Wednesday, September 17, 2008

HOW TO TRADE BREAKOUTS & BREAKDOWNS

The first area I look at is the general market, and whether it is trending up or down and key factors such as volume and any one-day reversals. Here’s the S&P 500:

Notice the one-day breakdown that occurred on September 4. The employment picture was terrible. That day marked my entry to get into 100% short positions. No questions, no doubts. One-day reversals are one of the most obvious signs that a trend has ended. If you didn’t add positions on that day, you could have added them in the next two days. Here’s a close up:


By the second and final rally day after the breakdown, you would have noticed that the rally was weak. Afterwards, you had another chance to short on the very first breakdown from the 50-day MA. Additional shorting opportunities occurred on the next three rally days, only to result in another breakdown. Throughout this article, I will mention terms such as flags, high-and-tight flags, sloped flags, pennants, symmetrical, ascending/ and descending triangles and other forms of consolidation you should look out for to get positioned before a breakout or breakdown occurs. If you have any questions, feel free to ask!

The next area to look at is the industry or sector of an individual security. I usually skip this step and move straight to the individual stock. Do what you’re comfortable doing.

Breakouts

Finish Line (FINL) is one of my favorite charts. This is the “measured-move” type of breakout. Notice how each consolidation is a ranged flag that acts as a “step” to a move higher? If FINL cannot make a new high and breaks down, don’t hesitate to short it. You can’t fall in love with the long or short side, there’s only the right side, so add this to your watchlist. Notice how FINL nicely bounces off of the 50-day MA several times? The moving averages are your friend…they tell you how to get in within 1-3 days of a breakout (better than waiting for weeks!)

Medivation (MDVN) is a different type of chart. Notice the sharp spikes? Different chart, same patterns. I say the last gap is an exhaustion gap that will most likely lead to an impending reversal since it’s a bearish gap up giving MDVN a very nice 180% run. Range flags such as the ones in FINL are not the only types of flags. As you can see, there are high-and-tight flags (that form after large spikes) and down sloping flags (As long as the flag’s low doesn’t close below the opening price of breakout, you’ll be fine). After you get into a strong flag pattern, the key is patience!

Quiz Time!

1) Sterling financial (STSA):

2) Jos. A. Bank (JOSB):

3) First Community Bancorp (PACW):

Note: Don’t forget to act quickly if there is a sudden breakdown or significant sign of weakness. Remember, the market is always right, and charts never lie. So if the chart tells you to get out then don’t be an idiot and keep on holding.

Breakdowns

Breakdown patterns exhibit the same patterns as they do with breakouts. Usually, the flags spend about the same time consolidating; however, many times they do breakdown quicker since the market falls about 40-70%+ faster than it rises. This is why so many short-sellers make a fortune in a couple of weeks or months.

Take a look at Mcdermott International (MDR). Notice the same flags that form in consolidation? The beauty of these patterns is that once a breakdown occurs, you get a nice 5-10%+ cushion immediately. That means, if a stock breaks down, but for some reason forms an island reversal and gaps up, chances are that you’ll be close to breakeven. No sweat!

Arch Coal (ACI) is one of 10 stocks I shorted in July that netted me a 23% return for that month. First, notice the one-day breakdown before the first flag? That automatically gave me reason to put ACI on my watchlist. Next, notice how weak the rally is? I typically wait 2 days before making a decision, due to short covering. After the first breakout, this stock presented no more concerns for me. Once a big break occurs, very, very, very few stocks make it back up in a short amount of time. Therefore, lookout for the breakdowns (such as the ones I try to post on greenfaucet daily) and watch them closely. ACI is also a special stock because it managed to form an island reversal. An IR is when a stock gaps in one direction, consolidates, and gaps in the opposite direction, forming an “island”. This reversal pattern is one of the most reliable patterns to come across.

But, be careful! After I look at the general market, on the individual stock, I look for the usual consolidation patterns but also support areas (for breakdowns). You don’t want to get caught in the beginning of a possible rally. My policy is to stay away, because there are thousands of stocks for me to choose from.

