Jesse Livermore famously stated that the money is made in the sitting, meaning that you often make the most most money by simply waiting for the right opportunity to present itself.
A prime example of that can be seen in the chart of Flex Ltd (NASDAQ:FLEX), which for four months was in a downtrend as evident from a series of lower lows and lower highs.
Then, all of a sudden, one day, Flex broke above its downtrending resistance line, and that was the breakout day.
So how do you find these types of breakout stocks?
What Is A Breakout?
A breakout is simply defined as the movement of a stock price below a support line or above a resistance line on increased volume.
Active traders need to be skilled at spotting breakouts because they signify high potential for a share price to continue trending in the direction of the breakout, whether lower or higher.
It’s easy to read the above definition and gloss past arguably the most important aspect of the breakout, volume. But as Dan Zanger, the infamously successful trader, once replied when asked if he looks at volume, and we’ll paraphrase, the only thing that matters is volume.
The reason volume is so important is it provides insight into the force of the move. You could think of volume as being akin to the power in a boxer’s punch, which could be a light tap or explosive. Low volume translates to little conviction behind the move, typically, whereas high volume usually means a lot of support behind the share price movement.
A stock that breaks higher on lower volume is less likely to sustain a move higher, and equally a stock that breaks below a support line on low volume may soon recapture its trend line. By contrast, when volume ticks higher, the odds of the move continuing up or down increases substantially.
The risk of ignoring volume is to get trapped by a “false breakout” whereby the share price lacks the conviction to continue trending in the direction of the breakout.
When major stocks like Amazon or Tesla break above key resistance lines or below crucial support lines, they often do so on volume that is as much as 50% higher than the daily average.
How To Spot Stocks Ready To Breakout?
Finding stocks ready to breakout requires technical analysis that can incorporate a variety of indicators, including trend lines, moving averages, oscillators and even Bollinger Bands.
The duration of a breakout can be determined using moving averages. For example, stocks moving above their 50-day average often signal a short-term breakout, whereas long-term breakouts are better signaled using the 200-day moving average.
A common oscillator used to signal breakouts is the Relative Strength Index (RSI), which can signal an impending trend reversal when it drops below 70 or rises above 30. For example, if a stock has been trending lower but the RSI rises above 30, a bullish reversal may be on the cards. Equally, a stock that has been on a bull run accompanied by an RSI dip below 70 could signal a bearish breakout is nearby.
Bolllinger Bands can be used to spot breakouts, too. A stock moving beyond these bands is often a sign of volatility and a potential breakout.
Often the simplest breakout indicators are the most effective. In the chart below, you can see Meta (NASDAQ:META) breaking above its downtrending resistance line, and continuing its move higher thereafter.
Sometimes trend lines form over very long time horizons and can lead to very significant breakouts when they finally do occur.
Take Disney (NYSE:DIS), for example, now. You can see how a multi-year support and resistance line have converged. When Disney share price breaks above resistance or below support, you can expect a meaningful trend to sustain for many months.
Often active traders are focused on short-term daily stock breakouts but longer term breakouts can be signaled by share price breakouts on monthly charts.
Take GEO (NYSE:GEO) as a prime example, which broke above a multi-year resistance line and continued to rise higher by almost 100% in a few short months thereafter.
If you are slightly longer term focused or simply want to check in no more than once a week, or so, versus daily for breakout opportunities, then a monthly chart may fit the bill.
What Causes A Stock To Breakout?
While the discussion so far has centered around stocks breaking out of technical patterns, the question arises what triggers a stock to break out in the first place?
The quick answer is a fundamental event of some kind. That could mean an earnings announcement, an acquisition, a regulatory ruling, a Federal Reserve policy announcement, a government report such as Consumer Price Index beating or missing expectations, or even an FDA announcement among others.
For instance, when shares of Nvidia (NASDAQ:NVDA) surged on two occasions over the past few years, both times the spark that ignited them was an earnings announcement.
How Economic Moats Affect Breakouts
One often overlooked aspect of breakouts is the economic moat a company possesses.
Take Apple (NASDAQ:AAPL), for instance, which has sustained a growth trajectory for well over a decade. The company’s financial success, meaning sustained revenue and profit increases as well as gross margins typically north of 40%, has translated to technical chart success.
It’s important to note that Apple’s wide economic moat has been a key factor in propelling AAPL share price to ever higher highs. The brand loyalty and fortress ecosystem have combined to create a moat so wide that few, if any, companies will ever be able to disrupt it.
Strategy and Timing
The key aspect to successfully trading a breakout is to identify it in the first place, but it is just as important to develop a strategy to exit a position.
Generally, a reversal of the trend direction accompanied by a break below a rising resistance line or above a descending support line would signal it’s time to exit.
Automated tools like our Financhill Stock Rating Screener can help you filter out stocks that meet your breakout criteria, too.
Insider Trading Activity
Here’s another valuable piece of information that many retail traders overlook, insider trading activity.
Studies have shown time and again that one of the most valuable signals to prospective investors is the activity of those with an information advantage.
Tools like Financhill’s “Trades made by Billionaires and Hedge Funds” can help you follow the money, literally.
The Bottom Line About Breakouts
Spotting a breakout is a combination of art and science whereby a more experienced investor is likely to identify key technical breakouts more predictably than a new trader.
With that said, by sticking to the rules of waiting for the right time as Jesse Livermore famously observed, and not taking action until volume is above the daily average, the odds skew in favor of the diligent, disciplined, and patient trader.
It may be best to hone your skill on a particular type of breakout too, whether that’s a break above resistance or below support lines, or using moving averages or oscillators, or cup-and-handle patterns. It’s difficult to be an expert in all of them at first, so select one or two and master them first.
The most obviously overlooked aspect of breakout success is that you will need to scan through a lot of charts regularly to spot the breakout opportunities. When they come, they are infrequent so you need to be viewing charts at regular intervals to spot them. If you’re an active trader then daily charts will be needed but if you prefer a less active approach, weekly or monthly check-ins will be needed.
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