In this part, we will delve into the tools for early detection of breakout stocks. Breakout trading can be implemented in almost all trading styles, which means it is available to all traders. Read on to learn the important nuances and about the anatomy of this style of trading and investing.
- Applying technical analysis to determine breakout stocks
- Bonus time: Market anomalies
Interact with the underlined words and green dots to get additional details and explanations.
Explanations and definitions of terms.
Applying technical analysis to determine breakout stocks
In order to identify stock breakout patterns, classic technical analysis techniques can be used. First and foremost, these are chart and candlestick patterns. Also widely used are methods of analysis of trading volume and indicators, based on volume. It may seem like gambling to find breakout stocks, but it is an investment with the goal of making real money. Let's take a look at how it works.
Classic technical analysis patterns 📈
One of the classic reversal patterns of technical analysis can be formed before breakout stocks appear. For example, double/triple tops/bottoms or head and shoulders. It is also possible to identify such stocks using candlestick analysis or price action methods.
Let's look at Pfizer stock, which declined strongly in 2020 and then also rose noticeably, becoming a breakout stock 🔽
We can see that before the stock made a breakout upside, the price formed a classic bullish inverted head and shoulders pattern with its highest highs/lowest lows around $28.11, $26.43, and $31.28. Thus, the neckline was formed by two highs from 3/17 and from 3/31.
The emergence of a reversal pattern significantly increases the chances for the stock to move into breakout territory.
The same applies to candlestick/price action patterns.
Volume analysis 📊
Breakout stocks can be identified fairly confidently using a volume indicator.
It is sufficient that at least one of two conditions is true:
- When the price reverses, there is a volume spike. It is essentially the same as a reversal pattern.
- When a significant support/resistance level is broken, the volume increases significantly.
The volume of Pfizer stock increased significantly when the lowest low ($26.43) was formed on 3/23. At the same time, there was no surge of volume at the breakdown of the resistance level.
Actually, we're being a bit sly here, as the spike in volume was seen across the stock market as a whole.
However, comparing this spike in Pfizer with other factors such as:
- The formation of the classic head and shoulders pattern.
- Pfizer's sector, which was "stronger" than the market.
One could conclude that the stock would turn into a breakout stock, i.e. it would break through its significant resistance level.
Bonus time: Market anomalies
There are many anomalies in the stock market that can be used to identify breakout stocks. Here are some of them:
The P/E effect
A stock with a low P/E can show a higher expected return. In other words, if you choose a stock with a lower P/E, the chances that your portfolio will include breakout stocks are significantly increased.
It has been observed that small capitalisation stocks increase the most in January of each year. It means that when choosing stocks to include in a portfolio at the end of the year, one should pay attention to shares of small companies. The chance to find breakout stocks among them increases significantly in January.
The Neglected-firm effect
The tendency to invest in neglected firms. This is more of a psychological effect. Breakout stocks can be looked for amongst the low-listed firms. Under certain market conditions, it is these firms that can be amongst the leaders of the breakout levels.
The tendency of low-yielding and high-yielding stocks to periodically reverse their positions. This means that companies whose stocks perform worse than the market may show higher returns in the next period and vice versa. Thus, stock breakout patterns can be searched using this criterion as well.
We talked about all the nuances and technical details for finding stock breakout patterns.
Let's summarize and highlight the main concepts 📍
- Technical and fundamental analysis methods may be used to find Breakout stocks.
- It is worth looking for breakout stocks among the stocks with the highest beta ratio.
- Stocks may move into the breakout category when the record date for dividends arrives. Traders will rush to buy such stocks before the record date, which can lead to a breakout of significant resistance levels. After the record date, they will try to get rid of them, which can lead to a breakout of significant support levels.
- When selecting breakout stocks, it is worth paying attention to the company's sector. Some sectors may appear better or worse than the market as a whole. In order to understand which sector will be among the losers or winners, one should try to understand the causes of economic decline or rise.
- Unexpected news can lead to breakout stocks. Unfortunately, it is a black swan and it is almost impossible to determine the exact moment when the news will appear.
- If a stock makes a classic bullish or bearish pattern, it is more likely to break support/resistance. It is worth looking out for such stocks.
- The trading volume of breakout stocks goes up when they break a significant support/resistance level. In general, any spike in volume is an anomaly worth looking out for.
- Several classic market anomalies can help identify breakout stocks. Such anomalies include the P/E effect, Small-firm effect, Neglected-firm effect, and Reversal effect.
In the hands of a knowledgeable trader or investor, breakout stocks are a great way to make money. If you have read both parts of our detailed material, you are familiar and ready to trade breakout stocks. Refine your data on a demo account and enter the world of real investment and trading with Olymp Trade!
Risk warning: The contents of this article do not constitute investment advice, and you bear sole responsibility for your trading activity and/or trading results.
A black swan is an unpredictable event that is beyond what is normally expected of a situation and has potentially severe consequences.