A breakdown happens when the price of a stock or investment falls below a certain support level, indicating that it might keep going down. It often occurs when there’s a lot of trading activity, and the price drop happens fast and sharply.
Understanding a Breakdown
Traders use various technical tools like moving averages, trendlines, and chart patterns to spot breakdowns in the market. They draw trendlines connecting low points on a chart to find areas where prices might drop. A breakdown usually happens with high trading volume, indicating strong participation in the downward move.
When security breaks below a support level, it suggests that selling pressure is strong and the market might continue to decline. Traders who use technical analysis might sell their holdings or even bet on the security’s decline (short sell). This breakdown often marks the beginning of a downtrend.
After a breakdown, traders should look for confirmation from different indicators and timeframes to make sure it’s not a false signal. For instance, if security breaks down on a short-term chart, it’s more reliable if longer-term charts also show a downtrend. A breakdown is the opposite of a breakout, where prices move above a resistance level. In the example chart, prices have dropped below the neckline of a head and shoulders pattern.
Trading a Breakdown
Traders can make a bet against security when its price first drops below a big support level. They do this by putting in a sell order just below that support level. When prices fall, it triggers stop-loss orders from other traders who are holding onto the security, causing even more selling. This can lead to some unpredictability in the trade, making it harder to get the exact price they want.
Another approach is for traders to wait for the price to bounce back a bit before they jump in. They can set a buy order at the point where the price first dropped, which now acts as a resistance level. Waiting for the bounce-back usually means they get a better deal compared to betting on the initial drop. However, there’s a risk that the price won’t bounce back to the level they’re waiting for.
Once they’re in a position where they’re betting against the security, traders can use a tool like a moving average to help them decide when to get out of the trade. For instance, if the security’s price closes above the moving average, they might decide to exit the trade. If traders think that the initial drop indicates the start of a longer downward trend, they might use a longer-term moving average to try and catch most of the downward movement.