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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.
Should you find yourself in the enviable situation of having purchased the breakout and see your stock rising, you mustn’t grow complacent. As a rule, new traders are most bold when they should be cautious and most cautious when they should be bold. Quick, substantial profits are apt to be fleeting in the market. So you can bet profit-taking, in the form of selling, will enter the market following any strong rally. At this point, you must make a decision concerning your position. There are many ways to determine where to take profits. A simple rule is to sell after three days is up. Markets will rarely have three higher closes without some selling driving the market lower – if only momentarily. If you take a long-term perspective, you may anticipate substantially high prices. In that case, either hold on or buy more on the inevitable profit-taking break.
Aggressive traders understand that they must strike when the iron is hot. There is a “70-30” rule in the market that says that 70 percent of the time the market is getting ready to move or churning sideways. That leaves just 30 percent of the time when the market is moving from level to level, either up or down. In reality, it is probably more like 90-10, with the market moving only ten percent of the time. That’s why you want to capitalize on a trending market. We are, of course, speaking in generalizations here. The market, as a whole, may be dead in its tracks. You only want to care if your stock is running.
It is hard to become an aggressive trader when one is new to the market. This will take time. This is especially true because the new trader is apt to become aggressive at precisely the wrong time – at the very top when his equity is at the highest. The real place to become aggressive is when you’ve found the right buying opportunity in the right stock. Then, if there has been a setback in the market and profit-taking occurs, you have an added opportunity to buy more. This is where you need to become flexible and buy weakness. As you may remember, on the initial gap up, you bought strength. This was the correct strategy. On the subsequent break, however, you now buy weakness. This is where you need to understand what is going on in the market.
Any run higher will generate sellers. Weaker hands will see this selling and think the move is over. Their selling is your buying opportunity. An aggressive buyer will typically buy three times depending on the movement of the stock price. First, you buy on the breakout. Second, you buy on profit-taking. Third, you buy any subsequent weakness. And that should be pretty much it. The third time should be the charm. If you buy three times and the market comes back on you, you may want to rethink your strategy – and perhaps bail out of the entire position.
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