The Anatomy of Trading Breakouts
Tuesday, December 11, 2007 at 09:44PM This is a subject matter that is very near and dear to my heart, as it is an art I have perfected over the years. Trading breakouts has been a subject I've covered many times in the past, but always comes out cleaner each time I let the ink bleed.
Here I am going to teach you everything you need to know about how to trade breakouts like the Option Addict. Buckle up.
To get started you need to know what a breakout is. I'll use a couple visuals to help you get the picture.
A breakout occurs when a stock price trades beyond a support/resistance (S/R) level into new territory. This is usually followed by heavy volume and increased volatility. Traders will buy the underlying asset when the price breaks above a level of resistance and sell when it breaks below support. The stronger the S/R, the more meaningful this event becomes. I know I shouldn't have to define what S/R is, but you'd be amazed...
S/R are levels that the price has touched (on more than one occasion) and has been reluctant to trade beyond. When stronger levels of S/R are broken, these normally lead to bigger moves in the underlying. Take a look at JCP, which was a trade I posted on my watchlist back in September.
Note how strong the support was on JCP, and the elevated levels of volume as the stock broke down. What was an average volume of about 4 million shares, quickly became an average of 6 million shares once the stock broke down.
The chart above of MOS is an example of what I DO NOT classify as a breakout. A stock that trends higher, normally makes new highs during each rally. A stock that makes higher highs does not stop at the same price level more than once to form resistance. With no resistance (or support), you get no breakout. I bring this up since I commonly hear individuals talking about uptrending stocks that take out prior highs, and refer to these scenarios as breakouts. If you do this, you are wrong.
Breakouts can also occur from price patterns, which if you read my blog, you already know how this works.
The chart above shows BGC breaking out of a recent triangle formation that I have been tracking since it originated on my November watchlist. Straight forward, right?
Now that you can understand more about breakouts, I am going to review the anatomy of how to trade them. Here is my 8 step process...
1. Identify the candidate
Find stocks that have built strong S/R levels, and watch them. This can include price patterns, but I only recommend you follow price patterns from my watchlsit. Any other price patterns you find are subject to my approval, mocking, and ridicule. Anyway, you must remember, the stronger the S/R, the better the outcome. Make sure you understand this when you start shopping for stocks to watch.
2. Wait for the breakout
Just because you found a candidate does not mean you ought to jump the gun and start anticipating anything. Wait patiently for the stock price to make its move. To be sure the breakout will hold, on the day the stock price trades outside its S/R, wait towards the end of the trading day to make your move. Trading at the open doesn't mean that the stock will sustain it's early price move, nor will it collect the necessary volume levels to sustain any continued price movement. Be patient.
3. Set a reasonable objective
If you are going to take a trade, set an expectation of where it is going. If you don't complete this step, you won't know where to exit the trade. Most traders will identify an average move that the stock makes, or measure the distance between S/R (especially when trading patterns). No matter what method you use, complete the step.
4. Allow the stock to "re-test"
This is the most critical step involved. When a stock price breaks a resistance level, that old resistance becomes new support. When a stock breaks a support level, that old support becomes new resistance. In nearly half the trades you take, the stock will test the level that it has broken after the first couple of days. Understand this and more importantly, own it.
When I trade breakouts, you ought to know that within the first few days of the trade, I am losing money on nearly half the trades I make. So when I trade any given breakout, after the first couple days I am usually losing money! Cue the question..."So Jeff, why trade breakouts? Why not wait for the re-test?"
Answer: "Because if I wait for the re-test, I miss out on the stocks that break out, scream higher and never bother to re-test. Those few trades end up being the best trades of the year for me." Here is one of my best breakouts of 07; GRMN.
Looking at the chart of GRMN, you can see the flag pattern I traded, and you can see that the stock never re-tested it's old resistance. It just started running and never looked back.
The chart of HLYS above gives a visual example of a re-test. Once HLYS broke support, not more than a couple weeks later, it traded back up to this level and used this as new resistance before heading lower. It is this move that you need to be patient through if you are going to trade breakouts. BTW- for those that remember this trade I offered on the Marketcast @ $27 per share....you can cover your short position at $6 today.
5. Know when your pattern/trade has failed
I exit a trade when the old S/R (breakout point) doesn't hold up as new S/R. This is where a pattern fails.
Analyze a 1 yr chart of PCZ. When you do, you'll notice the ascending triangle. It had a great breakout in early Nov, but failed only a few days later when old resistance didn't hold up as new support. This is where a pattern is considered "failed" and it is imperative that you take the loss at this point. Don't gamble with losses.
6. Exit trades towards the market close.
You can't discern at the open whether prices will hold at a particular level. This is why I wait toward the market close to exit a losing trade. If a stock has remained outside my pre-determined S/R level towards the market close, I will quietly take my loss and walk away from the trade.
7. Be patient
This speaks for itself, but this strategy will require lots of patience. When you are losing money on the trade in the early stages, when the stock price hasn't moved for a few days, when it looks like you might take a loss but must talk yourself into waiting towards the close-- all these steps require patience. If you lack patience, find another strategy to trade.
