Trading high volume breakouts in uptrending stocks is a popular strategy amongst position traders. Quite often these breakout stocks pullback to the breakout resistance level which now acts as a support level. When the resistance level is also the all-time then once the stock breaks out then there is no overhead resistance.
The pullback also gives the trader a 2nd chance to enter a position if they missed the breakout and the pullback provides a convenient level for placing the initial stop. These tight stops have the added benefit of giving very good risk-reward ratios.
A trade example of a resistance breakout which pulls back to the all-time high resistance is shown below in Chart 1. for Howard Hughes Corp. NYSE:HHC.
Chart 1. Position trade setup for HHC
Chart by stockcharts.com
The chart for HHC shows a stock that has broken through an all-time high resistance level at 76.70 with a wide range day on high volume after consolidating for the last six months. The 50-day SMA (simple moving average) is sloping upwards indicating strength. The stock then pulled back on declining volume and formed a Harami 2 candle reversal pattern with the lows just below the resistance level. Also the low of the pullback is approximately 50% of the breakout rally.
Generally it is a good idea to view a longer term chart so that the position trader gets a sense of where this stock has traded in the past.
The weekly chart for HHC is shown below since the stock listed in 2010.
Chart 2. Weekly chart for HHC
Chart by stockcharts.com
As can be readily seen from the above weekly chart, the stock is in a very strong uptrend since October 2011. The start of this uptrend is at the same level as the low of the week that HHC was listed. As can been observed from the weekly chart, HHC ran up to the 76.70 level after listing and then sold all the way back down to its listed price and then ran back up again to consolidate and finally breakout to new highs.
With Pullback trade setups it is generally preferable that the stock trades above the setup day’s high before taking an entry. The setup day is the last day shown on the daily chart. Trading above the setup days high shows strength and increases the likelihood that the pullback has reversed.
If HHC trades above the setup day’s high at 77.05 then a long position can be taken.
Position traders typically trade with end-of-day data. They tend to use stop buy orders to be executed the next day if the stock trades above the setup day’s high. A stop buy order is simply a stop-loss order used in reverse. The order is only activated if the stock trades above the trigger price – which can be set 0.20 above the setup day’s high. The stop buy order can be either a market order or a limit order. With a limit order the trader knows the price they will pay, but if the stock gaps up the order may not be filled.
Alternatively the position trader can wait until next day’s trading is complete and see if HHC traded above setup day high – if it did then the trader can place a buy order the following day.
The likely entry price with a buy stop market order would be around 77.25.
The position trader needs to plan how they will manage the trade before a position is taken. Trade management involves determining likely profit levels and setting stops to exit the position.
The likely profit that is achievable is useful to know in advance as the position trader can then determine whether the proposed trade is worth taken based on the dollar amount risked. The amount risked is determined from the initial stop-loss level selected.
Likely profit – the height of the broad consolidation range from chart 1. can used to determine the likely profit when used in conjunction with a wider trailing stop strategy.
The height is (76.70 – 67.30 = 9.40) added to the low of the pullback gives a potential rally of (76.00 + 9.40 = 85.40). The initial stop can be placed below the low of the pullback at 75.50 to allow some wiggle room.
The risk-reward can now be determined.
Likely Entry = 77.25 with Initial Stop = 75.50 and Potential Price Advance = 85.40
Potential Profit = 85.40 – 77.25 = 8.15
Risk taken = 77.25 – 75.50 = 1.75
Risk-Reward ratio = 8.15 / 1.75 = 4.7
The risk-reward is favorable at 4.7 since a lot of trades have ratios under 2.0 and the trader can make nearly five times the amount risked.
The next consideration for managing the trade is the trailing stop. Since a wider trailing is required, position traders could use a 20-day EMA (Exponential Moving Average) and exit when HHC closes below the EMA line (providing that this is higher than the initial stop).
Due to the potential for a strong rally coming off a six consolidation period, the position trader may decide not to exit at the profit target and see how far the rally can go. The trade management is illustrated below in Chart 3.
Chart 3. Position trade entry & exit – HHC
Chart by stockcharts.com
Using a 20-day EMA takes the trader out at around 100.00 after a three month rally.
The ADX indicator is normally used to locate strongly trending stocks with the view of taking an entry. However when a stock that the trader has a position in is trending strongly, the ADX can also be used to determine when the trend is weakening. Referring to Chart 3. this occurs when the -DI (red line) crosses up over the +DI (green line). Using the ADX gives much the same result as using the 20-day EMA. Position traders looking to ride the trend as high as possible may even decide that both the 20-day EMA and the ADX need to have signaled an exit.