Reducing the Risk of Trading Breakouts

This column was originally published on RealMoney on Feb. 15 at 11:29 a.m. EST. It's being republished as a bonus for TheStreet.com readers.

I put a lot of emphasis on volatility squeezes, those explosive setups that stem from a prolonged period of low volatility. Look at any chart and you'll see periods of high volatility followed by bouts of low volatility, which once again lead to high volatility. It's this cycle of activity that we try to exploit by committing to a direction as soon as it reveals itself.

A persistent problem for squeeze traders is determining the direction of the volatility expansion. When a stock starts to jump around, it often first gives false signals. A sudden rally after a period of low volatility can abruptly reverse and develop into a sustained downtrend. If you buy the initial breakout on faith that the breakout has legs, the bears will steal your lunch.

I've developed a simple way of reducing the risk of trading breakouts. It begins with the concept of multiple time frames that I discussed earlier this month. Here's how it works:

I first scan for all stocks that meet my criteria for a volatility squeeze using a daily time frame. My criteria are pretty simple. I look for stocks with a Bollinger band width of less than 6% of the 20-day simple moving average of the stock.

I then drill down to find only those stocks with a close above the upper Bollinger band on greater-than-average volume.

On Tuesday, this scan yielded 62 candidates. I then zoom out to a weekly time frame and scroll through this list to find the most promising setups based on trend, price pattern, fundamentals (not a misprint) and sector.

In essence, I'm doing a backward screen, first looking for stocks with favorable buying conditions and then sifting through them to find the best candidates for purchasing. This tends to be more efficient than looking for attractive weekly patterns and then trying to track them all as I wait for favorable buying opportunities to arise.

TC2005 users will find this method particularly easy because of the ease of scrolling between daily and weekly time frames.

Let's look at five that popped up on my screen Tuesday.

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The current weekly chart of the Dow Jones Industrials is much stronger than a year ago. Note how the 2005 rally began well below 10,500. By the time the bulls pushed it to 11,000, it was time to take profits. This time around, we've had a few months of consolidation at a level very near resistance. As such, any breakout is unlikely to be prematurely stopped by disciplined profit-taking.

Principal Financial Group (PFG) has made a higher low than the September low. RSI is bouncing off the low end of the range. I'd put a stop just beneath the recent low. The only way your stop will be triggered is if Principal rolls over before making a new high. In that unhappy event, you don't want to hold the stock.

This weekly chart of Walgreen (WAG) shows a higher low than the September bottom. The recent low was also contained within the Bollinger bands while the September low fell far beneath the lower band. Thus, Walgreen has made a higher absolute (price) low and a higher relative (Bollinger band) low. This setup should be protected by a stop just beneath support.

Any further strength in Masco (MAS) would put an end to the yearlong decline. Look at the RSI clip. Notice how this oscillator made a definitive transition from the upper half of the range down to the lower half as the price trend reversed from higher to lower. Now RSI is hinting at pushing higher once again. A weekly close above $31 would be a low-risk buy signal.

This weekly chart of Eaton (ETN) is bullish. The stock is very close to hitting an all-time high. The January low was higher than the October low on both absolute and relative bases. Wednesday's thrust above resistance is yet another higher high.

Because of the large distance between the current price and the most recent low, stop placement is a bit tricky. Set it too high and you risk getting prematurely stopped out. Set it too low and you could lose a substantial amount of money before your stop is hit. The solution is a scaled entry. The first purchase should be small, to be followed by more buying when the trend establishes itself.

Be careful out there.

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