How to Trade Break Out Patterns

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  • Break out patterns are important for traders. They can offer the opportunity for profits. And, they provide a ready made strategy for managing risks. Overall, for traders who rely on charts, break outs could be the most important pattern to consider.

    For traders who don’t rely on charts, break out patterns can also be useful. They can be a way to identify times when it can be best to add to their positions, or when to take profits. They can also highlight when the stock of interest isn’t providing a profit opportunity.

    Defining Break Out Patterns

    When discussing patterns, traders can become dogmatic and unrealistic. Some will insist on a precise definition while others will require confirmation from volume or other indicators. In trading, more requirements can increase the number of winning trades. But, it can also decrease trading opportunities.

    That is a critical trade off to consider. If a trader sets a high bar for entering a position by requiring that six or more different factors be in place, they may get just one or two trades a year. The trades may provide gains but often the trader is sidelined and making no money.

    On the other hand, traders without a plan might jump in and out of trades on a whim. This can be equally destructive behavior since it can limit the trading gains. Plans are important to traders but the plans should not impose unrealistic rigor on trading ideas.

    A break out pattern could strike the balance between the probability of gains and the probability of finding sufficient trades.

    We are defining the pattern in broad terms. A new high or a new low provides a breakout. The new highs and new lows can be defined consistent with a trader’s ideal time frame for trading. Active traders may want to act on one month break outs while more conservative traders might want a one year break out.

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  • Now, this could be done on a chart or a trader can use screening tools to find a new high and then turn to the chart to determine the potential risk and reward.

    Finding Break Out Patterns

    One way to find stocks meeting these requirements is with the free stock screening tool available at FinViz.com. At this site, you could screen for a variety of fundamental factors, high levels of institutional ownership and bullish institutional transactions Or, you could just screen on new highs. An example is shown below.

    FINVIZ stock screener

    Source: FinViz.com

    For this screen, we selected stocks making new 52-week highs. If the stock is making a new 52-week high it will also be reaching a new 20-day high. However, the number of new 20-day highs will always exceed the number of longer term new highs.

    When running this screen, more than 700 stocks, more than 10% of the stocks in the data base, were reaching new one month highs. This can be filtered down by adding price or volume criteria or some fundamental metric.

    There were 224 stocks making new 52-week highs on this day. Sorted alphabetically, advanced Auto parts, Inc. (NYSE: AAP) was at the top of the list. Its weekly chart is shown below.

    AAP weekly chart

    The breakout is moving above an extended bottoming pattern highlighted in the next chart. This chart also shows the price target based on that pattern. One method of finding the risk of the trade is also highlighted in the chart.

    AAP weekly chart

    The breakout is completing a pattern that began with a sell off that began last June. The pattern is simply price action that is breaking above the highs dating to that time. The price target is found with a principle of symmetry.

    Technical analysts simply expect a break out to cover a distance equal to the depth of the pattern. In this case, the pattern from high to low was about $58 in depth. Adding this to the break out level provides a price target.

    The pattern took a year to form so, again by assuming a sense of symmetry, it could take about a year for the move to the price target.

    Risk is found by assuming if prices retrace 50% of the depth of the price pattern, the break out is a failed attempt at a rally. In this case, the risk to a 50% retracement is about half of the distance to the price target.

    Traders now have some parameters they could use to evaluate their trade options.

    Comparing Trading Opportunities

    In keeping with a random approach to evaluating breakouts, below is a daily chart of Whiting Petroleum Corporation (NYSE: WLL). The annotations on the chart show the price target and risk levels using the same approach that was applied to AAP above.

    WLL daily chart

    This is a daily chart and the pattern was formed over about 22 trading days. That means traders could expect a move of about 11.7% in about a month if the objective is met. The risk is about 66% of the target which means the trade may not be as attractive to risk averse traders.

    Next is a weekly chart of WLL. It shows a different perspective and could be more attractive.

    WLL weekly chart

    Here, the potential gain is almost twice the potential risk and the time frame is relatively long, about 18 months based on the length of time it took for the pattern to form. This could be a more appealing strategy to long term traders and could provide a target for those taking the shorter term trade.

    Trading breakouts does not need to be complex. It can rely on simple chart analysis and a quantitative screening tool as we demonstrated here. But, it will require time to find and manage trades.

    If you are uncertain about your ability to dedicate the required time to trading, there is a TradingTips.com trading service, Triple-Digit Returnswhich uses a very specific system for choosing the right stocks to trade.

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