Friday, January 22, 2010

Understanding and Trading Stock Market Breakout Moves

Yesterday's market gave us a textbook example of a breakout move. It began with the identification of a multiday trading range, as noted in the recent post. Why a multiday range? Because over the course of multiple trading sessions, both bulls and bears are positioning themselves for the next move. When that move does occur, those on the wrong side of the trade have to scramble out of their positions, fueling the breakout move. As a rough rule, the longer the trading range, the more extended the breakout move.

Note that a trader didn't have to predict the breakout to still profit from it. The genuine breakouts will not return to their prior trading ranges for the reasons outlined above. The first retracement after the breakout can make a fine short-term entry point.

So what do we look for in a valid breakout move, as opposed to one that will ultimately fail and reverse? Here are a few keys:

1) Expanded volume on the break (see blue arrow above). That tells us that there is broad acceptance of lower prices and that institutional traders are participating in the move;

2) Volume heavily weighted toward buyers or sellers. We should see very positive or negative NYSE TICK on the break, and the proportion of volume transacted at market offer or bid should be quite high;

3) We should see broad participation on the break. Most if not all stock market sectors should be moving with the general averages, and we should see a commensurate break in the intraday advance/decline figures;

4) Intermarket themes should be confirming the break. In yesterday's case, that meant a rising dollar, falling commodities, rising Treasury prices, and risk aversion in credit markets.

The breakout move indicates that the fundamental supply/demand situation of the stock market has shifted, moving from the equilibrium of a trading range to a more one-sided trade. That one-sided action will continue until can reach a new equilibrium. That occurs when longer-timeframe participants become tempted by the new price levels and become convinced that the market has moved too far from value.

Until that time, the breakout move becomes a short-term trend. Traders who stand aside and fret that they "missed the break" can end up missing a more extended move by not recognizing the market's fundamental demand/supply shift.