How to Spot a True Breakout - TheStreet

Traders encounter whipsaws and false breakouts throughout their careers. We shouldn't be surprised when caught in these maelstroms, because we're playing an odds game, in which anything can happen at any time. In the real world, the most perfect trade can fall apart for no reason, with little warning. This reminds us that risk management isn't an optional skill if we intend to survive as market speculators.

Breakouts occur in zones of conflict. Both sides of the market are very passionate at these inflection points, but no one really knows how much buying power will be required to carry price into a new and sustainable uptrend. Therefore, any position taken near a breakout level carries considerable risk, no matter how the cards are stacked in your favor.

There are only three ways that price can respond to a breakout. First, it can carry through successfully to higher levels. Second, it can generate whipsaws that force losses on both sides of the market. Third, it can trap buyers in a failure event and start a trend in the opposite direction. Each of these common scenarios requires an appropriate counter-strategy.

A successful breakout occurs in three phases. It starts when price breaks above resistance. This is the

action

phase. Price expands upward and then reverses as soon as buying power fades. This starts the

reaction

phase. The instrument drops and spawns a pullback, where sidelined buyers get a second-chance opportunity to enter the trade. If all the stars line up, a second rally wave then triggers, pushing price above the initial breakout high. This marks the

resolution

phase.

Salesforce.com

(CRM) - Get Report

shows five iterations of this action-reaction-resolution cycle in the last six months. Note how the July, August, September and October breakouts to new rally highs were followed by pullbacks that proved the resolve of early buyers. The November breakout is still in the reaction phase, grinding through multiple whipsaws that are wearing down the uptrend.

The three phases of a "real" breakout are highly dependent upon positive volume characteristics. In particular, demand must exceed supply during the initial rally thrust. Volume should then drop off as it pulls back to test support in the reaction phase. Finally, the supply of new buyers at support must be adequate to ensure a healthy resolution phase. Whipsaws and false breakouts occur when these supply-demand dynamics fall out of balance.

Choppy swings during the reaction phase are commonly known as whipsaws. Natural tug and pull generates the majority of these unpleasant events, but hidden hands can also push around price to generate volume and wash out one side of the market. Whatever the source, whipsaws are responsible for many of the losses on a trader's P&L statement.

Whipsaws occur when a breakout doesn't generate an efficient resolution phase. This malfunction may or may not yield a false breakout. Pullback swings during whipsaw periods shake out weak hands and force price down into resistance, but a healthy supply of buyers will keep a floor under price, triggering choppy and erratic movement.

A successful breakout, i.e. confirmation, can trigger quickly after a whipsaw period finally dies out. It begins with a loss of volatility that allows positive technical signals to build on trading screens, encouraging a surge in buying interest. In turn, this generates a positive feedback loop that generates the momentum needed to carry price up and over the last high.

Humana

(HUM) - Get Report

topped out near $41 in September, dropped into the 50-day moving average and then rallied back to resistance, It broke out to a new high on Nov. 9 and got stuck immediately in a rising channel that's still holding back the uptrend. A rally over the upper trendline should end whipsaws and finally yield the resolution phase.

False breakouts occur when the action-reaction-resolution cycle fails to attract enough buyers. Many traders wait to enter positions at key breakout levels. Once these folks enter their positions, they're at the mercy of the market. In other words, their profits depend on others seeing the breakout and jumping in behind them. Major reversals occur when this second crowd fails to appear.

A breakout with insufficient buying power can drop quickly below a new support level and trigger a cascading selloff. This negative action also marks the resolution phase, but in the opposite direction. The dynamics are easy to understand. The failure traps traders who bought the breakout, throwing them into losing positions. Downside momentum then builds, triggering short-sale signals on a whole new batch of trading screens.

Hormel Foods

(HRL) - Get Report

rallied to a 52-week high in August and pulled back. It returned to that level in November, moved sideways for two weeks and then broke out. The rally failed immediately in a powerful reaction phase, driven by intense selling pressure. The current bounce into resistance looks like a good short sale, ahead of a resolution phase that breaks moving-average support.

Alan Farley provides daily stock picks and commentary with his "Daily Swing Trade" newsletter.

At the time of publication, Farley had no positions in stocks mentioned, although holdings can change at any time.

Alan Farley is a private trader and publisher of

Hard Right Edge

, a comprehensive resource for trader education, technical analysis, and short-term trading techniques. He is also the author of

The Daily Swing Trade

, a premium product from TheStreet.com that outlines his charts and analysis. Farley has also been featured in

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,

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,

Tech Week

,

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,

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,

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,

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and

Online Investor

. He has written two books:

The Master Swing Trader

and

The Master Swing Trader Toolkit: The Market Survival Guide

, due out in April. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks.

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