Thursday, December 07, 2006

"Breakout play" interpreted

Breakouts... one of my favorite ways to make money...
Most misunderstood by general public concept resulting in losing money...
Most misrepresented by institutional advisers / talking heads - in order to take your money...
Looked at Google Analytics today and saw that about 70% of visitors of this blog come from Yahoo Finance message boards - that means that most of readers, very possible, are beginning traders/investors and due to the fact that 2 out of 3 of my ideas are (or very closely resemble) breakout play - I feel obligated to drill down to details of what it is and how I play it [breakouts].

"Buy low sell high" - no offense but those who have became affected by propaganda better stop reading now ( not that there is something wrong with value investing - but that is what it is - INVESTING - and I'm not interested in making 9% over the next 20 years, I'm interested in, let say modestly - doubling my account in the GOOD year and not sitting on dead money on the bad year )

Simply put - breakout is a move out off the top of solid base. ( If base is a "Pennant" top is considered to be upper trendline )
It happens when stock which was not capable to penetrate "resistance" level ( or, let say - commonly believed "top" price for the stock) absorbs all the selling and shorting and then moves to the upside )

Good news first
If you are in the right breakout at the right time - you are going to make money faster than just by buying somewhere IN the base and hoping for a stock to rise. ( or fall ).

When stock exhausted its upward momentum, you sell it and go shopping for another 10-50% runner.

The bad news
3 out of 4 breakouts are "false breakouts" when stock is not capable of continuing upward move due to various reasons, to name a few: market mood change, no buying interest and such.
What happens after false breakout ( I consider temporary pullback to be a false breakout - temporary ) - stock will go back to the top of the base to form "cup and handle" chart pattern, consolidate, shake off selling pressure, weak hands and move up thereafter OR stock will re-enter the base to become dead money for a while ( if not forever ).

Important question would be - how to spot real breakout?
Two most important components:
1. VOLUME - MUST be at least 130-150% of average monthly volume.
2. SOUND BASE - you can use link on the left side of the site ( "Chart Patterns" ) and read more about my favorite ( and "safest" if there are such ) bases ( "Rounding bottom", "Cup and Handle", "Flat base", "Pennants" ). When there is NO solid base to break out from - that kind of breakout is more likely to fail.
VERY IMPORTANT - breakouts out of the short base ( lesser then 6-8 weeks in duration are in most cases prone to failing on the same day even if there is volume increase. I, personally, like to see even longer bases )

So, whenever I play breakout I prepared right out of the gate to lose 2-4% of my stake - this is why money management and position sizing are SO IMPORTANT. ( For more on money management and position sizing visit Trade Guild Blog published by Brandt A.K.A. BullTrapper - a lot of "right to the point" articles on this subject on that site ).

When opening position to "play breakout" you cannot "set it and forget it" - you cannot just place stop limit buy order and go away. Why? Since most of the popular discount brokers do not offer mechanism for incorporating price AND volume into your order ( and even if they do ) - it is best to monitor your intended/entered trade closely - this way if it is a false breakout without follow through on price/volume side - you'll have better chances of getting out with minimal damage ( the more chips you save the better your chances of catching real breakout and capitalizing on such ).

How to spot stocks about to breakout? It is a topic for a different article, which might follow.