Breakout & Resistance

The Smart Profits Report: Issue #179
Thursday, January 27, 2005

Breakout & Resistance: How to Anticipate and Profit From These Twin Concepts
By Mt. Vernon Research Team
Mt. Vernon Research

On Monday, I mentioned that one of the keys to a successful option trade was predicting how high an underlying stock should rise and when.

And that means you MUST understand the twin concepts of breakout and resistance.

Resistance is the level at which a stock will hesitate before rising higher, or stall completely and fall back, time and again.

A breakout occurs when a stock blasts through the resistance level. When a stock breaks through resistance, momentum often carries the stock well above the old resistance level.

You can be sitting on a nice profit if you time your option play right… Here’s an example of what I’m talking about… plus some basics for identifying resistance and breakout points using basic stock charts.

Why We Might Take Our 84% and Walk Away

Right now I’m watching my Comcast (CMCSK) April 2005 $30 calls. I recommended these calls to my Optionist readers back in mid-December, and we’re still in the position, up 84% so far.

Once they rose 60%, we sold off half so that those gains would be in the bank. But I’m not worried about this stock. The news is good. Fundamentals are attractive. Buyers are outnumbering sellers.

Comcast is on quite a bullish trend… it could easily go to $35 before the week’s out, above $40 before the calls expire. (My technical analysis points to Comcast rising to $45 before it’s all said and done.)

In fact, the stock has attacked the $33 price nine times in the last two days alone. But it keeps falling back.

So why is a stock headed to $45 unable to jump the fence at a mere $33?

That’s resistance. It’s something to watch out for when you make a bullish play. And it’s also why I’m going to take my 84% gains and walk if Comcast doesn’t crack $33 pretty soon.

Resistance Can Indeed Be Futile

Resistance is an area overhead where you can anticipate the stock might stall. On most charts, it’s the price where there was an old high in the past.

You can run your finger across the chart and see where the price line has stopped at the same price level many times.

When we got into Comcast, there wasn’t any resistance nearby. It was a “clean chart.” The trend was bullish, the stock was at its high at the time (just over $30) and rolling upward. But the first time it hit $33 it stopped and pulled back. Heck, it took a pretty sharp drop back to $31.50 before turning around and trying again.

Resistance Levels Explained

Resistance usually happens because buyers are sated for the time being. Everybody who wanted in at the going price got in. If you look at the volume right before it happens, you will usually see that the stock kept moving up for a few days but the volume was dropping. This is a pattern to watch for. It happens frequently before a stock peaks or stalls. (And this phenomenon is why resistance is also called “congestion.”)

Then comes a day when the sellers begin to outnumber the buyers. Many of these people are cashing in on their profits. The price will stall. That’s resistance, and the stock will need a good drive to push through it.

Charting Resistance Is Easy… Here’s How

When you are looking at charts and considering trades, it is easiest to find bullish plays for most new options traders. I suggest you look at the Comcast chart for a good example.

Use the CMCSK symbol. (The CMCSA is similar but at slightly different numbers.) I also suggest you use the www.stockcharts.com website to do this so that you will see exactly what I’m talking about.

You can see that in December when the price passed $30, there were no old highs above $30 in the past several months. That meant it was clear of all resistance and could move right up until the supply overcame demand again.

If you had made this trade in early November when the stock was at $29, you wouldn’t have had such a clean shot to the upside. The previous peak around $29.50 in October created resistance every time the stock got to that price again in November. Prices stuck around that resistance area for eight days.

Altogether it took Comcast from early October (when it first hit $29.50) to the middle of December to get past that resistance and continue higher without looking back.

Now, some people will say that the person who waited until December to make this trade missed a bit of action. It’s true, from $29 to $33 is a 13.7% gain on the stock. From $30 to $33 is only a 10% gain.

How Far Back Should Your Charts Go?

But options also involve a time premium and it is the most costly facet of any option that is not deep-in-the-money. If you’d made this trade in November, the six weeks you waited for the stock to get past $29.50 once and for all would have reduced your gains by at least 20% on an April option. And you had no way of knowing it would only be take six weeks. Stocks can hit resistance and go sideways for months.

Could I have spotted this resistance now at $33 in Comcast? Well, maybe. With a longer-term chart, using weekly prices, you can see that the price stopped climbing briefly around $33 five times going back to June 2003.

Which brings up the question: How long a chart do you look at? A good rule of thumb is, always use at least a one-year chart if you want to see all the pertinent resistance areas.

Breakouts: Huge Momentum Equals Huge Returns

So the next time you have a stock that can’t seem to make a break higher, pull up the chart and give it a shot.

See if you can spot some past congestion or an old high that creates resistance. This is worth doing not just to become adept at reading where your stocks might stall. There’s a bonus in it… When a stock breaks through resistance, that can be a strong buy signal.

When my Comcast shares go through $33, they will probably shoot up sharply again. And then it’ll be time to cash out the rest of that position for even higher profits.

Good investing,

Mt. Vernon Research

Today’s Smart Profits Cribsheet

Check out the Smart Profits Glossary for definitions of terms like “breakout” or “resistance” found in today’s article.
For more information on chart analysis swing over to Smart Profits #291, Head and Shoulders Pattern: A Proven Sell Signal Called Breaking the “Neckline”

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