One of the most popular trading patterns that astute investors look for is the Breakout. Simply stated, a breakout is when a stock clears a resistance level (a price that the stock has had consistent difficulty rising above), under heavy buying volume.

In the purest form, a stock is said to achieve a Breakout if it clears its uppermost resistance level, and soars to new highs, but for the purpose of short-term trading, a breakout is any significant movement to the upside, in which a stock performs all three of the following.

1. Clears a pattern of resistance. By pattern of resistance is meant that a certain price has been acting as a "ceiling", and the stock has shown continuous difficulty rising above that price.
2. Breaks the resistance with relatively heavy volume. A solid breakout occurs if the stock clears its resistance level while trading at much higher volume than it normally trades.
3. Trades in the upper range of its yearly chart. Breakouts have a higher probability of success if the stock is trading closer to its yearly high than to its yearly low.

If a stock is trading in the lower range of its yearly chart (closer to its yearly low), there is less of a chance that a Breakout will succeed. This is due to the presence of disgruntled shareholders (disgruntled because they have ridden the stock all the way down to its lowest levels), and any upward movement of the stock can be met with waves of selling pressure to "get even". The term for this selling pressure, when a stock attempts a comeback, is known as overhead supply, or overhead resistance.

The chart for Mylan Laboratories (MYL), above, shows a storybook breakout, as all three conditions are met: (1) The stock clears an upper resistance level (denoted by the blue, horizontal line), (2) soars under very heavy volume, and (3) has been trading in the upper range of its yearly chart.

Trading the Breakout

Obviously, it won't serve traders well by examining breakouts in hindsight. Rather, a breakout needs to be spotted just before—or very shortly after it occurs—to take advantage of potentially magnificent gains. The key is to watch for the 3 conditions (above), but in the reverse order, namely:

1. Keep your eye on stocks that are trading in the upper range of their yearly chart.
2. Watch for heavy trading volume occurring intra-day with any of the stocks you are watching.
3. Watch for the stock, trading under heavy volume, to clear an upper resistance level.

The chart shown above was chosen from a recent fundamental watch list (a list of stocks that have top fundamental properties such as earnings, potential growth, etc.), and could have been worth watching for a breakout since it is trading in the upper end of its yearly chart. Notice that the stock suddenly bursts through a level that it has had difficulty overcoming for the last several weeks, and it trades with its highest volume of the year.

Upon closer inspection, a 15-minute chart (below) indicates what you could have easily seen when the stock began breaking out. This would have been a classic trade, riding the stock to a 9% gain in a single trading session.

APPX trades “sideways” for several days, with relatively flat volume. Suddenly, it breaks
out of its range with heavy volume. This stock could have been easily spotted as a breakout.

Why the Breakout Works

A stock will generally hit resistance levels because shareholders tend to sell at certain prices. For instance, if a stock has trouble rising above $20, that usually means that people tend to unload the stock at or near that $20, putting undue pressure on any upside.

But if a stock finally breaks through an upper resistance level, it is said that the sellers have been "flushed out", and the stock is now free to move much higher.

Furthermore, if the stock is trading in the upper half of its yearly chart, there are fewer unhappy shareholders, and that, in itself, eliminates undue pressure on the stock. Finally, the fact that the breakout is a known pattern to traders and investors alike, a bandwagon effect is created, and the stock builds momentum to the upside (as depicted by the heavy volume).

The Caveat

There is one steadfast rule to remember: Breakouts tend to fail in bear markets, or on days of bearish sentiment. While some breakouts occasionally succeed, you must never play a stock moving to new highs if the overall market sentiment is negative. Unless the market is predominately positive, nine times out of ten, the Breakout will fail, because most stocks follow the lead of the market.