Breakouts and Breakdowns: When Support and Resistance are Broken

Breakouts and breakdowns.

A breakout is when a stock’s price moves through a level of resistance. A breakout can occur either out of sideways movement, or as a continuation of an uptrend, or as a reversal of downtrend. The latter two are generally where we see more price expansion. Our goal as traders is to buy just before breakouts occur and sell just before, or while, they slow.

A breakout consists of the following possible segments:

The leading breakout is when the price exceeds key resistance and heads to a new second-story ceiling. What you’re watching for is the first strong move above resistance, the breakout point. So if you’ve identified resistance as $25.00, you’re looking for the moment when the stock trades at $25.05 or $25.10. Not just when those numbers appear as the ask, but when actual trades are executed at that price. The other component you’re looking for is strong volume. The more people confirming the breakout, the better it’s chances.

With the price reaching a new high, many traders will start to take profits, and this newly available supply creates a new area of resistance. This is the pullback. When this profit-taking recedes and buyers reenter, another pivot occurs and the price heads upward again, creating another potential entry point, and the safest one. This is also a great opportunity to add to your position if you so choose. The stock now has proven buyers at the new elevated price.

Sometimes this leads to a secondary breakout where the stock rises above its new resistance and into a new trading range.

Quick aside: Beware of false breakouts around whole numbers, especially round numbers. Traders collectively fall into a psychological trap around these artificial barriers, acting as if these numbers are resistance or support just because it feels right, and a price can sometimes appear to be breaking out over one, only to fall back through a few minutes later.

As you might’ve suspected, breakdowns are the opposite of breakouts. The stock price penetrates its base support level. This is where you short the stock, a process we’ll detail later.

A breakdown consists of the following possible segments:

Inversely parallel to the leading breakout, the breakdown is when the price drops below key support. It could be time to unload the position you’re holding or an opportunity for you to short the stock.

The stock price might then rally into a pullback as fewer traders make their shares available, believing the actual value of the stock to be higher than the current market price, or at least reluctant to admit it isn’t worth its current price. The bears might soon regain control and push the price further downward. If they do, this is the safest point to short the stock. If you’re holding onto stock and you see the price drop below support again after the pullback, get out fast.

If the market is nearing close for the day and the price drops below support, swing traders might consider selling short here even though there aren’t enough minutes in the trade day left for day traders to seize the shorting opportunity, with the idea that the downward momentum will continue the next day.

If the stock starts trading sideways out of a breakdown, this is a positive sign for the price, and could be indicating that the price is going to pivot upward again.

A word to the wise: Things that go straight up go straight down. Be very wary of skyrocketing stocks.