Breakout Trading

The Smart Profits Report: Issue #314
Thursday, June 1, 2006

Breakout Trading: The “Stanton Gap Rule” For Next-Day Profits
By Jim Stanton
Advisory Panelist, Mt. Vernon Research

“New highs are bullish and often lead to higher highs. New lows are bearish and often lead to lower lows.” This is just one of many old Wall Street adages. For the most part, it’s true. But as with many rules, this one has an exception…

I’ve spent the last 20 years working with brokers and traders, and when a stock they’re following makes a new short- or long-term high, also referred to as a breakout, they immediately buy shares, or some call options, and then monitor the trade constantly, trying to figure out how much profit they can squeeze from it.

But I’m going to give you a much easier way to confirm a true breakout. And, just as important, I’ll show you how to prevent taking a loss…

Steer Clear Of False New-Highs

There are a number of reasons why stocks gap up.

The most common is based on news, whether it’s general economic news or bullish news on the company itself.

Think about it. How many times have you seen the indexes open higher on encouraging economic news, only to run out of steam and reverse course later that day? Similarly, a company makes a positive announcement that sends the stock higher, but investors quickly grab profits and the stock ends up lower.

This is the famous “buy the rumor; sell the news” adage in action. And if you’re not quick enough, you’re often the one left holding the bag at the end of the day.

Many traders believe the technical definition of a gap opening is when a stock jumps significantly higher once the market opens. But the trouble is that if a stock opens higher and a breakout occurs that day (we’ll call this “Gap Day”), the gap sometimes creates a false new high. This is where many investors get tripped up, as they pile into the stock with gusto, only to see it correct back down later that day.

Making Sure The Breakout Is Valid

Save yourself the frustration and a financial loss, and be patient. Don’t blindly follow everyone else. I’m a conservative trader and I’m always looking for ways to reduce my risk, so wait for confirmation that the breakout is valid before buying. And the way to confirm that it’s a true breakout is to wait a day and place a buy order just above the high of the “Gap Day” - let’s call this strategy “Stanton’s Gap Rule.”

Even if the “Gap Day” does prove to be a valid high, and you end up paying a little more for the stock, it’s much better than pulling the trigger too soon and then watching your investment decline as the stock fails to maintain its momentum.

Take a look at the chart below. It shows the performance of Time Warner (NYSE: TWX) from June 2005 to April 2006. It’s a perfect example of the “Gap Rule” exception in action:

Time Warner (NYSE: TWX) June 2005 - April 2006

Chart Courtesy of Trade Navigator Software http://www.genesisft.com

As you can see, TWX was pretty volatile over this period:

Having set a high of $18.70 on August 9, 2005, it then pulled back to the $17.50 level just three weeks later.
It then shifted course again and rallied back up to $18.59 on August 15, before closing at $18.50.
The following day, it opened at $18.63 ($0.13 higher) and quickly climbed to $19.

But look what happened after that. If you’d bought the stock on August 16, based on that breakout, you’d have lost money very quickly. And if you’d held your position, you’d have watched the stock sink for nine months.

The Key To Maximizing Profits While Minimizing Risk

Watch the market carefully and follow “Stanton’s Gap Rule.” In the example above, if you had waited a day and placed your buy stop at $19.01 (one penny above the “Gap Day” high), you’d have safely seen TWX fail to maintain its momentum, and avoided a loss.

If an economic report comes out after the market opens, or news comes out on an individual stock during the day, causing a breakout, I don’t take the bait. Investor sentiment is critical and it often makes sense to wait and see if the stock can maintain its momentum the following day.

At times, I use a breakout above a downtrend line to enter a trade, but using my own gap rule in these situations has kept me out of bad trades on many occasions. Sure, there will be times when applying this strategy might result in you paying slightly more for the stock/option, if it does continue its run higher. But doing so will lower your risk, and you’ll avoid the feeling of seeing your investment head south immediately after you’ve bought it.

Good Trading,

Jim Stanton

Today’s Smart Profits Cribsheet

May was a rocky month for the market. And some investors saw potential gains evaporate in a matter of 10 trading sessions, from May 9 to May 23… But Advisory Panelist Steve McDonald viewed the market’s recent slide as an opportunity. Find out why in Smart Profits #311, Don’t Let a Down Market Get You Down: Seven Tips For A Profitable Downside Bias.
We’ve taken a close look at “gaps” and “breakouts” today… While you’re at it, browse the free Smart Profits Glossary to round out your options vocabulary.

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