In the Dugout: Trading a Breakout

One of the easiest chart patterns to notice and profit from is a breakout from consolidation. Let me go into what this means and then show some examples using charts of prior breakouts. Stocks go up and down, but not in a straight line. If a stock starts to rise sharply on positive news, it often will take a breather before heading higher. This is much like a sprinter that can run only so far at top speed before some rest is needed. Once a stock starts to consolidate, it often will have a point that acts as resistance. This resistance will hold the stock down until enough strength is exhibited to send the stock through this ceiling.

When looking at charts, look for stocks that have tested over and over a resistance point. Much like a spring, energy is stored up during this consolidation and once released can send a stock dramatically higher in a short amount of time. The key to this breakout being valid is volume. If a stock breaks through resistance intraday, but volume is lacking, it won't likely have enough fuel (volume) to keep moving higher.

Let's look at the following chart that shows a great breakout.

"Chart generated by RavenQuote charting software. Copyright (C) 2000 #"

There are a couple things to note about TSG's breakout. First, the breakout occurred on higher than average volume. This is critical. Second, the stock rose approximately the same amount as its prior range. What I mean by this is that TSG was stuck in a $5 range about three months. For whatever reason, when a stock breaks out of a range, it will often trade up by the amount of this range. In this case, TSG reach $35 and now is consolidating again.

There are really two ways to play a breakout. One is to play the break as soon as it happens with the risk takers buying in on anticipation of the break. Another way is to wait for the stock to retest what once was resistance before entering. Obviously, in our example of TSG, this strategy would not have worked. Using this strategy though, helps keep traders from chasing a stock and also helps a trader feel confident that the breakout is for real.

A stock doesn't have to just be in a sideways consolidation to be a breakout candidate. A break above ascending and descending trendlines is another way to play a breakout. Overall, playing the breakout is a great strategy and with the use of proper stop losses can be relatively safe for a short-term play.

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