ETFs, due to their ease of use, cost efficiency and liquidity, have become popular vehicles for breakout trading. With more than 1,400 ETFs on the market covering multiple asset classes and global markets, traders and investors can always find a breakout occurring or one close at hand. Once you learn how to spot potential breakouts, you’ll need a strategy to trade them.
Breakout Trading 101
A breakout occurs when an ETF moves above or below a support or resistance level. Support and resistance levels are horizontal or slanted lines that contain the ETF’s price action. If the breakout is to the upside, it signifies the bulls have won the battle, and the ETF is likely to proceed to higher. If the breakout is down, it signals the bears have won and the ETF is likely to head lower.
Breakouts are highly tradable because the ETF must be in some sort of consolidation period—moving between support and resistance—before a breakout can occur. When the price is contained for a period of time, it acts like a coiled spring, resulting in a sharp move once the bulls or bears break the price above resistance or below support. For this reason, volume should increase on a breakout, or at minimum should be above average.
Figure 1 shows the SPDR Gold Trust (GLD) stuck in a tightening pattern, called a triangle, throughout much of June, July, and August of 2012. Drawing lines along the price lows and price highs during this period highlights how the price was getting compressed, readying itself for a move. An upside breakout occurred in late August, resulting in an aggressive move higher.
How to Trade Breakouts in ETFs
To find a potential breakout trade, look for ETFs that are bound by support or resistance levels. These levels are drawn by connecting more than two price highs for a resistance level and two price lows for a support level. Support and resistance may be horizontal, for example, when an ETF is moving up and down within a range between $9 and $10. Support and/or resistance may also be sloping, like trendlines, as they were in Figure 1.
Support and resistance should be well defined, and generally the longer the ETF has been trading between support and resistance, the more reliable the breakout will be. This is because many traders begin to trade based on the small moves between support and resistance, but when the breakout occurs, many of those traders will be trapped and forced to exit their positions at a loss. Other traders will be seeing a profit, realize they are right, and look to grab more shares.
Therefore, an increase in volume should accompany a breakout, showing strong interest from traders. If volume doesn’t increase, the breakout may still be valid and worth trading, but the lack of interest should make you wary.
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