There are many false breakouts. In fact, many traders will fade breakouts
to the up or downside as there are so many false ones and the profit
opportunity is worth the risk as long as a trader uses stops and manages
risk well.
Support, Resistance and Breakouts
Think of security prices as a war. It is a battle between a bull (the
buyer) and a bear (the seller). The bulls push prices higher and the bears
push prices lower. A buyer that feels an area has good value, will buy at
that level. The seller that feels that a stock has reached fair value, will
sell at that higher fair value price. The direction prices actually move
reveals who has won the battle.
Remember when a trade takes place, a buyer and seller agreed to a price.
There was a buyer and a seller involved in the transaction. The buyer feels
the stock will go up. The seller wants to move on to another stock that he
may feel will appreciate faster.
Support levels are the price where the majority of traders feel the value is
a good buy.
Resistance is the level in which the majority of traders feel prices will
move lower.
When the majority of traders and investors change their expectations, these
support and resistance areas get violated and a new trend may be beginning.
This can occur due to changes in expectation of earnings, new product
development, change of personnel, cut backs or expansions.
One interesting pattern that traders see after a breakout, is that the stock
or index retraces a part of the initial move by about 50%. If the 50%
retracement does not hold, the stock or index can still be in a trend if the
previous breakout resistance holds.
Let's look at an example of a breakout that may be failing
in Doubleclick Inc.,
DCLK.
On Thursday, DCLK broke out from a down trending narrow range base on very
heavy volume.
This action, of a break on heavy volume, is usually considered positive for a
stock and many times the stock continues to run.
However, a large number of these breakouts fail and reverse. When they do
reverse, the counter move can be vicious in the other direction.
Friday, DCLK closed on its low.
If DCLK breaks below 41 on Monday, I would exit longs from the break and
consider a Short on this failed breakout.
If shorted below 41, I would place a close stop at 42. The stock should
just continue moving down in the major direction of the trend.
