Just an interesting (and timely) look at the technical analysis term "the breakout"...courtesy of stockscores this week.

GS40

The breakout. In its simplest form, it occurs when a stock hits a new high, moving through a price ceiling that has held up for some amount of time. Stocks that are strong must eventually break out so it is understandable that a very basic trading strategy is to buy stocks that are making breakouts. However, I have found that trading with just this simple criterion is not a good way to make money. To use breakouts as an entry signal, you have to add other criteria.

Let's first make sure we understand what dynamic is in place when a stock breaks out. If a stock is hitting a price that is higher than it has seen for some time then the market is really saying that the fundamentals are better than they have been for some time. Investors are willing to pay higher prices because they believe that the company's business is worth more. So, breakouts are significant because they represent a change in the perception that investors have about the company's ability to make money in the future.

That is why I like considering breakouts; there is something significant fundamentally behind them. However, it is important that we find a way to differentiate between breakouts caused by emotion and those caused by information.

Better trading opportunities occur when investors are motivated to pay a higher price because of new information rather than emotion. Higher prices caused by emotional investors chasing a hot stock higher are likely to see a correction and actually represent a good short selling opportunity.

So, when considering breakouts, we need to have techniques that help us separate the emotional breakouts from the informational breakouts.

This is actually quite simple to do. When a market is emotional, there will tend to be price volatility. By that, I mean that price will be changing day by day. Typically, an emotional breakout to the upside will be preceded by an upward trend where investors are eagerly buying the stock. So, the first rule of breakouts is to not buy them when they are preceded by price volatility.

Instead, we want to focus on stocks that have been trading in narrow, normal trading ranges. If a stock is trading sideways and has a pretty boring price pattern then the breakout represents the beginning of something. New information has shocked the buyers in to paying more. Informational breakouts are best when they come from periods of sideways trading.

When assessing breakouts, we also need to determine if the breakout has real buyer power behind it. Moving a stock to higher prices requires buyers motivated by greed. If that is lacking, then the stock will sink lower as sellers take profit. So, breakouts to the upside must be accompanied by volume, for volume is the fuel of the buyers. Stocks have a hard time going up without volume, although they can fall lower without it.

Breakouts will have difficulty evolving in to upward trends if there are people who own the stock at higher prices. These people have been losing money on the stock and are likely frustrated with holding it. As a result, they are more likely to sell the stock when it gets back to what they paid for it. So, when analyzing a breakout, it is good to consider how long it has been since the stock has traded at this price. I find that breakouts are more reliable if they represent a move to at least a two year high.

Finally, we need to think about the mood of investors because, even though information can cause a breakout, a sustained trend needs investor optimism to keep it going. Therefore, it is important to look at the shape of the pattern in to the breakout so we can understand who is in control of the market. Rising bottoms indicate the buyers are in control, falling tops show the sellers are in control. Upside breakouts are best preceded by investor optimism as shown by rising bottoms.

To summarize, the best breakouts are those motivated by new information that justifies investors paying a higher price. Breakouts from sideways, low volatility trading with strong volume supporting the breakout, rising bottoms in to the breakout and up to prices that have not been seen for two years will have the best potential for an upward trend.