How to Detect Breakouts Before They Happen

09/30/2010 12:01 am EST

Focus: STRATEGIES

Breakout trading is the mother's milk for momentum traders because it offers the quickest acceleration and velocity for the money involved in the trade. A trader who can make an annual 10% return on his or her money with improved velocity can make a 10% return in a month or better. Theoretically, this gives a skilled momentum trader the opportunity to make a 10% return each month on their capital, provided that they can maintain this return each month.

Combine that with velocity, where you move from cash to asset and then asset to cash enough times that you can earn up to 120% return in a year.

Even better, if you compound your returns from month to month, you could earn a potential 314% return on your capital.

The potential return for breakout trading is quite high, which is why many traders trade these types of moves exclusively. They are explosive and move quickly, allowing the trader to rack up quick returns and deploy capital quickly and efficiently.

The problem that most aspiring momentum traders and even the experienced momentum traders have is that there can be a number of false breakouts. Most breakout patterns emerge from tight price ranges that have been trading up and down like the tide with no real indication as to when they are going to emerge into a full-blown breakout.

For bullish breakouts, these tight price ranges have price levels that serve as support and resistance points, forming over a period of eight weeks or more. The highest probability for effective breakouts are at least near their two-month high before it begins to run. When the stock trades up through the upper range of the trading range that is near its price highs on higher volume, this confirms the bullish breakout.

At times, waiting for a breakout to come about can test the limits of patience for any speculator, and about the time they are looking for new opportunities in the market, a breakout occurs and leaves them behind. Those lucky enough to have the emotional self-discipline to move on to the next trade can count their blessings, while others—usually beginning traders—become overwhelmed with the fear that they are missing out on the move. This results in manic buying or selling by trying to chase a trade, but they only end up with mediocre entries, and more often than not, typically cause a string of losses due to a lack of focus in their trading approaches.

chart
Click to Enlarge

For more than four months, from October 2009 to February 2010, Apple Inc. (AAPL) traded back and forth until the Williams' %R signaled an early breakout, exploding AAPL into a bull run.

Fortunately, there is a method using a momentum indicator that can let you determine an early breakout before it actually trades up through the resistance price level in the trading range called Williams' %R. This is a momentum indicator measuring overbought and oversold levels, similar to a stochastic oscillator. It was developed by Larry Williams and compares a stock's close to the high/low range over a certain period of time, usually 14 days. See Figure 1.

It is used to determine market entry and exit points. The Williams' %R produces values from zero to –100; a reading over 80 usually indicates a stock is oversold, while readings below 20 suggest a stock is overbought.

You can detect early buy signals within the trading range by observing this indicator when price approaches the upper resistance point and goes into overbought territory, then dips down to the 50 median level of the indicator and trades back up to overbought territory. This signal will indicate that the daily price action is revealing a rush of buying and will cause the stock to explode upward into a new bull run.

By Billy Williams of StockOptionSystem.com

Related Articles on STRATEGIES