Swing and day traders don’t have long time horizons when it comes to picking stocks. Swing and day trading require different skills and techniques, but the common theme is that stocks aren’t held for very long. Stocks that are held for days or even mere minutes require a certain level of volatility for trading to be successful. Buy-and-hold investors can watch stocks slowly ascend over time with little interest in the market’s daily fluctuations. Plus, holding for longer than a year gives you a nice tax break (at least for the time being).
If you’re looking for ways to uncomplicate your tax bill, short-term trading definitely isn’t one of them. Day and swing traders need to have different profit goals than buy-and-hold investors since taxes take a bigger bite out of the pie when stocks are held less than a year. That’s why short-term traders look for breakout stocks, but the trick is figuring out which stocks are primed to breakout before the move occurs.
Definition of Breakout Stocks
In high school, there was nothing worse than a breakout. But when it comes to day or swing trading, there’s nothing better. A stock ‘breaks out’ when it pushes through a previously unreached level of support or resistance. Support and resistance are technical trading indicators used to decipher a stock’s range. Using these indicators, traders plot the likelihood of the share price’s next move and place their orders based on this info.
A breakout stock is simply one that has a quick (and often short-lived) period of volatility, either to the upside or downside. Most traders consider a breakout to be a bullish trend, but stocks can also break through support levels and create short selling opportunities. But how do you spot breakouts before they occur? Buying shares after the price has risen 15% in a day usually means you’re just holding the bag for someone who got in earlier.
In order to spot potential breakouts through support or resistance, traders look for chart patterns to sharpen their decision-making. Certain chart patterns often signal an increased probability of a breakout – here are five patterns to look out for when searching for breakout stocks.
Chart Pattern #1: Triangles
A triangle pattern is notable when looking for breakout stocks because it’s a reversal pattern with a clearly defined level of support or resistance. Triangles can be bullish or bearish patterns, it just depends on whether the triangle is ascending or descending.
An ascending triangle is a bullish indicator that often signals a trend change is quickly approaching. On the other hand, a descending triangle is a bearish sign and often precedes a drop in the share price. The support or resistance level on a triangle pattern always occurs around the same price, making them easy to spot with the naked eye. Here’s an ascending triangle on the chart of Carnival Cruiselines (NYSE: CCL).
A couple features stand out on this chart in regards to the triangle pattern. First, the pattern occurs after a steep decline, which in this case is a roughly 40% drawdown. Second, the upper trend line of the triangle is almost completely horizontal (making the same high and then retreating) while the lower trend line is moving steadily upward making higher lows. As the lows get higher and higher, the trend lines converge to form the titular triangle.
In this scenario, traders would look for increasingly higher lows as the trend lines move toward convergence. Shares are purchased right as the price closes in on the resistance level in hopes of breaking out, with a stop set at the previous low on the lower trendline.
Chart Pattern #2: Flag
At first glance, triangle and flag patterns appear similar. But while triangles are reversal patterns, flags are continuation patterns that point toward the next leg up (or down) in the current trend. Flags often form after a significant move has already been made and shares begin trading in a defined range. Think of these stocks like NFL players – sometimes they need a water break for a few plays.
The first identifiable feature of the flag (or pennant pattern) is the flagpole. You’ll spot the pole easily because it’s either a lot of red or green candles all in a row. After the pole, the stock will perform some range-bound trading that often creates lower lows and lower highs, forming a rectangular flag shape that appears to be flapping in the breeze. Take this Bank of America (NYSE: BAC) chart for example.
After a multi-day run, the shares cooled off and began to trade lower despite no real change in volume. The new highs and lows formed a pair of trend lines that resembled a flag (or pennant as they’re sometimes called). The breakout here is similar to the ascending triangle – once the upper resistance level is breached, the price is primed to run.
Chart Pattern #3: Saucers
Throughout 2020, the hope amongst investors was that the market and economy would have a V-shaped recovery where the bounceback was as fierce as the initial decline. While the broader economy is debatable, the major stock indices clearly had a V-shaped recovery and ripped to new highs while the COVID pandemic was still raging.
Stock traders look for a different type of recovery pattern when looking for shares to buy. A saucer, or U-shaped, pattern usually takes a while to form, but it creates a clear reversal signal by forming a large base that acts as a level of support.
Sunrun Inc (NSDQ: RUN) is a solar energy manufacturer that served as great swing trading fodder in the later stages of 2020 and into 2021. In the chart above, the price forms a long saucer-shaped base over a period of three months from October until January of 2021. Toward the end of this period, the share price began creeping up toward the high made in October before finally breaking out in early January. Once the previous October high was eclipsed, RUN shares were off and, well, running.
RUN is a good lesson on the fallibility of technical signals because a similar saucer shape appeared on the chart between May and June of 2021, but the pattern failed to hold and the stock continued to decline. Remember, technical signal increase the probability of predicting a breakout, but no signal is 100% foolproof.
Chart Pattern #4: Cup and Handle
Another cousin of a previous pattern, the cup and handle also creates a saucer-like base before a false breakout creates what looks like a handle on the end of the saucer. The cup and handle almost looks like a saucer pattern with a flag attached to the end. And like a flag pattern, the cup and handle is a continuation pattern that signals shares may just be taking a break before continuing along the current trend.
It’s important to differentiate between a continuation and reversal pattern because a saucer and cup and handle materialize in two completely different trading environments. Let’s take a look at a popular meme stock to emphasize this point. Here’s Express Inc (NSDQ: EXPR):
EXPR is one of the so-called meme stocks like AMC Theaters (NYSE: AMC) and GameStop (NSDQ: GME) that roared to unprecedented levels earlier this year. After reaching a high of nearly $9 at one point in June, the stock was cut in half by mid-July. The saucer section of the cup and handle formed between the end of June and beginning of August. The handle finally made its appearance in mid-August and the stock is currently enjoying a nice breakout as of this writing.
Chart Pattern #5: Wedge
If you can handle your wedges, you’ll probably be pretty good at golf. That adage also goes for trading – learning to spot and buy the wedge pattern can be a profitable technique to add to your repertoire. A wedge is a reversal pattern and can be either bearish or bullish depending on the direction of the wedge. An ascending wedge is often a bearish reversal signal, while a descending wedge is a bullish sign. It’s important to keep factors like trend and volume in mind when trading the wedge pattern.
Like cup and handle patterns, wedges aren’t always the most popular signal amongst short-term trades because they can take a long time to form. Here’s an example from cosmetics company Coty Inc. (NYSE: COTY).
COTY shares have been in a steady downward trend since May, resulting in both lower highs and lower lows. The price has been channeled into this descending wedge pattern that certainly doesn’t please current shareholders, but could indicate a reversal since bearish volume is beginning to dry up. Wedges often take weeks or months to materialize and the pattern can persist longer than your time horizon, so consider your own trading goals before jumping into a trade based on this pattern.
Trading breakouts can be a path to quick profits, especially if you can spot patterns quickly (or if you have access to a quality stock scanner). But breakout trading also highlights the limitations of technical analysis. By using chart patterns, we aren’t trying to predict price movement with absolute certainty. Technical analysis is just a tool to help increase our odds of finding a profitable trade.
Since technical indicators are limited, you’ll always want to approach a trade with two or three factors in mind. If you think you spot a pattern like a flag or saucer, always zoom out and make sure the trend agrees with your assessment. Monitor for changes in volume because volume begets volatility and volatility is required for a breakout. And always be aware of any upcoming catalysts that could render your trading plan obsolete. Technical analysis is a great weapon for traders – just know where it’s blind spots are.