Breakout Trading Strategy

Breakouts

One of the most powerful investment techniques is to exploit the explosive nature of a breakout. The term “breakout” should be relatively self- explana­tory. It signifies a price move that is dramatically out of the ordinary for the normal trading pattern of a trading entity. How do candlestick signals and formations benefit in breakout trading? Being able to evaluate what the con­tinuing move will be after a significant price move becomes very important. Is the price move a one-day fluke? Did severe short covering affect the price? Will the trend continue after a significant percentage price move? These are all questions that can be answered by simple evaluation of the candlestick forma­tion at the end of a trading day.

There is a significant difference of a breakout where the price starts low and ends near the top of the trading range. This creates a large white candle. A price that opens up significantly higher and closes at the lower end of the trading range is a completely different scenario. Although the price may be dramatically up for the day, the type of candlestick formation produced on that day provides significant investment information.

Fig. 6-18, The INVN chart clearly illustrates a change in investor senti­ment when an outside event affects a stock price. Notice how the stock jumped from $2.50 a share to $8.00 a share during the 9/11 attacks on the World Trade Center. The large volume breakout, although impressive, did not have any major significant price move for two months after the breakout. The fact that the breakout day opened at around $11 a share and closed near $8.00 affected the price trend. The buying started three days later after a small Morning Star signal formed but overall the price of this stock was almost the same as where it opened on the breakout day in mid-November

As seen, the price started moving significantly after the breakout. But the large black candle on the breakout day indicated there was still some doubt in inves­tor sentiment at the end of the day. This was reflected in the stock price for a few months.

The fact that a breakout has occurred in the first place reveals something. That something may be a new dynamic coming into the stock price. That dy­namic may have been created by internal improvements of a company. The new investor sentiment may also be caused by an external event that changes the outlook for a company’s fundamental potential or a commodity supply or demand potential. Whatever the cause for the breakout, an investor wants to be able to analyze whether a dramatic price move is a one time shot or if it’s the beginning of a huge price jump. Candlestick analysis greatly enhances the abil­ity to evaluate the potential move.

The common sense that is incorporated into candlestick analysis makes in­terpreting a breakout situation relatively easy. The signals are still the important criteria. The analysis of what the signal represents, in correlation to the trend, is greatly entranced with simple explanations of what the candlestick formations are illustrating. Fig. 6-19, The Applied Digital Solutions Inc. chart revealed important information. The breakout opened and continued to move up, closing on the high. It moved through the 200-day moving average with no problems. This becomes a significant message.

The term breakout can be applied to stocks that have traded in a flat range for an extended period of time. A giant move to the upside, based on any news announcement or world event, becomes an important ‘alert’ system. Simple logic dictates that if a substantial price move takes effect after a particular event, the price move becomes a beacon for analyzing what a company’s po­tential should be in view of that event.

The development of other formations, after a breakout, becomes very re­vealing as far as what the next potential move will be. The evaluation, of what the reaction should be from investors after an extensive move, is easily ana­lyzed when understanding candlestick analysis.

Fig. 6-20, The Air T, Inc. chart illustrates additional buying enthusiasm, even after a 50% move in the price on the breakout day. The fact that the slight gap up the following day was followed by continued buying indicated that the buying pressure had not diminished. This creates a much different evaluation versus seeing a gap open, followed immediately by selling, or an open that occurred back down in the previous days trading area.

Having an immediate visual graphic of what investor sentiment is producing is paramount when debating whether to hold a position or take profits. When prices increase dramatically, percentage-wise, in very short period of time, hu­man emotion factors have to be analyzed very quickly. The greed factor, the fear factor, or the profit taking aspects have to be accounted for as quickly as possible. Buying and selling decisions become quicker on the trigger. The fear of not getting in fast enough or getting out fast enough becomes exaggerated in the price movement.

The elements of a breakout pattern can involve other technical indicators. As seen in Fig. 6-21, the W R. Grace & Co. chart, the 50-day moving average began acting as support. Witnessing a big price move becomes the alert.

The fact that the price move was created on big volume is another indicator. A large price move, accompanied with high volume trading and breaking through the top of an established price range, is a significant message. It clearly illus­trates that a new dynamic has entered this stock price.

