As I showed you last week, stocks (and other underlying securities) can often trade between support and resistance for sustained periods of time. When this happens, the underlying is said to be in a channel. Channels are helpful tools for traders because they allow you to predict how a stock will behave, and pick your options accordingly.
While channels can and do last for weeks and months at a time, all stocks, ETFs, futures, and commodities will eventually break out of a given channel.
But how do you know when an underlying is about to break out?
And – more importantly – how can you profit?
Identifying Breakouts and Breakdowns
A breakout can occur to the upside or the downside. If the stock trades above and can sustain the price move above resistance, it’s called a breakout.
If the stock breaks below and can sustain the price move under support, it is called a breakdown.
When I say “sustain the price move,” I am referring to the stock trading above or below and staying there a day or two or three. Because occasionally a stock will trade above resistance or below support for a day before falling back into the channel. That is referred to as a false breakout.
Now, I tend to look at everything through the prism of an options trader. Which means I’m looking for the underlying to make a particular price move within a predetermined amount of time in order for my options trades to work.
So when you’ve identified a possible breakout or breakdown, you want to keep in mind that the anticipated move in either direction is roughly equivalent to the range of the channel. If the stock was making a six-point move (as in Express Scripts Holding Co. (NASDAQ:ESRX) chart above) between support and resistance while in the channel, it’s likely that it will make a similar move to the upside or downside (depending on whether you’ve identified a breakout or a breakdown) when it moves outside the channel.
It is also likely that the price action outside of the channel will mirror the price action inside the channel when it comes to the time it takes to make the move. As you can see, it takes between two and two-and-a-half weeks to move from support to resistance, so you’re going to want options that expire between 30 and 45 days to give them time to work.
I’ll show you how all this works in just a moment…
Using Volume to Confirm a Breakout
The price move has a much better chance of being sustained – and becoming a true breakout rather than a false one – if it’s backed by a surge in volume. A spike in volume indicates that traders believe that the underlying will hold at these new levels, and it’s a positive sign that the stock is in fact breaking out.
If the stock makes its break on low volume, it may very well trade back into the channel. If you make a trade on a false breakout, you’d want to set your stops for when the price heads back into the channel rather than wait for it to trade down to its previous support level. That will help you preserve capital.
One more thing to keep in mind – just because a stock makes its break and the volume surge is there to back it up and give greater confirmation that the break will hold, that doesn’t mean the stock will immediately make the move. That can take a little time.
Remember – the price action on the breakout/breakdown is going to mirror the price action inside the channel, so it’s going to take a bit of time (in the case of ESRX, two to two and half weeks) for it to make the full price move.
Old Resistance Becomes New Support
A consolidation of price is very possible. As you see in the ESRX chart below, the stock was in an ascending channel, making six-point moves between support and resistance.
Below the chart is the volume graphic, where you can see the consolidation of trading at the support line for about eight trading days or so. In this time of consolidation, and it could be very brief, the ideal situation would be that it hovers while volume is declining.
This indeed happened on ESRX – and the key thing to notice is that the price action inched up and touched the extended support line. To me, this is a technical formation where the old support line is now becoming new resistance.
Shorts have come in and taken the stock lower on high volume. The shorts weren’t aggressively going after ESRX to push it further down just yet, maybe waiting to see if the bulls come back in and start buying it on sale.
This did not happen, and the lack of volume shows you neither camp was ready to commit one way or the other.
Then on August 18, the stock price hit the ascending support line and proceeded lower.
This is where you’d want to make your move – and it would be a bearish trade to capture profits as ESRX moves lower. This old support line is now a possible resistance line, so any closing pricing above that pivot high around August 18 would be your stop loss point.
The anticipated price move to the downside would mirror the moves the stock made while it was trading in the channel. In this example, the price moves between support and resistance were six points, so that is what I would consider my expected price move once the stock breaks down.
And, again, it looks like it takes about two to two-and-a-half weeks to make that move, so I would look for options that expire minimum 30 days out.
Now the price at the resistance point is $91. Expecting that stock to drop six points would make my technical target stock price to be $85.
Now, you could short the stock, but I am an options trader, so I would consider a short-term In the Money put option about a month out at least. You could also consider a bearish spread trade setup.
And as you can see from the chart, ESRX did indeed make a move lower to $85, so any trade you had on this would be closed for whatever profits you could get at that level.
Here’s your trading lesson summary:
|Channels are great for predicting a stock’s price action. But no channel is going to last forever. Here’s how to identify and profit from a breakout (or a breakdown):
- If the price of the underlying trades above resistance and stays there, it’s a breakout. If the price of the underlying trades below support, it’s a breakdown.
- The expected price move for a stock on a breakout or breakdown should be roughly equivalent to the price move it made within the channel.
- True breakouts and breakdowns are usually backed by volume as trades commit one way or the other to the direction of the underlying. Watch out for false breakouts!