Mastering Breakouts: A comprehensive guide for trading breakouts effectively

The words of William O'Neil, doesn't represent your neighbour but rather influential players like mutual funds, hedge funds, and other major investors propelling the stock's ascent

The term 'breakout' is a widely used concept in trading, akin to a popular line from a Bollywood movie: "Rahul, naam toh suna hoga?" In simpler terms, imagine a stock being held within certain resistance and support levels for a considerable period, much like a prisoner confined behind bars. Then suddenly, the stock surges upwards, breaking free from its constraints, just as a clever inmate executes a successful escape.

When you've identified a growth-oriented stock with strong fundamentals, a well-formed base pattern, and a clear entry point, there's a crucial step left: waiting for a breakout. However, not all breakouts yield success because some are supported by strong trading volumes, while others lack this support.

To me, trading volume is the heartbeat of a stock. It represents the basic interplay between supply and demand. Major price movements are typically accompanied by substantial increases in trading volume. This significant volume, in the words of William O'Neil, doesn't represent your neighbour but rather influential players like mutual funds, hedge funds, and other major investors propelling the stock's ascent.

A breakout occurs when a stock surpasses its designated pivot point with trading volume that's at least 50 per cent higher than its average volume over the past 50 sessions. The most promising movements start with colossal volume surges of 100 per cent or more. Such instances mark a turning point for the stock and offer potential for substantial gains—assuming there are no major shifts in the stock's underlying strength or the overall market's trend.

Experience shows that a stock often gains momentum after it successfully breaks out from a well-formed base pattern. However, a breakout accompanied by low trading volume is generally a negative signal. This suggests that institutional investors might not be participating in the move. In such cases, the stock might continue to consolidate, possibly forming a handle or even correcting.

Another tool to gauge the strength of a breakout is the Relative Strength Line (RSLine). This line should be reaching new highs or demonstrating robust growth. It reflects the stock's strength compared to a chosen benchmark, often the Nifty 500 index in my case—a broad based index in the Indian stock market. A rising RSLine indicates the stock is outperforming the broader market.

Conversely, a falling or stagnant RSLine is concerning as it signifies the stock is trailing behind. This could be due to the stock being in a late-stage base, signaling diminishing momentum. Late-stage bases are risky because they typically emerge after a prolonged uptrend.

Weak volume during a breakout or a lagging RSLine should raise caution or prompt you to monitor the stock closely before committing. Alternatively, wait for higher volume to confirm the move a day or two after the breakout.

Remember, while it might be tempting to buy a promising stock before it hits its entry point, it's wiser to refrain from doing so. Many stocks falter or retrace just before reaching their entry levels.

Furthermore, a stock that sharply drops below its entry point and fails to recover swiftly is waving a red flag. Such breakouts often prove unsuccessful, especially when the overall market is struggling or undergoing a correction.

In conclusion, trading volume is the lifeblood of momentum trading and a vital factor in price dynamics. The interplay between price patterns and volume is paramount to my trading decisions. These aspects are my initial focus and carry substantial weight in shaping my choices to buy or sell. The relationship between price and volume provides valuable insights into the stock's future price direction.