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Understanding the
Di erence Between a
Sign of Strength and
a Buy Signal – May 29,
2007
by DAN

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One popular trading method used by swing traders is
buying breakouts. Each of us might have a specific and
unique set of criteria for buying a breakout; but there are
some common elements.

1. The stock must trade in a much wider range than

normal. This wide trading range indicates increased
interest in the stock relative to recent trading action —
buyers must pay higher prices than they have
previously needed to pay if they wanted the stock.
2. The close must be near the top of the intraday range.
This strong close typically indicates that the demand
for the stock is persistent, and was more than just a
frenzied patch of buying by retail traders.
3. Trading volume must be higher than normal.
 Relatively heavy volume is another indication that
interest in the stock is higher than normal — new
traders are finding the stock and their aggressive
buying is reflected in the higher volume bar. (Note:
How do we know it is aggressive buying rather than
aggressive selling that’s creating the extra volume?
Easy — the closing price is near the top of the range,
remember? That can only occur when buyers are
more aggressive than sellers).
4. The stock must clear near-term resistance. The
attractiveness of a breakout trade is that the stock has
room to run. The absence of near-term resistance is a
strong signal that buyers will not run into a significant
overhang of stock from sellers who are eager to break
even on what has been a losing trade.

With these rules as the framework for buying breakouts,

let’s take a closer look at the technique. Most traders will
agree that buying breakouts is tougher than it seems.
The fact is, many breakouts fail and momentum-driven
buyers can often be left holding the bag after top ticking
the stock with an ill-advised market buy order.

Let’s go through a series of snapshots of an uptrending

stock and see if we can sharpen our skills in buying
breakouts. The name of the stock in the following charts
is not important (though it is a chart of one of the stocks
currently on our Focus Stock List). We can see this same
pattern play out on many different stocks.

Let’s take a look.

Notice how the price has been in a very gradual uptrend,
just bouncing along the 20-day moving average, while
maintaining a pretty close distance to the 50-day moving
average. This is a stock that looks poised to break higher
— we just don’t know when.

The next day, we got our breakout. The stock gapped

above near-term resistance on very heavy volume and
closed near the top of the intraday range. Many traders
would want to jump on this move and buy the next day.
However, notice how far away the current price is from
the 50-day moving average — much higher than usual.
Let’s see how buying this breakout plays out.

The stock did move higher the next day — no doubt in

response to the buying frenzy created by momentum
traders. But over time, this breakout faded and fell right
back to test the 20-day moving average. But does that
mean that the breakout was a failure? Let’s fast-forward
another week.

After nearly tagging the 20-day moving average, the

stock began trading higher and ultimately broke above
the prior high on heavy volume. It also closed near the
top of the intraday range. Viola — another breakout! The
stock continues to move higher. But once again, notice
the extreme distance between the closing price and the
50-day moving average. So let’s assume that we buy
this breakout and see how the trade works out.

Well, this time, the stock fared better, moving up 4 of the

next 5 days. But, like the last breakout, the stock
eventually fell back to test the 20-day moving average.
Now, this is as good a time as any to bring up a point
about moving averages. Notice how the slope of the 20-
day moving average has increased since mid-
September. This increase in steepness reflects a trend
that is becoming stronger — confirmation of the signals
we are getting from the breakouts. Strong uptrends are
often characterized by multiple breakouts; steepening
moving averages confirm the strength.
 

Once again, after testing the 20-day moving average, the

stock began trading higher again for the next several
weeks. And once again, the stock exhibits yet a third
breakout that meets our criteria — a wide trading range
on a move above resistance, on heavy volume. And
once again, notice how far above the 50-day moving
average the closing price is. Are you starting to see a
pattern yet? Is this the time to buy this breakout?

Once again, the stock moves higher over the next

several days, only to pause enough to test the 20-day
moving average yet again. Now, keep in mind that
buying each of these breakouts would have been a
profitable trade. But that’s not the point. We aren’t just
after profitable trades. Rather, we want to maximize
those profits. And that requires getting the best, most
disciplined entries possible.

There are several takeaways from this series of charts:

1. Differentiate between a sign of strength and a buy

signal. A high-volume breakout is a sign of strength.
 Stocks in demand make dramatic moves above
resistance at the precise time when the available
supply dries up, forcing buyers to pay up for the stock.
But, as often happens, this frenzied buying pushes
the share price far above the key 20- and 50-day
moving averages. This is what strong stocks do!
When we see this type of move, we have confirmation
that our bullish assessment of the stock is correct. We
can then make a decision that we want to buy the
stock — but only at a low-risk entry level. Buying at an
extreme distance away from the 50-day moving
average is not low risk. Be patient and wait for the
right time to buy.
2. After exhibiting a sign of strength, stocks tend to
consolidate long enough to allow the 20-day moving
average to catch up. This dance plays out over and
over again in uptrending stocks. Each breakout often
leads to a test of the 20-day moving average as
support. This test can take place by a pullback of the
stock price, or by sufficient sideways trading to allow
the 20-day moving average to rise far enough to catch
up to the price. But either way, the 20-day moving
average tends to be tested.
3. A low risk buy point of a strong stock is on this test of
the 20-day moving average. This is that point at which
a disciplined entry can be made, with a stop loss set
slightly below the 20-day moving average. Using this
technique, a failure of the 20-day moving average as
support leads to a reasonably small loss.
4. Uptrends tend to last longer than we think they will. If
you understand this ebb and flow of price action
during uptrending stocks and exercise the discipline
to wait for a sound entry, you’ll have more confidence
to hold a stock through the inevitable retracements or
pullbacks that occur during uptrends. This confidence
will translate directly to your P&L.
  

TUTORIALS

 MAY 29, 2007 12:00 AM

WEEKEND UPDATE: RTI INTERNATIONAL (RTI) –

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MAY 31, 2007 →
MAY 28, 2007

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