Trading breakouts in stocks and other markets can be one of the most profitable setups one can utilize in their trading arsenal. The fact is that markets, and stocks specifically, spend most of their time trading in a range. Because they have this tendency for sideways price action, when markets do happen to expand their price action the magnitude of movement can be extremely powerful. This is what makes trading a breakout in a stock so appealing- the possibility of a very large gain made quickly on the position. So that begs the question then of how do you go about trading such a scenario?
There are a ton of ways to trade breakouts and a trader’s choice may depend on how much capital they are trading with and what their risk tolerance is. In addition, a trader should certainly consider past price action and volatility of the individual stock itself. If people are risking hard earned capital on a trade, then it is important that traders try to pick stocks that have the potential for explosive price action either up or down. Because a trader can potentially make money whether the stock goes up or down, which direction the stock ends up breaking out is irrelevant. What is important is that the trader is there to tag along for the ride. Here are some simple strategies for taking advantage of a price breakout:
First determine the stock’s current trading range. For example, if Apple has been trading from $400-$600 per share for the last twelve months then it would appear that the stock is comfortable in that range. One can simply monitor the stock as it approaches either the high end or the low end of that trading range. Should a violation of the range occur, one will go with it by simply buying or selling shares at the market. For example, should Apple break out to the upside and start trading above $600 per share that would be a signal to get long and buy shares. Conversely, should Apple start trading below $400 per share that would be a signal to get short and sell shares. Regardless of direction the idea here is that price will move and attempt to find a new com for zone thus producing profits for the trader if the stock moves.
Here is a recent example on GE. It creates a trading range, forms some support and resistance areas. Then you get a breakout.
This strategy can be simplified further by placing resting stop orders at specific price levels. This way a trader does not need to monitor the market as closely. A resting stop order simply is a buy or sell order for a number of shares that becomes a market order once the stop price is hit. Using the above example, you could place a buy order at $605 per share and place a resting sell order at $395 per share. Should the stock trade $395 the trader automatically sells shares at the market. Should the stock trade at $605 the trader will automatically buy shares at the market. The use of these stops enables you to take a sit and wait approach and enter the market only when a potential breakout is underway.
There are many different ways to control risk on such trades. Two of the simplest are by liquidating a position immediately if it returns into the previous trading range. Another popular method is simply having a stop order at the middle of the range or opposite end of the range to flatten the position should the breakout be false.