Breakouts

By: George Angell

The following is an excerpt from George Angell’s Small Stocks, Big Profits

The breakout is a classical bullish pattern that occurs when the number and strength of the buyers overwhelms the sellers.  As the name suggests, breakouts occur when prices move away from an area where they have been consolidating for a period of time.  The corresponding bearish pattern is typically known as the breakdown.  In the breakout, the accumulation of shares exceeds the distribution and share values rise.  The breakout is normally accomplished on a price gap when share values leave a space on the chart which is often not filled.  The unfilled gap on a chart is known as a breakaway gap.

The breakout is the simplest and most important pattern for the beginning chartist to know.  By definition, a rising stock must take out its high.  Buying the breakout, therefore, is one of the strongest possible buys a technical analyst can make.  Unfortunately, the strategy is fraught with danger since one is buying a new high amid a flurry of buying activity.  The risk is that the breakout proves false and the market then subsequently trades back down into the so-called consolidation area between the resistance and support.  When the pattern fails in this fashion, this is known as a false breakout.  For the buyer of the breakout, this failure means trouble.  The buyer, who buys a breakout, may have just purchased near the top of the move.  The failure of the move suggests the odds now favor prices trending lower.  The best way to deal with the scenario is to immediately sell the position at a loss.

A more encouraging sign occurs when the breakout is accompanied by high volume.  A high-volume breakout will frequently mean a legitimate move to the upside.  Often news-driven, this breakout must be purchased immediately lest the investor be left behind.  A typical scenario of a news-driven event culminating in a breakout will be a better-than-expected earnings report released before the opening bell.  With a mountain of buy orders bidding the stock higher, the opening price will often gap higher and run.  When this occurs, you have a breakaway gap.  This breakout is the real thing.  Timid investors who cautiously wait for “reason” to enter the market and push prices lower will be disappointed because their orders to buy will go unfilled.

Breakouts can be confusing to the novice trader who is unprepared for the fast and furious price action that often accompanies them.  The breakout can be indicative of a stop-running operation in which the market is momentarily taken higher (in order to run the stops) only to be lower moments later when the initial buying flurry subsides.

As a new investor, it is important that you understand this phenomenon.  Stop-running means the market is purposely bid up in order to generate stop-orders.  When a market is bid into the stops, the stops, which are orders to buy at the market, generate buying activity.  In this instance, the stop serves to protect the short-seller, which is someone who borrows stock to sell in anticipation of buying back shares at a lower price.  Should the market surge higher, the short-seller finds oneself in a lot of trouble since he must repurchase shares he sold short regardless of price.  Obviously, if he must pay a higher price than he sold, he will sustain a loss.  Thus, the short seller will place a stop order to protect himself above the market.  When the stops are run, market orders are thus triggered.  This buying activity temporarily causes prices to rise as the stops generate buy orders from the short-sellers.  Once the buying dissipates, however, the market typically goes “dead” – and a freefall is likely to occur.

As you may begin to realize, the investor is on the horns of a dilemma when it comes to breakouts.  On the one hand, if he fails to purchase immediately following a breakout, he may miss the subsequent move; on the other hand, if he is quick to join the buyers following a breakout, it may just be a stop running exercise, and the market will collapse.  So how do you decide?  If you take the position, one of two things will occur: either the position will be profitable immediately or it will not.  In the first instance, you have the right side; in the latter, you need to exit as quickly as possible.

If you hesitate following the breakout, however, you will typically miss the move.  Breakout markets often follow weeks, if not months, of sideways price action during which the bulls and bears are engaged in a prolonged struggle.  When the market finally breaks and runs, then that’s the direction it is going to go.  If you are hesitant following a breakout, one of three things will probably happen to you.  One, you will chase the market.  This suggests you will be paying more than you wished for the stock.  Two, you will buy the high, meaning you will soon have paper (unrealized) losses.  Three, you will miss the move entirely.  As you can see, none of these alternatives are particularly attractive.

In summary, the investor must keep in mind the following four points:

1. The breakout is often the beginning of a major move.  By definition, the breakout occurs at a higher price than that at which the market has been trading.  Do not be afraid to pay-up to get abroad a breakout.  If it is a legitimate breakout, prices will continue to soar.
   
   
2. Look for confirmation of the move.  While the breakout can be a powerful sign of a bullish scenario, the investor needs to be careful lest the breakout fails and prices fall into the consolidation area.  The primary component of a breakout is price and volume.  On a good breakout move, prices will be bid up, often on the open following a news event.  The move will be accompanied by strong volume.
   
   
3. Beware of false breakouts.  The move is not without its risks.  A failed breakout will result in immediate losses to the breakout buyers; if you are a buyer of a failed breakout, take the loss and exit the market immediately.  The market should run on a breakout.  If it doesn’t, look elsewhere for an opportunity.
   
   
4. The breakout is often a continuation pattern.  The breakout is often a confirmation of an already-established trend.  The pattern typically occurs from a consolidation following the creation of a strong first leg.  In this instance, the breakout signals the beginning of the second leg.  Trends, as a rule, are comprised of two legs which are comparable in both time and price.