The combination of a gap up and a large candlestick body, with expanded volume, and the price breaking out through a resistance level, is a clear mes­sage. The bullish candle formation left little doubt at the end of the day that the bullish bias was still present. Had a significant shadow been viewed at the end of the day, to the upside, then a different analysis would have been applied.

The question arises as to whether this may not be demonstrating exuber­ance at the top. That observation would have been more crucial had this been a day of large buying at the end of an uptrend. In this case, this was a breakout from a flat trading area, definitely a different trading mode than witnessed in the prior month and a half.

Breakouts can also occur in an established trend. If they can clearly be observed in a price pattern, such as a trading channel, and a large-volume price movement breaches that trading area, that breakout now reveals new investor sentiment coming into the price. How a price moves out of the norm, in a trading pattern, is illustrated by the candlestick formation. The information revealed in that formation can be used to great advantage for entering very profitable trades.

Does a breakout always immediately signify massive gains? Not always! However, a breakout from an established trading area should at least be the shot across the bow. Notice in Fig. 6-22, the Catalina Marketing Corp, chart, the breakout was obvious. Yet the main thrust of the uptrend did not occur until three weeks to a month later. The gap up from the breakout day now becomes an important factor. The pullback, after the initial breakout, appeared to stop at the bottom of the bullish breakout candle. The fact that the 50-day moving average and the 200-day moving average crossed as the price came back to the bottom of the breakout candle adds significance.

The candlestick signals provide relevant information in a breakout situa­tion. Notice in Fig. 6-23, the AVII chart how a breakout, that more than doubled the price of the stock, was followed the next day by a Bearish Harami. That information provides a completely different scenario than if the buying was still present the day after the breakout. This is nothing more than utilizing what the Japanese Rice traders have observed for centuries.

Will the price of this stock eventually recover to the high of the breakout? More than likely. That provides the candlestick investor with an alert system to watch for new activity in this stock. Keep in mind, the basic element of a breakout situation is that a new dynamic has entered into the stock. The probabilities indicate that the new dynamic will not disappear after one day of trading. Whatever news or event that affects the price greatly is probably going to be revisited within a reasonable amount of time.

A huge move? What do the candlestick formations tell you is happening at the end of the trading day? This information is valuable. The proper evaluation of a breakout candle can produce very large profits.

Breakout Summary

How do you find a breakout situation? This is a very simple scan. It involves finding the stocks that have the biggest percent move during a given timeframe. Breakouts are usually news-driven. They can be found in all-priced stocks. Volume will have a great important also. Volume should be significantly greater than a normal trading day. Some common sense still needs to be applied when evaluating volume. A stock that normally trades 3200 shares a day that has a big moves on 40,000 shares a day should not have as much relevance as a stock that normally trades 200,000 shares a day and moves up to 4 million shares in one day. Logic dictates that a low-volume stock can be moved around by one purchaser.

Breakouts are the result of something significantly different happening for the future potential of a company (or any other trading entity). That result can be visually analyzed in the candlestick bodies following the breakout move. Simple analysis wants to identify whether the buyers are still involved. The presence of more ‘buy’ signals, such as gaps up, acts as an efficient analytical tool. The strength of an up move will be predicated upon the candlestick for­mations appearing during or very soon after a breakout candle appears. As with all analysis of candlestick signals, a black candle following a breakout does not necessarily reveal a reversal if that black candle does not portray a candlestick ‘sell’ signal.

The same rules for analyzing candlestick signals in a normal trend should be applied in a fast-moving breakout situation. A Shooting Star on a second day of a breakout still requires confirmation the following day. A Bearish Harami reveals a different scenario.

The elements that form a breakout situation can produce extremely large profits for the investor that takes the time to analyze what the candlestick formations are revealing. Is it worth chasing a stock that is already up 40% on the day? If you can interpret what the chart pattern is revealing, using candle­stick formations, the fear of chasing can be eliminated. The confidence that comes with understanding what that chart formation can produce allows the candlestick investor to participate in analyzed and calculated trades.