8. Exit at your target
If you are not exiting the trade with a loss, then you are in the trade. You will remain in the trade until the stock price reaches its objective, or you have reached your time target without yet hitting your target price. Worst case scenario...if you think the trade has legs, exit half the position and let the other half run.
These are the steps you will need to take to successfully trade breakouts. This also ought to clarify some of the repeated questions I am asked about how/when I exit trades. As you can see, this isn't an overly complicated topic, but one I am sure you would have figured out with a little experience in the field. As always, I am here to shorten the learning curve, so take some of these tips into consideration next time you trade a breakout.
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Reader Comments (154)
Its a monster!! You are a monster.
Anyone buy shares of CPLA yesterday?
SFM- I got carried away, huh?
Jeff- Thanks for the tutorial. On step 5, Know when your pattern/trade has failed, the illustration with PCZ shows how it closed below support. As you have said, draw support and resistance lines with a crayon, not a fine line. Is there a certain percentage you would allow a stock to fall below that line drawn on the chart where you would still count it as a valid stop at support? It would have been a disastrous gap down to have missed the PCZ bullish pattern failure. I suppose you could always get back in if a stock headed north again from where you got out. Thanks,
Stan
Jeff,
EXCELLANT! Thanks for the great tutorial. I know all of these things but still fail occationally to be disciplined in the application.
I would never try to stop a Monster (capital M) from doing his job.
Stan,
It has to be clearly broken, and volume sometimes is a giveaway. To be honest, no...I don't have a certain dollar amount or percentage. I just evaluate and make a decision.
So? How much do we owe you for this? Whatever it is it will be too low! Thanks!!!
Jeff,
That was amazing. What a wealth of information, and awesome to have it all in one place/post.
One issue I seem to have when trading breakouts is that by the end of the day, often times the stock has moved pretty far from the breakout area. So usually I move on, but miss a lot of big movers. Is it safe to say that as long as I am willing to accept the risk if the breakout fails, for the potential reward that is still left given the price target, it is ok to take the trade at this point, rather than waiting for a restest that may never come??
Thank you for taking the time to post this! Awesome. And definitely one for the Greatest Hits.
Another one for the Greatest Hits. Thanks Jeff!
Jeff,
I am a detail person, so all those little details you outlined are fantastic! Thanks!
I know you said you evaluate and closing time and make a decision, but my question to you is, do you ever take other levels of support and resistance into consideration before exiting?
i.e. if there is a diagonal trendline just below support on a breakout and at closing time it is sitting on this line, yet has clearly broke support that you took the trade on. Will you still exit?
I hope that made sense.........
The information on the Garmin video goes well with this post.
http://www.youtube.com/watch?v=E0NXhwqrQAM&eurl=http://
www.optionaddict.net/my-trading-videos/
LisaG,
Good point. If you were expecting a $5 move, and the stock has already moved 2-3$...it makes the risk/reward much less attractive. There are many times where I am waiting for a great trade, but the move was too substantial.
Jodi,
Sure...especially when you are looking for an exit that will protect profits. Each scenario might be different, but for trade failure, I only take old S/R into consideration. Nothing else.
Jeff -
Thanks for a great post. I interpretted OXY as failing its pattern yesterday when it closed below the centerline if its triangle at about $70.50. Obviously today it is up on Fed news, but would you have agreed that yesterday represented a failed breakout?
Thanks!
John
John,
I had the exact same situation with TM yesterday. Although I am disappointed that TM is up significantly today, as is OXY, both their patterns had failed and the chart left no option but to get out IMO.
Jeff,
Thanks. This is one to print out and frame.
I also might read it out, record it, and play it to myself while I sleep so I'll be sure it sinks in.
Thanks again.
Jeff-
Would you consider breakouts as valid if they occur due to "irrational" market exuberance and widespread market hysteria such as yesterdays 300pt decline due to Fed news? Does this external influence on a stocks failure of S/R constitute a valid breakout?
Jeff & OAs,
Any thoughts on SOLF as a bull penant (?sp). I question it because there was not a clear uptrend before the flagpole.
Thanks!
Jeff... Great post!
My question is on volume. Is it more important on breakouts going up and less important on downside?
Also on BGC, volume is decreasing as price rises. Does this mean it will stall out sooner then later?
NVDA - Breakout? Is this where patience is needed?
Whats up Jeff
I was curious to know what, if anything, will make you close a trade intraday. If a stock is just dropping too far beyond your trendline dont you just jump ship?
Also, I was reading your post on "Amateur Hour" and I stumbled across this...
"Disclaimer: The Option Addict takes more trades in the first half hour of a trading day than small Mutual Funds take in a Quarter."
Do you use a different style of trading for your morning action?
Jeff,
great post. It will take sometime for me to fully absorb this but I know this is worth lots of profit in my account for sure.
Jeff,
I'm a long time reader and first time poster. First and foremost, thank you for the wealth of knowledge and the wonderful forum you provide. I've learned a ton. I'm still working on timing entries and exits, but am getting better on other aspects of technical analysis.
