Buy Signals Part 2 - The Breakout

One of the first things I’ve learned about reading stock charts is that sometimes the most important move happens after a stock has been doing almost nothing.

When a stock trades sideways for a period of time, this is called consolidation. The stock moves back and forth within a fairly narrow range, with buyers and sellers generally in balance. But this quiet period can set the stage for a much bigger move.

Look for the Breakout Above Previous Highs

On a candlestick chart, consolidation usually creates a clear ceiling and floor. The ceiling is called resistance, because the stock has had trouble moving above that price. The floor is called support, because buyers have repeatedly stepped in to keep the stock from falling below it.

When the stock finally moves above that resistance level, it is called a breakout.

This is often an important signal because the stock is breaking out of the range where it has been stuck. If buyers continue to step in, the breakout can be the beginning of a new upward trend.

There is also a potential safety advantage. If the breakout fails, the stock may fall back toward the support level created during consolidation. That gives an investor a clearly defined price level to watch and can help determine when it is time to exit the trade.

Catch the Move Early

The goal is not to buy a stock after it has already risen dramatically. Instead, the idea is to identify the stock near the beginning of a potential move.

A stock that has just broken above resistance may have much more room to run than a stock that has already climbed for weeks or months.

This is the difference between an initial breakout and a continuous, potentially overextended uptrend that is already underway.

Why Initial Breakouts Have a Better Safety Net

• An initial breakout is close to its previous support level and may offer a better balance between potential reward and risk. If the breakout is false, this stock has an established price range to fall back to with minimal loss.
• An overextended stock may still continue higher, but if it suddenly reverses, there may be no nearby support to slow the decline. If this stock loses momentum, who knows how far it might fall?

Volume Helps Confirm the Breakout

One more thing I look for is volume.

Volume tells us how many shares are being bought and sold. When a stock breaks above resistance, I want to see a noticeable increase in volume. On a chart, this appears as taller volume bars below the price candles.

A breakout with strong volume suggests that there is significant buying interest behind the move. A breakout on weak volume may be less convincing and could turn out to be a false breakout.

For me, the basic lesson is simple: Look for stocks that have been building a base, watch for them to break above resistance, and use volume to help confirm that the breakout has real strength.