5 Tips For Buying The Best Breakout Stocks (With Less False Signals)

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The following blog post was originally published on May 1st, 2017.

We periodically like to go back to older Morpheus Trading Group blog post and articles to revisit certain trade strategies for relevant tips and insights.

In revisiting the following post, our goal is to shed light on great industry insights and improve upon any of your current trading strategies.

We hope you gain some valuable trading insights and strategies with the following article that’ll help you buy the best breakout stocks. Happy Trading!

Buying a range breakout is a popular stock trading strategy, but which breakout stocks have the best chance of following through for monster gains?

Continue reading to learn five valuable tips that will help you buy the best breakout stocks (with less false signals).

The wide popularity of breakout stock trading is owed to the simplicity of the concept — a stock that is range-bound must eventually “break out” in order to move higher.

Breakout stock trade setups are relatively easy to spot when scanning charts, but you may need to deal with a high percentage of false buy signals if you do not have objective guidelines to follow.

In this article, we will share with you a handful of simple rules we discuss a few techniques to help reduce the number of false breakouts.

In order to improve your performance in breakout stocks, you should first look to trade only valid basing patterns.

If you are not familiar with basing patterns, you may press here for a quick primer before proceeding.

5 Tips For Buying The Best Breakout Stocks (With Less False Signals)

In a recent blog post, we alerted you to a potential breakout in New Relic ($NEWR) and highlighted several basing patterns on the stock chart.

Now, we again use charts of $NEWR to demonstrate the five tips to improve your performance when buying breakout stocks.

The first three tips below reference the first weekly chart that follows.

1. Be wary of wide bases

The first base (A) is wide, with nearly a 50% pullback off the highs.  In general, patterns where the price corrects more than 30-40% off a recent high are not ideal. In this chart, we also see the majority of that base formed well below support of its 40-week moving average, which is also not ideal. Since the rally off the lows of that base (~$20) shot the stock 90% higher to the $38 area, the stock probably won’t have much gas left in the tank to break out to new highs without first going sideways for at least several weeks.

2. Use caution with V-shaped patterns

In the second base (B), the stock corrects about 27% off its high and dips below the 40-week moving average again.  However, this dip below the 40-week MA isn’t nearly as bad as the prior base, and is not a deal breaker.  Nevertheless, the sharp run-up from the lows of the base to the highs in just four weeks (in January) gives the pattern a V-shaped look.  A V-shaped pattern, especially with a very quick move up the right side of the base, is a red flag.  We would have preferred the price action stall for a week or two to form a handle (short pause) before breaking above the prior high.

3. Shallow corrections are best

The correction in the third base (C) is shallow, with a pullback just 17% off the high.  It is easily the tightest correction of the three, with several weeks of tight price action holding above its rising 10-week moving average.  We also see the entire base forming above a newly rising 40-week moving average.  This is the sort of basing action that frequently leads to an explosive breakout.  Of course, we have no way of knowing for sure, but this is the breakout to buy (if the price breaks out above the range).

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4. Aim for early entry points

As soon as a stock rallies above the high of its range, it prompts many breakout stock traders to buy the breakout at the most obvious point. However, you should instead consider buying a stock “early,” prior to its blatantly obvious breakout pivot. By getting an early entry, only within a tight base nearing a breakout level, you reduce your risk in the event of a false breakout. You can further reduce your capital risk by reducing the share size of your initial entry, then adding to the position when the breakout is confirmed (only add to a winning position).

5. Use the Relative Strength Line for confirmation

Measuring a stock’s strength relative to the S&P 500 is a reliable way to to confirm a bullish chart pattern, as explained in this article.

The relative strength line is a technical indicator available on many trading platforms that helps confirm a stock’s true strength in current market conditions.

The relative strength line used here is calculated by diving the price of $NEWR by the price of $SPY.  This line is not to be confused with the RSI indicator.

The higher the reading of the relative strength line, the more bullish for the stock.

If a breakout stock moves perfectly in sync with the S&P 500, the relative strength line would move in step with the price of the stock.

But what we’re really looking for is the relative strength line to rally to new highs ahead of the price, which would offer a valuable clue that the stock is quite strong.

On the weekly chart of $NEWR below, the top half shows the price action of the stock, while the bottom half shows the relative strength line:

Point A – $NEWR has rallied almost 100% off the lows and is close to the prior high of $40 (~ $38.70).  The relative strength line does not confirm the price, as it stops well shy of the prior high.  $NEWR lagged the S&P during that advance.  With the relative strength line not confirming after a 50% correction, point “A” would not yet be an ideal time to buy the stock in anticipation of a breakout.

Point B – $NEWR breaks out in late January above the highs (point “A”).  But, the price action is once again not confirmed by the relative strength line, which this time isn’t anywhere near the last high at point “A” (negative divergence).

Point C – $NEWR clearly shows a base with the most potential, forming a tight-ranged pattern above the rising 10-week MA.  The relative strength line finally confirms the price action here, as the line has moved in step with the price action and has actually outperformed, making a “higher high” at point “C” ahead of the price. THIS is what you want to see and indicates the stock may soon breakout of its tight range.

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$NEWR – Poised For The Best Breakout

Applying your five new tips for buying breakout stocks, the tight basing action and confirmation from the relative strength line suggest that $NEWR could now be ready to stage a powerful breakout.

Subscribing members are already long New Relic in The Wagner Daily newsletter, from earlier buy points of $38.60 and $39.50.

Again, we have no definitive way of knowing if $NEWR will follow through with its breakout, but we believe the odds of a successful breakout are now in your favor.

When buying breakout stocks, keep in mind that overall broad market health and volume analysis both remain factors to consider.

Also, be aware that $NEWR is tentatively scheduled to report its quarterly earnings on May 9.

What is your favorite tip for buying the best breakout stocks? Drop us a comment below to share your thoughts.

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