For new investors and investors of all kinds, a trend-based approach is the easiest path to profitability. Within the trend-following realm, there are two main methods of purchasing stocks: breakouts and pullbacks. Advantages and disadvantages exist in each technique.
Breakouts
With breakouts, the advantages include:
· Little or no overhead supply: Overhead supply refers to the fact that the stock has traded at the current levels (and above them before). Often, it can be difficult for stocks to cut through these old price levels as investors underwater use these rallies to salvage the trade. With breakouts to new highs, this is not an issue.
· More confirmation: As the old but true Wall Street saying goes, “Sometimes when you’re trying to pick bottoms, all you get is stinky fingers.” With breakouts, you do not have to pick a bottom.
On the negative side, disadvantages include:
· Breakouts are often “obvious”: Since many investors trade breakouts, too many eyes on a stock at a particular point can make the stock prone to failure or price shakeouts.
· Require more downside risk: Because you’re buying the stock at highs, breakouts require more downside risk as a percentage (unless you put in an arbitrary stop which I do not recommend).
To increase the odds of success in a breakout purchase, look to purchase fundamentally strong stocks in “hot” industry groups, breaking out in heavy volume (40% above the 50-day moving average or more is ideal) and closing high in the daily range.
Image Source: Zacks Investment Research
Pullbacks
With pullbacks, the advantages include:
· Tighter risk: Because a trader can buy pullbacks against a moving average or a previous breakout zone, the risk involved is typically lower.
· Ability to latch on to a winning stock: If you’ve missed a move in a true market leader, pullbacks allow you to latch onto a trend without chasing.
On the negative side, disadvantages include:
· Potential to miss out on a trade: Potentially, you will miss out on a stock that breaks out clean and doesn’t look back.
· Buying weakness: As I mentioned earlier, in this process, you never know how far a pullback will go for sure.
To increase the odds of a pullback purchase, I look for a stock pulling into the 50-day moving average in an orderly fashion. Ideally, volume dries up during the pullback, and the stock breaks above a clear downtrend line, signaling that it is done going down.
February pullbacks in the top homebuilding stocks such as Lennar (LEN), DR Horton (DHI), and Pulte Homes (PHM) are good recent examples.
Image Source: Zacks Investment Research
Current Examples
Breakout Candidate:
Zacks Rank #1 (Strong Buy) stock Samsara (IOT) is an example of a current breakout candidate worth watching. Monday, the stock shot higher by more than 7% on volume 45% above the average. The stock has held the breakout since – a sign of strength.
Image Source: Zacks Investment Research
Advanced Micro Devices (AMD) is giving investors another chance to get on board. Shares are returning to the 50-day moving average for the first time since breaking out. The pullback is very orderly and volume has been bone-dry since the stock began correcting.
Image Source: Zacks Investment Research
What’s best for you?
There is no one size fits all answer regarding whether breakouts or pullbacks are better. See what fits your personality best. Also, a helpful exercise a trader can do to eliminate guesswork is to conduct a thorough post-analysis of past trades. What worked? What didn’t?
Ultimately, the best strategy for an individual trader will depend on their risk tolerance, trading style, and the market conditions.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
