In the 3rd of these series: -“Investing: Doing it yourself”, I detailed a technical method / strategy of selecting stocks called bottom fishing. Part 4 focuses on another technical strategy- “Break-Outs”
Technical Analysis: Break-Out Strategy
At any given time, a stock is in one of three technical phases – up trending, down trending, or consolidating. When markets or stocks consolidate, they more or less trade sideways without a specific direction. During consolidation, prices are confined to a defined range over a period of time (3-months, 6-months, 1 year, or over 5 years).
Classic Break-out Example: A look at Ford (F) in 2010
For most of 2010, Ford Motor Company (F) traded between $10 and $14.00. It respected a $4.00 price range, consolidating its 2009 uptrend, and then in October of 2010, a technical “break-out” occurred. Ford broke that 10 month range ($10.00- $14.00) to the topside (see chart) and within 3 months was trading above $18.00. A “Break-out” trader or investor will buy Ford on a daily close above $14.00. When a "break- out" occurs, the investor expects either continuation of an uptrend (or downtrend) or the establishment of a new range. The minimum exit target on an entry at let’s say $14.00 equals the length of the old range ($14 +$4.00). In other words, the minimum target price on the range break at $14.00 is $18.00 (the 2011 high is $18.97).
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There are specific kinds of risks with “break-out" strategies with the biggest being something technical analyst call a “false-break”. In fact we had two false breaks in Ford in 2010 (March 2010 and April 2010). Prices poked through the $14.00 ceiling in both cases only to return into the old range the next trading day or two. For this reason, it is very important to “test the break”. A real "break-out" is normally event driven. An event could be news release of significant revenue or profits above market estimates (Like in the case of Ford), announcement of a stimulus program that benefit the industry etc. It is also best to buy a "break-out" on a pullback and not on the initial break.
As in the case of Ford, I wouldn’t have jumped on Ford on that October break of $14.00. The "break-out" was confirmed with strong “follow through” as Ford rocketed to $18.97. A safer entry strategy is to wait for Ford to pullback to that $14.00” break –out” price and then enter for a 2nd test of $18.00. A retest of the old "break-out" price doesn’t always occur but it is better to miss the boat than to get caught on the wrong side of a false break.
Here‘s a summary of how to trade a break out.
- - Identify “break-out” price,
- - Validate "break-out" (was it event driven? is there sign of follow through?)
- - Wait for a pullback towards "break-out" price for entry.
Quote of the Day:
Friendship improves happiness, and abates misery, by doubling our joys, and dividing our grief -
Joseph Addison
Joseph Addison
Written by Isaiah Olateru, Founder & Chief Technical Analyst - Eternal Market Analysis
