, it is likely that if an index is having a breakout, a lot of individual stocks within the index are as well.

Not all breakouts end in profit, as prices could always end up moving the other way, resulting in a loss. This is called a false breakout. Another result is that the price may breakout but then fail to move much afterwards. Not only does this mean that you will not get the profit expected, it also ties up your capital, wasting time and energy. For this reason, it is advisable to place a stop loss on each trade. This controls the risk and ensures that one losing trade does not jeopardise the whole account.