A breakout is one of the most common trading strategies, yet if you are new to trading or have some experience trading breakouts, you may find that they're not as easy to trade as they appear. Often the breakout turns out to be false, losing you money. The breakout bounce trading strategy can reduce the number of false breakouts you lose on, saving you money, and still provide you with an affordable entry price.
To use the breakout bounce trading strategy, you must be able read and interpret stock charts. A stock chart that shows the price history of a stock will aid you in making trading decisions. Free charting applications, including FreeStockCharts.com, are available online, where you can practice seeing and implementing the breakout bounce strategy without risking real money.
Look for Breakouts
If a stock, or any trading instrument, has been trading within a range, watch to see if it breaks out. A range is when a stock moves between a lower (support) and upper (resistance) price point, but cannot move beyond those price points to any significant degree. The breakout occurs when the price finally breaks through the support or resistance level. If the price moves through resistance, it['s called an upside breakout and indicates that the price will continue to rise. If the price moves through support, it's called a downside breakout and indicates that the price will continue to fall.
Wait for the Pullback
A false breakout occurs when the price moves above resistance or below support but then quickly retreats back into the former range. Traders who made a trade thinking the breakout was real will lose money if this occurs. The breakout bounce trading strategy avoids this scenario. Instead of making a trade when the breakout occurs, you will wait for a pullback. If an upside breakout occurs, you will watch as the price moves higher, but won't make a trade until it begins to move lower again toward the original breakout price. How this pullbacks reacts will determine if you make a trade or not. By being patient and observant, you can determine if the breakout is real or fake.
Watch the pullback following the breakout. If the price moves back through the original breakout price, it is a false breakout, and you won't make a trade. A trade is made only if the pullback stops before the original breakout price and then begins to move in the breakout direction once again. For example, consider a stock in a range between $48 and $50 that breaks above $50. The stock rises to $50.50 and then begins to decline. If the stock stops falling before reaching $50 and then begins to move higher -- the bounce -- you buy the stock.
Once you make a trade, the trade is not over: Risk must also be controlled. Since the breakout bounce strategy takes a trade only if the pullback doesn't move through original breakout price, the original breakout price can be used as a stop loss. If our stop loss price is hit, we exit the trade at a controlled loss.
Taking profits is the way you make money from a trade. A profit target is a price, determined in advance, at which you will take profits and close out the trade. A common method for establishing a profit target is to use the height of the former range, added to the breakout price. For example, a range develops between $48 to $50 and then breaks above $50. After you receive a valid trade signal, you could place a profit target at $52: $50 minus $48 plus $50.
Cory Mitchell has been a writer since 2007. His articles have been published by "Stock and Commodities" magazine and Forbes Digital. He is a Chartered Market Technician and a member of the Market Technicians Association and the Canadian Society of Technical Analysts. Mitchell holds a Bachelor of Management in finance from the University of Lethbridge.