What is the Breakout Pattern?
A breakout is the point at which the market price of any stock breaks away or moves out of a trading range or pattern. The trend usually continues in the direction of the breakout but to avoid any doubts, traders often look for a 5% move outside of the previous trading range. It is only after the same happens that they consider the breakout to be a valid indication of a continuation of the trend for future prices in the direction of the breakout. Ideally, the breakout, if accompanied by a high volume of trading in the stock, confirms that the stock is ripe for an upward price range.
A breakout theory often signals a move out of a situation from congestion zone and can lead to significant changes in the perception of price trends in trading days ahead. The breaking of an important trendline provides the traders with the first sign of a change in trend, often followed by a trend reversal. The breaking of a major upward trendline might signal the beginning of a sideways price pattern, which would be identified as a reversal or consolidation type later.
However, the theory should be carefully exercised by the traders, once the stock moves 4-5 per cent above the earlier trend line. A study of technical analysis can strengthen a perception of changes in supply and demand and allow for stronger trading opportunities for traders.
A breakout often happens after the stock prices may have already started moving in a higher price band for some time, and finally cross the resistance levels. Effectively, breakout is that area in a price chart of stock/ index, a little below which the stock or index may have faced a substantial resistance, possibly on more than one occasions. However, any breakout gets substantiated when the stock price crosses the breakout level, with a strong volume of trading on any day.
One of the major advantage of using the breakout signals and theory related to same is that it is an early indicator of any decisive movement from congestion zones. This offer the traders with an opportunity to make up their mind to take fresh position with confidence.
The disadvantage of using breakout theory for trading is that the theory should not applied in case of stocks not having a long price history. In such cases, it may be difficult to point out towards the next resistance level, which the stock could face soon after a breakout. An upward breakout with high volumes further confirms the theory of breakout.
Another drawback of using breakout theory is that sometimes, the stock prices barely manage to reach a breakout level of 5 per cent above the deviation, and then start showing a reversal very fast. In such cases, the breakout theory could prove to be false indicator, and gives the trader with no option to cover his position very soon.
â€˜Secrets of Profiting in bull and bear marketsâ€™ by Stan Weinstein.
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