The Breakdown on How to Play Breakouts, Pullbacks
Wednesday, September 2, 2009 | Teeka TiwariRating:
During the last few weeks (albeit with a few editorial detours on the way), I've been sharing an investor education series with you, geared toward helping you to harness the strategies and lessons I've learned as a professional investor. This week, I want to cover two very powerful trade entry approaches with you. While these certainly do not cover the entire gamut of every trade entry method, my goal today is to show you a couple of ways to take advantage of stock market moves, and the signals you should be watching for, before you go long.
We are going to cover the following:
1. Buying on a breakout.
2. Buying on a pullback when a stock is in an uptrend.
'Break Out' of Your Investing Routine
A breakout is when a price movement, through an identified level of support or resistance, is usually followed by heavy volume and increased volatility. (Definition courtesy of Investopedia.com.)
Not all breakouts are created equally, which is why many breakouts fail and reverse back lower.
Big Volume is Critical
One of the key elements to playing breakouts successfully is to only involve yourself in breakouts that occur on large volume. You want to see at least 50% more volume than normal.
Make Sure the Breakout's Not a Fake
Another way to put the odds in your favor is buying breakouts that are experiencing big volume AND are breaking out to all-time new highs. When buying at all-time new highs, you want to be careful about not getting caught in a false breakout, especially if the stock is very extended.
When I am playing stock breakouts, I typically place my purchase price at a whole number. So, if the previous high on a stock was $37.63, I'll place my buy at $38.
If the breakout is real, then the stock shouldn't look back for a second. This is why, when I play a breakout, I place my stop-loss just below the low of the previous day.
Keep Your Risk in Check
Sometimes, the previous day's low price can be far away from the breakout price. In these cases, I moderate my position size to take into account the extra risk I'm taking on by having a stop-loss point relatively far from my entry point. If the stop-loss is too far away to make sense, then I simply pass on the trade.
If the breakout is the real deal, we shouldn't come close to getting sold out. But if it's a "head fake" or a weak breakout, I'll get stopped out very quickly and, more importantly, for small money.
In a broader-based, uptrending market, this is a great short-term profit-making machine. Depending upon the price of the stock, you can scalp multiple points per play while taking very little risk.
This Strategy Works Best When:
1. The underlying stock is in an uptrend.
2. The overall market is trending higher.
3. Breakout is on at least 50% more volume than normal.
Use Pullbacks to Take Advantage of a Winning Streak
I love buying in on pullbacks when a stock or Exchange-Traded Fund is trending higher, but this strategy is very market-dependent and very "streaky." It either works beautifully or is an absolute pig!
The key to making this strategy work is to only use it when the underlying stock is in a solidly established uptrend. During bull-market periods, this strategy is a goldmine. During flat-to-down periods, this strategy is a wealth-wrecker, so use it wisely!
Find Strength in the Numbers
The way this strategy works is by buying on pullbacks in stocks that are experiencing a temporary sell-off while undergoing a larger move higher. I use it to trade both stocks and commodities.
Again, the No. 1 key component to this strategy is only applying it to stocks or commodities that are strongly trending higher. The strategy works by using a three-day Relative Strength Index (RSI) indicator to compare recent gains in a stock to its recent losses.
We wait for the three-day RSI to drop to 30 or below and then reverse up to 50 or higher. We buy the underlying stock when the RSI crosses 50. We use a stop-loss based upon the previous three-day low.
If the three-day low is actually higher than your entry price, then use the low of the day that you entered the trade as your stop.
Below is a six-month chart of Goldman Sachs (GS), each green line represents an RSI buy point.
You can trade these any way you wish, super-short-term or you can use it to trade a longer-term trend. It's a very flexible strategy.
This Strategy Works Best When:
1. The underlying stock is in an uptrend.
2. The overall market is trending higher.
3. The three-day RSI first hits 30 or lower, then reverses to 50 or higher.
2. The overall market is trending higher.
3. The three-day RSI first hits 30 or lower, then reverses to 50 or higher.
Do not use this strategy on a stock making lower lows! You want to use this for stocks making higher highs. This tool is by no means a "Holy Grail," even if the Goldman chart makes it look like one.
The misapplication of a strategy can be as bad as, or worse than, having no strategy at all.
Your Key to Success
Whatever approach you use, make sure that it's appropriate to the market that you are in. Market entry approaches come in multiple flavors -- approaches that are geared toward rallying markets, falling markets and sideways markets.
Both of the strategies I've shared with you today come under the "rallying markets" umbrella. They will fail miserably in a sideways or falling market.
Knowing definitively what type of market you are in is an article for another day, and one that I look forward to sharing with you in the future.
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Teeka Tiwari
Chief Investment Officer
ETF Master Trader
