Identifying Breakout Levels

One of the most important reasons why technical analysis is such an important practice is because the study of charts helps us identify ‘breakout’ levels in stocks. Shreya Chaware explains what exactly a breakout level is and how best one can identify breakout levels in stocks



Prashant Vaid is a small-time investor in equity markets from Coimbatore. He has been investing in stocks for more than five years now. His broker provides him suggestions about good stocks and Prashant takes that advice seriously whenever he has some surplus money to invest in the markets. On account of the fact that he has started getting good returns on his investments, Prashant now wants to allocate more money to the equity markets. Matching his increasing appetite, his broker has upped the ante of suggestions. To further improve his gains, Prashant has subscribed to a stock advisory service which promises to suggest those stocks that are on the verge of a ‘price breakout’.

Prashant first studied the call given on a breakout basis and once convinced he decided to invest Rs 20,000 in each call. He noticed that the breakout calls generated good returns in quick time. After booking good returns in quick time when he invested for the first time on a breakout call, the stock prices moved in the reverse direction and Prashant had no clue what to do as he had not placed any stop loss. The stock advisory company suggested a stop loss; however, Prashant was so confident that the stock price would move up that he did not heed this advice, only to realise that the stock had fallen by more than 12 per cent while he expected a gain of 20 per cent in the counter.

Prashant is still holding that stock in the portfolio which reminds him of his mistake of buying a stock with a false breakout and not placing stop loss even when advised by the stock advisor. Buying a stock at breakout levels is an opportunity that can excite anyone and everyone who participates in the market, no matter what type of investor, whether short-term or long-term. However, before buying stocks at breakout levels, it is important that investors carry out some research thoroughly and follow the basic guidelines so as to improve not only the strike rate but also the overall risk management.

Defining a Breakout

What is a breakout and how can you identify breakout levels? For most investors it is wishful thinking to see a stock make a big move immediately after having bought the share. But however good an investor or a trader may be, it is highly unlikely, if not impossible, to witness a big move immediately after having purchased a stock. No matter how difficult it can be to ascertain accurately the big moves in stocks beforehand, there is an extremely important tool called technical analysis which can help investors realise their dream of identifying in advance stocks that are going to make big moves or give a breakout, as is known in technical analysis parlance. However, the tool of technical analysis needs to be mastered and may not always be accurate to forecast price direction. If practiced well, technical indicators can help you identify breakout levels well in advance.

Breakout levels are nothing but price points which are crucial in determining the overall direction of the underlying securities. Breakout levels can be identified with the help of technical indicators and are nothing more than the crucial support and resistance levels. The following chart patterns and technical tools can help identify breakout levels in advance:

✓ Bollinger Band breakout
✓ Cup and handle pattern breakout
✓ Triangles
✓ Flags and pennants.

Identifying High Probability Breakout

For traders and investors, usually the best breakouts are the ones that violate the most obvious and well-defined support and resistance levels. The strong support and resistance levels are often the levels of massive supply and demand. The violation of these sacrosanct levels usually leads to buying and selling frenzy. Traders simply have to profit from such heightened price actions.

1) It is important to ascertain long-term trends.
To book profits using the breakout levels, it is essential to understand precisely the important support and resistance levels. However, to improve the odds of successfully booking profits using breakout levels, it is important to understand the medium to long term trend of the underlying security. The behaviour of the underlying security before the breakout says a lot about the success of the breakout. If the underlying trend is already bullish and the breakout happens at the given resistance levels, the chances of a successful breakout improve by a good margin. The same cannot be said of breakout levels when the underlying trend is either sideways or bearish and the underlying security breaks the resistance level. Any chartist will relish trading a breakout on a 15-minute chart, also confirming the long-term trend in the direction of the breakout on hourly and daily charts.

2) Breakouts with high volume are important.
In essence a breakout is nothing but a signal that there is a shift in supply and demand for the underlying security. When the breakout is aided with higher volumes, it sanctifies the support and resistance levels and there is an increasing probability of the underlying security moving in the direction of the breakout.

[Triangles and flag or pennants typically provide cleaner breakouts on intraday charts and better risk and reward ratios than ranges.]

[When a breakout occurs, the market is telling you that there is a shift in supply and demand. As bulls or bears become more aggressive, this can lead to an imbalance large enough to sustain the breakout through the channel. The key is to watch the volume.]

Low volume breakouts can be false breakouts and traders should be extremely careful while betting on breakouts with low volumes. Besides, high volumes breakouts could be suggestive of the fact that institutional money is supporting the breakout of the underlying security. To understand the volume trends in breakout, one can observe the moving average of volume in the underlying security. Traders should be excited to see at least 150 per cent or more jump in the 50-day average volume.

3) Higher volatility is good for breakouts.
It is observed that breakouts with higher volatility are the ones with better prospects. In technical parlance, the price bar that breaks out should have a very wide range. A bullish engulfing candlestick pattern is a perfect example in this case.

4) One must also understand the significance of stop loss and breakouts.
Stop loss if placed randomly is bound to get triggered and that is exactly what happens with novice traders. It is advised that the stop loss be placed below the most recent swing low.