Allis-Chambers Energy (ALY) formed a double top and broke the 50-day MA (add to watchlist!). Thankfully, you’ll notice that the market gives you plenty of chances to short. Just because a stock broke doesn’t mean “it’s too late”. Check out the long flag on ALY and how it churned at the 200-day MA, totally unable to rally strong off the moving average. Just focus on the long flag…at this point I’m thinking to myself “this chart looks terribly weak”. After the second breakdown, a symmetrical triangle formed. I don’t usually enter a position into a “symmie” because a break can occur in either direction. In this case it proved to be a continuation pattern that preceded the largest breakdown since the double-top! It pays to be patient. By this time, you would have a 20-25% cushion, giving you enough room to absorb any loss that might possibly get in your way. Good stuff? If you play these consolidation patterns correctly (and stick to your strict exit rules), then large losses become very rare occurrences.

This is a chart of LG Display Co. (LPL). Remember the breakout chart of FINL? This is the inverse of it. Remember when I said bear markets fall much faster? This is evident by the lack of range flags. Instead, you see a series of small flags (most are only 2-4 days long). Once the ball rolls downhill, it’s very difficult to stop it. Again, plenty of opportunities to short!

Bucyrus International (BUCY) formed a weird-looking slanted triple top (this is not a head-and-shoulders because the height of the head doesn’t exceed the shoulders). Couple things to observe: 1) the inability for the second top to make a new high, 2) the large one-day breakdown following the top (put on your watchlist!), 3) the weak rally afterwards, and finally, 4) the strong gap down signaling the end for BUCY. BUCY has been churning at the 50-day MA for 2.5 months, and that’s usually a long time. How do I know that the gap down (first circled) was the end of it? It happened on the strongest volume within that 2.5 month pattern. Once it’s over, it’s over, don’t ask questions, just short!

Hercules Offshore (HERO) formed a nice head-and-shoulder pattern over a 2.5 month period. Notice the flags once again. See the red box? Pays to be patient! Another ball that rolled downhill that couldn’t be stopped.

Gran Tierra Energy (GTE) formed a strange pattern, but I made a new name for it. It’s called the double-top-head-and-shoulders. I’m not sure if it exists, but who cares. I would have added GTE on my watchlist on the first break of the 50-day MA and short within 2-days inside the flag. Notice how I don’t say short on the break? This is a dangerous 50/50 proposition. Sure you might do well if it goes down, but what if shorts decide to cover and the stock rallies 10-15%? Good luck! Therefore, my policy is to not chase stock, but short on the flags. A simple, low-risk/high-reward trade.

Breakdown Warning!

Seriously, if I had any nice patterns to show, I would, so no quiz this time. Everything has gotten crushed so badly and a lot of stocks are in free fall, which leads me to point out something very important:

I do not recommend that you short any gap downs in excess of 25%. The reason is because a dead cat bounce may form or a huge short-covering rally may form the next day, gapping the stock up. Spike downs where an appropriate pattern follows, is ok. Theses bounces are known to take out shorts many times over who chased a stock down or followed a gap down. In a case where there is considerable selling (and if its not a failing financial company) – wait – let it bounce up to as close to the bottom of the gap as possible, then it may be a good short.

Strategy

Whenever I post breakouts and/or breakdowns, just keep them on your watchlist. You might also want to know that I don’t use expensive programs or complicated algorithms, etc. I manually find my set ups on free charting websites. The strategy will not only multiply your returns, but will also help you save in unnecessary trading expenses (I do not have a single paid subscription to any type service and everything I do use is free and publicly available). Fat profits and very little overhead – what a great combo! If you keep an eye out for these patterns and execute the trades, then you will outperform this market. Good luck!

3 comments:

Anonymous said...

excellent post!

djplastik said...

Hi John. I totally missed following up on the buy signal yesterday for ABX. Knew I should've watched it more carefully this morning. Obvious kneejerk reaction, but the breakout should at least put gold in a consolidation pattern. What do you think? I'm thinking of buying it on a pullback from a possible sell the news tomorrow on gold. Seems way overdone for 1 day. Also bought DUG this afternoon. Risky short term play, but working so far.

John C. Lee said...

Most of us did. I wasn't expecting gold to make the largest one-day move ever. Make sure the pullback is a proper one. I'll be watching the IAU.