I bought 100 CPLA yesterday at $69 early. Yesterday's initial reaction to the FOMC had me a bit worried in all my trades. But this one is shaping back up nicely. I do have some questions on this one, though. I saw two different potential patterns. I drew support connecting the last 3 lows. Then a resistance line just shy of $75 made what looked like a nice ascending triangle. But then I wondered if the 2 peaks could be a double top and signify a reversal. I didn't see any real confirmation of this reversal, so actually took this as a trend trade bouncing off the support line with a target around $75. If the ascending triangle confirms, I see a target closer to $85. Am I reading this right?
I also bit on a speculative trade of ATW ahead of confirmation of it's pattern. It's looking good at the moment. Hopefully today's close will confirm.
Again, many thanks Jeff!
Doug
Jeff, Thanks for the reminder on breakouts. How easy it is to forget what you have always stressed in the past.I for one have heard you express this more than once! The retest is one that I will own from here on out.Also close out my trades that break through support at the end of the trading day. I'm writing these in concrete.Thanks Again.
Amazing. What a great layout. Can't thank you enough for taking the time to do that Jeff! This will help me so much in my trading.
Matt,
That is a good question. Using GS as an example.... I know many were watching that symmetrical triangle "expecting" it to break to the upside. However, it broke to the downside. I would not have trusted this to be a valid breakout, given yesterday's market action.... But WTF do I know??
Jeff,
I would be interested to hear your take on this one as well.
Stephen,
Yes. I don't trade breakouts in the morning, but everything else I trade is typically at the open.
Toni,
Volume is just as important in breakouts as breakdowns.
Doug,
Keep it simple. At this point, now that you are in the trade...whatever pattern you want to call it is inconsequential.
Mokarimakka,
No...this is where you are comitting trade suicide.
Matt,
A breakout is a breakout.
John,
I would disagree. The apex is the breakout point in this pattern, which has acted as support.
Two words -- Greatest Hits!
Counter Fed day is losing momentum...
Jeff
yes I bought CPLA yesterday and bought SDS this am when the market turned. You info is golden as always.
COH breakout? This was on Jeff's last watchlist.
Correction. COF ... Sorry
Jeff,
I have read all of your breakout posts. They keep getting better.
This one deserves to be player of the year and posted in to "Greatest Hits". TRULY AWESOME!!
Thanks for all you do!
Jeff,
Thanks for the post.
I'm really trying to understand price action. Do you mind expanding your thoughts and explain a bit more about what the psychology is behind breakouts? Specificaly, are breakthroughs of S/R usually triggered by some external event, i.e. earnings announcement, downgrade, etc.? Also, what is the psychology the retest itself? Are traders letting things cool off or lazy or what?
Jeff,
Great tutorial on breakouts. We printed and will keep as a reference. Thanks for shortening our learning curve.
You are a wizard....{*:*} Magical thinker!!!! That's you!
Jeff,
You've hit an all time high on the teaching scale. Truly awesome.
TRMB - Thanks for your thoughts. I think it's confirming today.
CPLA - took this trade yesterday afternoon, thanks!
MSTR - if it stays at its current level(down $1.60) this is an example of a failed triangle breakout, yes?
ESLX - this is a trade I took of my own accord. Solar play that seems to be starting to move and was at a trendline support yesterday.
ESLR, not ESLX, sorry.
Jeff,
What an awesome post!!!
B-rad,
"I'm really trying to understand price action."
Aren't we all?
Jeff:
Is it possible that FLR is setting up for a cup an handle pattern. Obvioulsy it has not confirmed as are not higher than the left side of the cup but I am not sure about the volume aspect of the pattern. Thanks in advance for your comments.
JB
BTW- I don't know why today's post just generated over 100 unread e-mails from the "contact me" icon, but knock it off already!!!
Next person to hit that button on my site before I can disable it gets a special gift for the holidays.
It's called an IP Block.
JB,
No... I'd say not even close. Check my price patterns tab for a visual of that pattern. Hope that will help.
Ah .. Sir Kohler ...
You keep doing stuff like this one ... and you'll need more server space .. We won't be able to get through because of the increased traffic you will draw to this site.
A masterpiece of assistance for your fellow addicts!
Thanks very much! It's in my 'reference manual'....
I'll second this as "Post of the Year" FABULOUS!
PS- I was kidding about the IP block...but not kidding about going easy on the emails.
Got a question? Post it here :)
reading this just changed me as a trader, thanks jeff!
so jeff, i'm guessing you will get into COF near the close or is there not enough volume for a breakdown?
~~~~~EXCELLENT~~~~~
this is why we luv you, you never stop teaching us....thanks
i hope ISRG is just a retest ;-)
time to go back to work...ugh!!!!!
Jeff,
Thanks for putting the breakout tutorial together. It is awesome what you do to teach us. Please add to your greatest hits. And it is a great reminder about patience on the retest with this strategy.
Jeff,
Can we take LULU for instance....... What do we call yesterdays action, its not in new territory, but rose above a strong level of resistance with some really high volume. Do we trade this like a breakout?
BTW, I put LULU out for your approval, mocking or ridicule because I don't believe its been on your watchlist ;)