Developing a Breakout Strategy

Breakout strategy is a term used to describe the practice of noticing when a stock has broken through its previously defined ceiling. When this occurs, there is a large chance the stock will climb sharply and present a profit opportunity to the sophisticated investor. To develop a breakout strategy, though, an investor must be aware of trends in a stock, how to identify a false breakout and when to purchase a breakout stock in order to maximize profit. 

Identifying Trading Channels

A trading channel is a range of prices a stock trades at over a number of years. For example, you may identify a stock that has consistently traded between $5 and $7 a share for the past 5 years. This stock is swimming within its narrow channel, and it is not likely to break out of that channel unless a large change happens within the company or to investor attitudes towards the company. Simply identifying this channel is the first crucial step to finding a breakout possibility.

Finding an Initial Break

If the stock mentioned above suddenly jumps to $8 per share, it has finally broken out of its little trading channel. It is important to assure the price stays above the ceiling, called a resistance level, for at least a few trading days. Otherwise, you may simply be witnessing a blip caused by a single investor instead of a general market attitude toward the stock. If the stock is above its resistance level consistently, though, you may have successfully identified a breakout stock.

Watching the Stock Dip

You will not be the only one to see this breakout. Other investors, some of whom own the stock, will witness the high price. They will sell to maximize profit. You may find a few days or weeks of heavy trading of the stock at this high price, but the trading will eventually subside. Typically, the stock will dip back below the resistance level for a time. This is when a breakout stock is preparing for its true push, and this is the right time to buy.

Capitalizing on the Second Rise

A second group of investors will see the stock has fallen slightly but the value is still high. These investors will begin purchasing the stock, and the price at this point will see nearly no ceiling. In a successful breakout, the stock will climb until it reaches a new trading channel where the floor value, called the support price, is above the initial resistance level of the stock. For example, in our example above, the stock now trades in a channel between $7 and $10 per share.

Avoiding False Breakouts

If you purchase the above stock after its initial dip, you will be hoping you have correctly identified a breakout, but you could be wrong. Some stocks do not experience the second rise, and they will not actually break out of their channel. In order to avoid purchasing a false breakout, monitor the underlying values with the stock. Determine if you can explain the rise and dip by another reason; if so, you may want to avoid purchase.

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