Breakdown: What it is, How it Works, Trading it (2024)

What Is a Breakdown?

A breakdown is a downward move in a security's price, usually through an identified level of support, that portends further declines. A breakdown commonly occurs on heavy volume and the subsequent move lower tends to be quick in duration and severe in magnitude.

Understanding a Breakdown

A breakdown can be identified by traders using technical tools such as moving averages, trendlines and chart patterns. Traders can draw trendlines on a chart that connect several swing lows to find areas where prices may be susceptible to breaking down. Heavy volume should accompany a breakdown below key support levels, which showsparticipation in the move lower.

Technical traders can either close out any existing long positions or short sell a security when it breaks below a support level, since that is a clear indication that the bears are in control and that additional selling pressure is likely to follow. A breakdown often signals the start of a downtrend.

When a security initially breaks down, traders should seek confirmation from several indicators and other chart time-frames to ensure the move is not a head-fake. For example, a breakdown on a 15-minute chart has a higher probability of continuing lower if the daily and weekly charts are in a downtrend. A breakdown is the bearish counterpart of a breakout. In the chart below, prices have broken down below the neckline of a head and shoulders pattern.

Contrarian traders may look to trade failed breakdowns.

Trading a Breakdown

Traders could take a short position when the security’s price initially breaks down below major support. To do this, asell stop-limit order would need to be placed just below the support level. Once prices break down, the decline is likely to be intensified as stop-loss orders for long positions are triggered with additional selling pressure coming from breakdown traders. The extra volatility caused by the breakdown may result in a mediocre fill, due to slippage.

Alternatively, traders can wait for a retracement to enter the market. They could place a limit order where the security’s price initially broke down from; that area has now become a resistance level. Entering the market on a retracement is likely to result in a better fill than trying to catch the breakdown early. The flip side is the security may not retrace back to the trader’s limit price.

Once in a short position, traders could use a trend following indicator, such as a moving average as a trailing stop. For example, when the price of the security closes above the moving average, the trade is exited. If traders believe the breakdown is the start of a new downtrend, they may want to use a longer-term moving average to try and catch the majority of the move.