How to Find a Breakout in Trading

By Michael Griffis, Lita Epstein

A stock remains stuck in its trading range as long as it bounces between zones of support and resistance. Short-term traders may be interested in these movements, but as a position trader, you’re looking for a more substantial trend, so you must wait for something to change the status quo and cause the stock to break out of its trading range.

A breakout sometimes signals the transition of a stock trading within a range to a new uptrend or downtrend. When breaking out to the upside, you want to see the resistance zone violated by a significant amount, certainly by more than 5 or 10 cents.

More important, you want to see the stock trade through its resistance zone on much higher volume than the average. Ideally, volume needs to be at least 50 percent higher than average. More volume is even better.

Baxter International, Inc., (BAX) and is a textbook example of a stock breaking out of a trading range. BAX had been trading within a narrow range from mid 2005 through June 2006. The support line is drawn just above $34.50 and the resistance line near $38.00. The support and resistance levels were tested several times in 2006.

[Credit: Chart courtesy of StockCharts.com]

Credit: Chart courtesy of StockCharts.com

On July 20, 2006, BAX opened well above its previous close, traded through the zone of resistance and closed at $38.88. This pattern — where a stock’s opening price is well above its previous close and moves up, breaking out of its trading range — is called a breakout gap.

Although not a requirement for a stock to break out of its trading range, a breakout gap does bolster the case for this rise in prices to be a transition from trading within a range to a new uptrend. Trading volume was almost 8 million shares, or almost triple the average daily volume of 2.7 million shares.

As the chart shows, BAX continued to trade higher. Although you cannot see it in the chart, BAX continued its rally through May 2007. The BAX breakout in 2006 was an almost picture-perfect setup for a trading opportunity. Baxter is a leading stock in pharmaceuticals. The stock built a solid trading-range base and broke out on higher-than-average volume. Then BAX went on to rally for almost a year. Nice.

BAX faced a similar trading range again in 2011. After taking a significant drop on Dec 1, 2010, when it closed at $49. The stock traded between $49 and $59 until September of 2012 before starting on its current upward trend. On April 4, 2013, it closed at $71.12. Looking back at the trading history for a stock will help you improve your abilities to recognize a breakout.

Wait patiently for winning patterns

We can hear the gears grinding from here. Yes, it’s a nice trade…but you’re probably saying to yourself, “Couldn’t I have bought BAX for about $35.00 several times between February 2006 and June 2006? Why wait until the breakout drives my entry price up?”

The answer: Finding a good trading signal is important; avoiding bad trading signals is more important.

Foretelling the future is hard. Of course hindsight is going to tell you that buying BAX at $35.00 would’ve earned you more money than buying it above $38. But when the price was $35.00, how could you know that BAX wouldn’t stay in its trading range for years? Or how could you tell that BAX wasn’t going to break out of its trading range and start trending lower?

It happens. In fact, if the stock had traded below its zone of support, technical analysis would’ve suggested a potential opportunity to sell BAX short.

Another important reason for waiting for a breakout is that when you enter a trade, you need an exit strategy. For now, know that you need technical signals to show you when to exit your position, the same way you needed them to enter the position in the first place.

If you’re trying to buy stocks at the bottom and then sell them at the top, few signals are available to tell you whether your entry signal has failed.

Fine-tune your trading-range breakout strategy

Three ways you can fine-tune your trading-range breakout strategy are

  • Observing that breakouts from long trading ranges tend to result in more profitable buying and selling than breakouts from shorter trading ranges.

  • Understanding that breakouts from tight trading ranges, where price fluctuations are confined to a relatively narrow price range, usually result in better trades than when trading-range price fluctuations are wide.

  • Waiting for a short while — possibly two or three days — to confirm the trading range breakout. Waiting to see whether the stock falls back into the trading range before you take a position can save you from a negative market reaction. A wave of selling immediately after a breakout is not uncommon, and the way the stock reacts to that selling is as important as the breakout itself.

Consistently snagging the lowest price is nearly impossible, regardless of whether you use technical analysis, fundamental analysis, a Ouija board, or follow the best prognosticators in the business. Technical analysis can help you find transitions, but it can’t tell the future. As a technician, you never (almost never) buy your stocks at their lowest prices, and you rarely exit your positions at the highest prices.

However, if you wait for a solid trading signal, you can ride the middle part of the trend for a large portion of the move. Try not to be greedy. The middle part of the trend is a very profitable place to trade.