How Pro Traders Use Charts to Hunt for ‘Breakout’ Stocks
At first glance, the gain in Oracle Corp.’s stock last Nov. 1 didn’t look all that noteworthy.
Shares of the database software company had been stuck in a two-month trading range, and the $1.81 rise that day barely pushed the stock over that range.
But to active traders who study stock charts, Oracle shares had just flashed a resoundingly bullish sign.
The closing price was a new high, and it was reached on a huge jump in trading volume--two signals that a big move might be underway.
Sure enough, Oracle rose 3.5% the next day and 8% the day after that on continuing heavy volume. Suddenly the stock was up more than 20% in three days--and was on its way to an almost 228% surge over the next 4 1/2 months.
Have you ever wondered how professional traders find stocks just before they begin to soar? Here’s one way: They pay attention to market action on days like Nov. 1.
Many investors who piled into Oracle that day and over the next few weeks did so by following its price and volume patterns--a practice known as technical analysis.
As Oracle showed, technical analysis can yield distinctive clues about the immediate direction of stock prices. Many professionals use it as a timing tool to supplement their fundamental research. The goal: to buy good companies at the right moments.
One of the most vocal practitioners of technical analysis is William O’Neil, the founder of Investor’s Business Daily. This article is based largely on his strategies.
Two central concepts of technical analysis were at play in Oracle’s stock last year: “bases” and “breakouts.”
Stocks sometimes trade in recognizable patterns known as bases. As the name implies, a base is simply a period of relatively poor price performance during which a stock lays the groundwork for a potential future advance.
Bases can occur at both new lows and new highs in a stock’s price. This story focuses on bases that follow a sharp rise in a stock’s price, to new highs or near new highs.
Two common bases of this variety are “flat” bases and “cup-with-handle” bases.
Technical analysts study bases because they’re looking for breakouts. That’s simply the term given to the surge in a stock as it rockets out of a base.
Breakouts sometimes are spurred by good news, such as an earnings report. But it’s very bullish when a breakout occurs with no obvious news to explain it.
That could suggest either that savvy investors see something that most others don’t, or that many investors have been eager to own the stock for some time, and now are making their move, for whatever reason--perhaps because of a general rise in market bullishness.
To be sure, technical analysis isn’t foolproof. Stocks don’t go up just because their charts say they should. Some breakouts fail--in other words, the stock drops sharply shortly after a surge.
“Not all breakouts follow through, of course,” said John Murphy, a well-known technical analyst and president of Murphymorris.com. “Otherwise, we’d all be rich.”
Nevertheless, breakouts can mark the start of a powerful advance in a stock’s price.
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To understand bases and breakouts, consider the accompanying chart of Oracle.
The stock traded in a narrow range during September and October. That was a classic flat base.
In a flat base, a stock’s price fluctuates within a relatively tight range--normally no more than 15% to 20% from top to bottom. On a chart, the stock appears to be moving sideways.
“The better [flat bases] are in a fairly tight trading range where the highs and lows are pretty well-defined,” Murphy said. “You could almost draw two flat lines, one over the prices and one under them, and spot when the breakout is.”
Technical analysts generally don’t want to buy a stock during a base. Instead, they want to look for signs that it’s a “proper” base that may set the stage for a future advance.
A proper base has several characteristics. First, daily trading volume must dry up at key points. In a flat base, for example, volume should be light and steady.
That shows that most “weak” shareholders--those most likely to sell the stock--have probably already exited, thus leaving the stock in the hands of more committed holders.
In general, the longer a stock’s basing period, the more bullish it is. Only investors with the most conviction about a stock will hold it for a long time rather than redeploy their money elsewhere.
Why is it so important to know there are committed investors? Because if the stock breaks out, those investors will be reluctant to sell. Incoming buyers must bid up the stock price significantly to coax it out of the hands of committed investors. In simple terms, demand far outstrips supply.
In a true breakout, trading volume should be huge--at least 50% higher than the recent daily average, and preferably the heaviest in several months. Indeed, without high volume, most analysts wouldn’t buy into a price breakout.
Heavy volume signifies strong demand from institutional investors who generally buy large blocks of stock. Because institutions wield enormous sums, their buying is what pushes up prices.
“It’s a good sign when stocks have huge volume increases at the breakout point, especially if it’s the heaviest volume since the base began,” said Greg Kuhn, general partner of Kamco Partners, a hedge fund in Easton, Pa.
The best point at which to buy a breakout stock is when it reaches a new high, or close to it, depending on the type of base involved.
The reason is psychology. As the stock reaches a new high, all investors have made money on it. They’re more likely to hang on to see how much profit they can make rather than be anxious to sell to minimize a loss.