Timing the Entry

Any trader has three options to enter a breakout viz. prior to the breakout, at the breakout levels or after the breakout. An entry after the breakout could be the most conservative strategy as it requires double confirmation and the strike rate of success also could be high. However, there are very many aggressive traders who prefer to enter the stock before the breakout. Here the confidence to enter before the breakout levels emanates from the prior existing trend in the underlying security. If the stock is already making higher highs and higher lows and the volume is increasing indicative of heavy accumulation by institutional investors, traders can take a chance to enter the trade before the breakout levels.

The entry price in this case will enable traders to book handsome profits. There are some traders who prefer to enter at the breakout levels and usually there could be some slippage in such cases. If a trader chooses to enter the trade at the breakout levels there would be higher slippage and increased volatility experienced by the trader. However, there is a very good chance that the profits will be realised quickly.

Sourabh Sisodiya
CFA - Co-Founder at Quantify Capital

How to identify reliable breakout patterns ?

Momentum trading is a strategy that aims to capitalize on the continuance of existing trends in the market. For eg if we see for the period 1996-2000 the technology and media stocks went 300x, for the period 2003- 2008 Infrastructure & commodities went 100x, and for the period 2009-2014 pharma and consumption stocks went 50x.

This leads us to the conclusion that no matter what the broader market is doing, there is always a particular sector which is in its own bull run. Momentum trading involves a strict set of rules based on technical indicators that dictate market entry and exit points for particular stocks.

Now for trading the stocks which are in momentum we have to check the following things:

✓Trend
✓ Momentum
✓ OI Data
✓ Futures Data

Trend: The trend gives the general direction of the stock. It is important that the trend should be aligned in multiple timeframes.

For Trend we will use, Price > 20 SMA in daily as well as hourly time frame

Also stocks trading within 15% from 52 week high have high chances of trend continuation.

Momentum: Once the trend of a stock is confirmed, we can check the momentum of the stock using the RSI Indicator. If RSI > 55 in daily time frame we can buy and if RSI < 45 we can sell.

OI Data and Futures Data: These can be used as additional confirmations if the trend and momentum conditions are satisfied.

If there’s unwinding in Max Call OI

Then it indicates that call writers are trapped and can lead to bigger upmove. So one can look for unwinding in max call OI strike as an additional confirmation

Examples: Here if we check the daily chart of Naukri is in uptrend. [ Date 05/01/2021 ]. It was also trading at all time high which indicates a strong bullish trend. The stock had already doubled from its 52 week low and had hit a new 52 week high. All other stocks of the IT sector also were at life highs. Hence, we can keep such stocks in radar for intraday trading.

Another example is of UPL: UPL is bullish in Daily time frame and all other conditions also are satisfied.

1) Trend : Price > 20 sma in daily and hourly time frame Also stock is within 15% from 52 week high

2) Momentum : RSI is > 55 in daily time frame.

So to conclude, for a reliable breakout : Buy stocks in which

✓Price > 20 sma in daily & hourly time frame
✓Stock should be within 15 % from 52 week high
✓Also RSI > 55 in daily time frame

[A plan before entering a trade includes defining a stop loss level where if the stock falls to a certain price point, you automatically sell, take a small loss, and move on to the next trading opportunity.]

Conclusion

Identifying breakout levels and entering the trades at the breakout levels can be an extremely profitable exercise in equity markets.

[A failed breakout is when the price momentarily breaks through the support or resistance level, but is quickly rejected. The market usually falls back into the price channel it was in before after a failed breakout; sometimes it breaks down below the price channel.]

However, to identify the breakout levels and enter and exit the trades profitably on a consistent basis will need lot of practice, patience and trading skills as well. The techniques of trading at breakout levels need to be mastered and once mastered the other important elements of trading such as risk management and avoiding leverage etc. need to be taken care of. If you talk to experienced traders, they will confirm that the market will tell you almost immediately if a breakout trade will work. If after the breakout the price does not move in the anticipated direction, chances are it is not a real breakout after all.

[A breakout trade is when a stock breaks above or below a significant support or resistance level after failing to do so in previous attempts.]

Trading with the help of breakout can be more doable with liquid counters. The breakout in less liquid counters can be really violent and volatile and may lead to huge losses if it is a false breakout. It is advisable to look for breakout levels in the futures and options counters and in BSE 200 index constituents. This will ensure liquid counters with good volumes and will help in managing risks better. It is crucial that traders analyse and anticipate lower risk trades. A point to note is that breakout in small-caps and mid-caps can be more productive at times. Traders have to strike a balance between risk and return. The risk-adjusted returns would be better in liquid counters most of the times.

The most important aspect of trading breakouts is to not to trade in all the breakouts. Unfortunately, for traders most of the breakouts can be false alarms. There is a chance that a novice trader gets frustrated by trading in all the breakouts. A more matured way to trade in breakouts is to wait for confirmation. Seasoned investors and traders allow the stock after the breakout to drop back to the breakout levels and if the stock bounces from the breakout levels – we have a confirmed breakout. Usage of triangles and flag or pennants chart patterns is highly recommended while identifying a breakout.