Buy What Breakout?
Stockscores.com Perspectives for the week ending October 7, 2005
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In this week's issue:
People that watch stock charts often talk about breakouts. Every book on technical analysis has a discussion of their importance and even fundamental analysts will use the term when a stock they like breaks to new highs. Despite the popularity of the breakout, studies have shown that they are actually not very predictive. That is another way of saying that buying breakouts is not a good way to make money. However, I believe that the problem is not the breakout, but the person judging the breakout. By being far more selective on what constitutes a breakout, a trader can become far more successful in using them.
A breakout is most simply defined as a break to a new high for a set time period. If a stock has been trading at around $50 for a while and then has a strong move to the upside to close at $55, it has broken out. Typically, technical traders use the breakout term when a stock has broken through a ceiling or resistance price and out of a trading range.
The idea is that you buy a stock when it breaks out of a trading range, but I am quite confident that applying this simple rule for buying a stock would not consistently lead to profits. It might if the market was in a bull market, but you would give back all of your profits when the general market changed directions. Therefore, we must work to further define a breakout.
I want you to start with the basic definition but then eliminate stocks if they do not meet the following criteria:
Trend - the trend leading in to the breakout should not be up or down, it should be sideways. When a stock trades sideways it means that the market has become complacent and is in general agreement about the value attached to the stock. Do not buy breakouts that are at the end of an up or a down trend.
Mood - the mood of investors leading in to a breakout is important. Generally, investors are optimistic when you can identify rising bottoms on a stock chart. If falling tops are leading in to a breakout, then you are buying in to pessimism rather than optimism. Only consider breakouts that are out of a period of optimism.
Volatility - a breakout is significant because it demonstrates a willingness among buyers to pay more for the stock. However, is that willingness a fluke or is it truly meaningful? If the stock is trading with very little price volatility before the breakout it is likely that the breakout is meaningful. When a stock breaks out of a period where there was a lot of price volatility, the breakout is more likely to a fluke. Therefore, only consider breakouts from periods of low price volatility.
Volume- volume is an indication of enthusiasm for a breakout. If a breakout happens with a lot more volume than normal then there is a lot of enthusiasm for the stock. Breakouts that lack strong volume often fizzle out fast because they are lacking this enthusiasm.
Resistance - breakouts need to be through important levels of price resistance. To determine if there is resistance, look at a stock chart and ask a simple question. Are there a lot of people that own this stock at a higher price than where it is now? If the stock traded at higher prices, check to see how much volume traded at that price and how long ago it happened. The farther back in time that a resistance price was hit, the less important it is because more people that bought back then will have sold by now.
Therefore, we want to buy stocks that are breaking through RESISTANCE, with strong VOLUME, from low price VOLATILITY, from an OPTIMISTIC MOOD and out of a SIDEWAYS TREND.
If you apply that many criteria to your definition of a breakout, you will find the predictability of buying breakouts improves dramatically.
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The markets are pretty shaky right now so I think it is a good time to stay on the sidelines for most investors and traders. You have to be a pretty savvy trader to make money when market conditions are as they are right now. There is nothing wrong with sitting on cash.
With that said, I think it is a good time to learn. Therefore, I want to highlight a couple of charts that demonstrate the breakout concepts that I explain above. Consider the following:
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1. T.UTS
This is a chart of T.UTS, a TSX listed stock that has done quite well. Here are some comments relating to the numbers on the chart:
1. The stock is breaking out here but it is not breaking from low volatility. While hindsight shows that this was a great entry point, it was not a high probability trade and should have been avoided.
2. Now we have what we need, a break through resistance from low volatility out of a period of sideways trading. The volume is very strong and the breakout is very abnormal. Notice that the Signal Stockscore is spiking up and the Sentiment Stockscore is above 60. Rising bottoms show optimism.
3. Also a good entry after the stock traded sideways for a couple of weeks again. Volume jumps up and the stock makes another good breakout.
4. Now we are getting far in to the up trend, so entry becomes too risky. These breakouts are confirmation of the trend and confirm that this stock is worth holding, but not worth buying
5. The buyers are getting tired and this final break marks the end of this stage of the up trend. A good time to sell
6. After six weeks of price consolidation where price volatility compresses and trading goes sideways, we get another breakout. Quite far in to the long term trend, so it is riskier but still a good set up.
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2. VSGN
The chart of VSGN shows how not sticking to the criteria can lead to a big loss. At point one, we have a break to a new high. However, notice that there is quite a bit of price volatility leading in to the breakout and that volume is not considerable. The stock has been trending higher for a number of months, another reason why this breakout should be avoided. At point number two we actually get a breakdown signal that is predicting a downward trend. At point two, the stock break through support from low volatility, from pessimism (falling tops) and from a period of sideways trading. Three days later the stock suffered a huge gap downward.
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References
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Disclaimer
This is not an investment advisory, and should not be used to make
investment decisions. Information in Stockscores Perspectives is often
opinionated and should be considered for information purposes only. No
stock exchange anywhere has approved or disapproved of the information
contained herein. There is no express or implied solicitation to buy or
sell securities. The writers and editors of Perspectives may have positions
in the stocks discussed above and may trade in the stocks mentioned. Don't
consider buying or selling any stock without conducting your own due diligence.
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