“You buy on the breakout because you have eliminated the whole psychology that has controlled the stock--the ‘Get me out as close to break-even as possible’ ” psychology, said Dodge Dorland, chief investment officer at Landor Investment Management in New York. “The new psychology is now, ‘All the weak holders are out.’ You have a new breed of [investors] no longer looking back trying to eliminate losses. You now have [investors] looking for real profits.”
Oracle’s breakout last Nov. 1 was a classic case, as volume hit its highest level in six weeks.
Stocks will sometimes retreat in the days immediately after a breakout as some investors take profits. That’s OK as long as volume remains light, analysts say.
The profit-taking can give investors who missed the breakout a chance to get into a stock.
But on really good breakouts, stocks rise so quickly over a matter of days that they don’t give you a second chance to buy at a reasonable price, Murphy said.
Here’s a key question many investors naturally ask once a breakout is in progress: Should you “chase” the stock on the way up, if you didn’t buy it in the first day or two?
O’Neil advises investors to steer clear of a stock that has risen more than 5% from the breakout point. Because some breakouts carry stocks up by just 10% to 20% total, O’Neil doesn’t like to come to the party too late.
Other experts say it’s OK to buy if a stock has already jumped 10% to 15% from a base, if the breakout looks very strong. In hot markets, of course, stocks that are breaking out may go on to double or more in a short period. But for investors who are specifically trying to play short-term moves, the risk of getting in late rises with the stock price.
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So-called cup-with-handle stock bases can be trickier to detect when they’re in progress. But they are far more prevalent than flat bases in today’s volatile market.
They got their name because, on a chart, they sketch the outline of a cup with a handle, as the accompanying chart of Copper Mountain Networks shares shows.
Cup-with-handle bases often occur after a stock rallies for an extended period to a new high. The cup traces the downturn, and subsequent rebound, to near the stock’s previous peak.
After a rally to a new high, it’s normal for a stock to drift lower because of profit-taking or a general market decline. That forms the left side of the cup.
As the profit-taking lets up, the decline ends and the cup should form a relatively rounded bottom. That’s a sign that weak holders have been gradually shaken out. (It compares to a “V” chart pattern in which a stock’s recovery occurs too quickly to dislodge all the weak holders.)
Trading volume should contract as the cup pattern wears on, as sellers become exhausted. On days when heavier volume occurs, the stock should close higher. That shows that big investors are stepping in to support the stock at a level where they consider it cheap.
“You want to look for these little clues,” Kuhn said.
The right side of the cup forms as investors’ perception of the stock improves, such as when the general market is rebounding.
Most experts will only buy stocks with cup-with-handle bases that have run for at least seven weeks. A 10- to 12-week base is preferable; basically, the longer the better.
Technical analysts begin to pay particular attention when the right side of the cup begins to approach the left side peak--where the stock had previously reached its highs before sliding.
But it’s important that cups be followed by “handles.” Handles occur when investors who bought the stock near the previous high sell once it hits that level again.
In the handle period, the stock ideally should move slightly lower on light volume, as the last of the weak holders are shaken out. Handles that tilt upward are more likely to fail because they may not shake out as many weak holders.
Handles can last up to several weeks, though many handles lasted only a few days in the recent explosive market rally as investors, anticipating breakouts, piled into many stocks that had been in basing periods.
Once a handle is formed, the stage is set for a potential breakout. The ideal time to buy is when the stock rises just slightly above the peak of the handle--and on huge volume.
To see the process in action, consider the Copper Mountain chart. The stock formed a five-month cup-and-handle pattern before breaking out Feb. 2.
The stock formed a rounded bottom and mostly closed higher on the heaviest volume days in the bottoming process. It completed the cup Jan. 21, then formed a downward-tilting handle for seven days before its breakout.
The breakout occurred when the stock was just below $60 and began the day after the company reported better-than-expected quarterly profit. From that point, the stock zoomed to a recent peak of $115 before pulling back to $88.19 as of Monday.
Of course, recognizing such basing patterns, and breakouts, is always easier in retrospect. And no matter how convincing a stock’s chart might look, company news, or a general market slide, can easily change the outlook.
Mastering technical analysis, says Kuhn, “is not a science--it’s an art.”
Times staff writer Walter Hamilton can be reached at walter.hamilton@latimes.com.
(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)
Breakout From a Flat Base
On Nov. 1, shares of Oracle Corp. broke out of a classic “flat” base to a new high on the biggest trading volume in six weeks. That was a sign institutional investors were anxiously buying the stock--and that a strong rally was kicking off. The stock went on to surge to a recent peak of $85.
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Source: Bloomberg News
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Cup-With-Handle Formation
On Feb. 2 shares of Copper Mountain Networks surged out of a five-month “cup-with-handle” base on their second-heaviest trading volume ever. After the stock completed the right side of the cup,rising back to the old peak, a seven-day handle was formed amid light trading. That gave way to a breakout.
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Source: Bloomberg News
