Monday, October 02, 2006

More on the Breakout pattern

Based on the comments of Trader:R, I thought I would expand a bit more on the breakout pattern. Just like how some gap ups often get filled, breakouts often get tested. You can play the breakout, or you can also play the test of the breakout, both choices are perfectly valid. But for the purposes of this pattern catalogue, the point I want to make is that the breakout is a high probability setup. Why? The volume provides the "juice" to turn prior resistance into the newest support level. All the bagholders that were stuck at that prior resistance level have now been removed - there is literally no more resistance (at this level), and that in turn attracts new buyers to jump aboard to drive the stock up.
Now, there are a couple other ingredient that I failed to mention about the breakout pattern.

1. The breakout pattern works best when the breakout is in the direction as the trend. In the example that I used, GD was above the 200d, 50d, 20d MA's. All the MA's were trending up. The trend is your friend, yada, yada, yada. This is also consistent with the Chairman's dummy Trading questions (is the trend up or down?). When the stock moves in harmony with the trend, that is when you get your high probability setup.

2. There is no gap up from close of the previous bar (yup, starting to think timeframe-less here). The opening price must be below the previous close for this breakout to work. That's because gaps tend to create a different behaviour in the stock, and that may negate the effectiveness of this breakout pattern.

Going back to the example of GD, the buystop would be just above the resistance level @69.9 (or the psychological resistance @70 if you wanted to be safe), initial stop would be just below the previous day's close @69.25-ish. After the breakout, how you manage your stop depends on whether you want to play it tight or loose - this goes back to your own risk tolerance. Once there was follow thru buying the next day, one possibility would be to move the stop to the next day's low@71. Or if you wanted to play it loose, just move the stop up to just below the new support level@70.

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