Stock trading and investing have an ocean of opportunities to create successful portfolios. Traders and investors adopt various strategies to ascertain the optimum entry and exit points that can lead to maximum gains by taking advantage of market volatility or the current market trends. Among these various strategies are also looking for breakout stocks and creating a portfolio based on this strategy. Given below is the meaning of breakout stocks and related details of the same.
Read More: Straddle strategy – All you need to know
What are breakout stocks?
Breakout stocks refer to stocks that have recently broken out of their trading range or price consolidation pattern. These stocks subsequently started to move up sharply. This price movement is often accompanied by high trading volume and is a sign that investors are becoming more bullish on the stock. Traders and analysts usually identify breakout stocks that are exhibiting signs of a breakout through the use of various chart patterns and indicators. Some of these patterns can include a cup and handle pattern, a double bottom, or a head and shoulders pattern.
Key characteristics of breakout stocks
Traders have to use technical and fundamental analysis to identify the breakout stocks and to take suitable trading positions. Some of the common characteristics that can help in identifying breakout stocks are given below:
#1. Strong fundamentals
To identify breakout stocks, traders and investors need to look out for stocks of companies with sound financial health. The growth potential, industry outlook, and competition in the industry are also to be reviewed to understand the future prospects of the company. A company with good fundamentals can help support a stock’s price rise making it a good candidate for a breakout.
#2. Positive technical indicators
Technical analysis tools that are used to identify breakout stocks include chart patterns such as support and resistance levels, trendlines, moving averages, and Bollinger Bands. Traders usually look for patterns where the stock price is within a range and then breaks above or below that range. This indicates a potential breakout.
#3. Increase in trading volume
Traders should also review the volume of the stock that is breaking out. Such stocks are typically accompanied by an increase in trading volume. Higher volumes of the stock can be used as a confirmation that the breakout is valid and may continue.
#4. Supporting market sentiment
Market sentiment is a strong driver of market trends. Therefore, when the market sentiment is positive, it usually results in driving up the stock prices. Stocks that are poised for a breakout are also part of this movement and can gain from market sentiment.
#5. Impact of news and events
Traders should also have a close eye on the current news domestically or internationally that has a material impact on stock prices. Such news often results in a stock breaking out.
#6. Use screening tools
Novice traders and investors can also use online brokerage platforms that offer screening tools. These tools can be used to identify breakout stocks based on certain parameters like the level of volatility trading volume and the movement of stock prices.
What are false breakouts and how to avoid them?
False breakouts are the possible trend reversals that occur when a stock appears to break out of a trading range but subsequently fails to sustain the upward momentum. The stock thereafter snaps back into the trading range. False breakouts can result in losses, so it is important to be able to identify and avoid them.
Some of the ways to avoid false breakouts are given below.
#1. Wait for confirmation
Traders need to primarily wait for a confirmation of the breakout before making a trade. This can include waiting for the stock to close above the breakout level, or waiting for a significant increase in trading volume.
#2. Use multiple timeframes
Instead of focusing on a single timeframe, traders need to use multiple timeframes to identify the breakouts and confirm it. Using multiple timeframes will further help in confirming that the breakout is not just a short-term spike.
#3. Watch for support and resistance levels
Traders should also keep reviewing or monitoring the key support and resistance levels. It is also important to consider the possibility that the stock may be approaching a level of strong resistance which can limit its upward potential.
#4. Be aware of market conditions
Other important considerations include monitoring the broader market conditions. This includes the market volatility levels and the sentiment of other traders. During high volatility, markets can show mixed sentiments and traders should be aware of such misleading or unclear market signals.
#5. Use stop-loss orders
Stop loss is often considered to be a trader’s best friend as they are instrumental in protecting their interests. Traders should therefore set stop-loss orders to limit potential losses. This will help protect the trader’s portfolio in case the stock does not sustain the breakout and instead reverses.
#6. Conduct thorough research
Analysing the market and the company is the primary function of the trader to understand the price and volume movement of the stock. Traders have to, therefore, thoroughly research the company’s financial health, its growth potential, its competition, and any upcoming news or events that may impact the stock price.
It is important to remember that breakout stocks can be a very profitable trading opportunity at the same time it can be quite risky too. If the stocks are not able to maintain their momentum and snap back it can lead to significant losses for the traders. Therefore, it is prudent to have a clear understanding of the market and the company to have a successful portfolio.
Breakout strategy can work best in the case of stocks with high trading volume. The increased volume indicates the increased interest of participants in the stock which can lead to a breakout.
Traders should focus on stocks with strong technical indicators as well as strong fundamentals to effectively use the strategy as mere technical indicators can be misleading at times.
Few technical indicators that can be used to locate breakout stocks are the RSI indicator, Bollinger bands, and moving averages.
The central idea of the premise of the breakout strategy is to take long positions on the stock after its breakout above the resistance level. This is backed by the high trading volume and the uptrend of the overall market.