Thursday, June 25, 2009

Five Things to Look for in a Stock Market Breakout

It's easy to become lulled by range-bound trade and then miss a significant price breakout. There are several things I look for in identifying a promising breakout move:

1) The presence of an extended trading range - On average, the longer the range, the more extended the subsequent breakout/trend move, as a greater number of traders are forced to cover positions (thereby extending the breakout).

2) An increase of volume on the attempted breakout - The fresh higher or lower prices attract the participation of large, institutional traders, as we begin to accept value at higher or lower prices.

3) One-sided sentiment on the attempted breakout - A valid breakout will show persistently elevated or weak NYSE TICK and extremes of volume transacted at the offer or bid.

4) Limited retracements - Pullbacks following the breakout thrust are limited both in terms of TICK values and amount of points retraced.

5) Broad participation - The attempted breakout will have broad participation, with the major indexes and sectors moving to new highs or lows.

Many good breakout moves occur following short-term oversold or overbought markets. That is because many traders who are holding positions short or long are trapped by the breakout and need to exit, adding to the buying/selling of momentum traders.

The above five features of a valid breakout make a nice checklist to keep in mind when we trade within an extended range.