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Volume in
Breakouts
In its purest form, a breakout is
the period immediately following a consolidation. It is that point in time
where consensus is reached and those that were on one side of the market are
overwhelmed by those investors on the other side. For that small moment in
time investors agree on price direction.
Most traders say that stocks are
mired in some form of consolidation pattern fully 70-percent of the time.
The other 30-percent brings dramatic price breakouts -- both up and down.
Obviously traders are looking for breakouts because it is during this period
that the majority of successful (predictable) trades occur.
Upside
Breakouts
Consider this upside breakout for
Dial Corp. (DL). For several months the soap maker was largely ignored by
both traders and investors alike because fundamental prospects were thought to
be less than exciting. The company was a steady, if not spectacularly slow
grower but there was no immediate reason to buy or sell the stocks.
By now you should recognize the
pattern created by the price action for Dial Corp. (DL). It is the dreaded
wedge. These longer-term patterns are characterized by dramatic declines
in both volatility (trading range) and volume. That was certainly true of
Dial Corp. from late December 2000 through the middle of July 2001. After
hitting a low at $10.10 in the middle of December the stock surged to $15.50 in
mid-January, fell back to $12 in the middle of March through late April, rallied
toward $15.25 in early June, only to fall back to $13.50 in the middle of
July. In late July Dial Corp. began to rally toward $15 on increased
volume. Several sessions later volume increased dramatically and the stock
had a
breakout to a relative new high. Note that both volume and volatility
contracted dramatically during the consolidation phase and exploded as the
upside breakout occurred.
Understanding the importance of
volume in an upside breakout is fairly simple, volume must expand on the
breakout if the move is to be considered valid. Volume and downside
breakouts are more complex.
This is because volume is not
necessarily required. This makes sense because unlike rallies where
increased volume is needed to absorb normal selling pressures, in a decline
stockholders become demoralized and that emotion leads to inactivity. Yes, there
will be downside breakouts that are characterized by dramatic surges in volume
but these events will always be at the end of the move lower as stockholders
capitulate. This makes sense because the longer the decline proceeds the
more volume becomes the ally of buyers, not sellers. Indeed, as mentioned
in our previous sections, traders need to be wary of increased volume after a
longer-term decline because very often it means the end of that move is near.
Downside
Breakouts
Let's consider the downside
breakout of natural gas distributor Enron (ENE). Once considered a broadband
play because of its foray into the Internet infrastructure business, Enron fell
on hard times in February of 2001. Indeed, during the span of just seven
months the stock had two noteworthy downside breakouts.
During December 2000 through the early part of
March 2001 Enron was mired in a large wedge formation. The stock had lows
at $65, $66 and $67.50 in December, January and March respectively. The
top part of the wedge was defined by highs at $83.50, $82.50 and $81.75 in
December, January and February respectively. The downside breakout occurred
in early March at $67.50 amid very subdued volume. Despite this the stock
sank to $52 in less than two weeks and it was not until volume increased that
the decline subsided. The second wedge began with the $52 low in the
middle of March. After several tests of that support level, Enron shares
fell through $52 in the early part of June. Once again, volume was
relatively light but this downside breakout ultimately led to a decline that
would see the Enron shares sink to less than $35 just a week later.
Conclusion
-
Generally, volume follows trend, that is in a
rising trend volume should expand on rallies and contract on declines.
In falling trends volume should expand on declines and contract on rallies.
-
When volume contracts after an extended rally,
or expands sharply after an extended decline a dramatic reversal will
normally transpire.
-
Volume and volatility contract in
consolidation patterns because investors cannot reach consensus, they are
undecided.
-
Volume should expand significantly for upside
breakouts. If volume does not expand the breakout is considered
illegitimate.
-
Volume may not expand for a downside breakout
because falling share prices cause demoralization and inactivity among
stockholders. During such circumstances, fewer shares are required to drive
prices lower.
With an understanding of all of the basics under
our belt let's get ready to tackle the fun stuff, reversal chart patterns.
volume
in consolidations 
reversal
chart patterns
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