Wednesday, July 17, 2013

The Breakout Buy Pattern

Click on Chart to Enlarge

This chart is a daily chart of the Dow 30.  As I indicated in the last post, I am posting what I believe to be the typical higher reward and lower risk breakout buy pattern if one is looking to go long a market on a breakout.  As I stated in the last post, I think the technical indicator set-up is fairly obvious to be alert for a probable failed breakout here, but I also respect the fact that markets trading at all time highs can experience persistent trends on successful breakouts.

I discussed this breakout buy pattern last August and September, and probably other times as well, but here is the basic pattern.

1) Don't buy on the initial move to new highs.

2) Wait for the breakout to a new high to occur, and then for price to move back below the old high and create a swing high on the chart.

3) Buy on a stop order on the NEXT move to new highs, with a stop below the lowest point between the 2 breakouts

The rationale here is that the markets have an uncanny way of putting breakout buyers at a paper loss at some time before continuing the trend.  And also if you study final highs preceding corrections you often see brief breakouts that last a few days and then fail and never push to new highs on a second breakout.  I touched on that in a post last year about what final highs have looked like.  And anybody who has studied technical analysis at all should understand divergence patterns.  So when an indicator divergence pattern is set up and the market looks to make a break to new highs, that is often the final dumb money surge and where the smart money will be unloading shares.

So to avoid some of these obvious pitfalls and market pressure, if we simply let the market breakout and then expect to see some smart money selling come in and push prices back below the old high, we can then gauge whether that is strong selling or weak selling.  The CoT data (though delayed) is often very helpful in gauging this as well.  And by only buying when the market has enough buying capacity to push again to new highs, we have eliminated many of the most obvious bull traps from our trade selection.

I believe that this strategy will often offer a better reward to risk profile as well.  If you think about it in the current market scenario, let's say that prices push to new highs tomorrow.....well where does your stop go?  From an objective charting basis of support and resistance, I would have to say no higher than the 7/3/13 low which is pretty wide.  The typical second breakout may offer a stop that is 1/4 to 1/2 that wide with still roughly the same reward potential.

I will monitor this potential buy set pattern if the Dow and S&P 500 push to new highs.  It doesn't work 100% of the time, but is a much better buying plan here than just getting in on an initial push to new highs.