When you think of a breakout, think of a volcano, in a good way.
A breakout is the moment that a stock passes its ideal buy point in an eruption of price and volume.
Although the stock jumps, a breakout during a market uptrend usually represents the start of a significant price advance.
Why? Because the buy point marks the level where a stock clears resistance. Sellers don't show up past that level and the stock has clear sailing.
But until a stock makes a strong move above resistance, an investor can't tell if there's a price ceiling nearby.
Not all breakouts are the same. Simply put, some are good and some plainly stink.
There's two main criteria to grade a breakout: price action and volume.
A good breakout holds its gains for the session. You may buy at the buy point, but then the stock turns south.
If the stock turns negative on the day of the breakout, it's a red flag.
Consider selling the stock. Remember, you can always buy back in at a later buying opportunity.
That's not to say a breakout leads to a straight ascent. There will be ups and downs. But a good stock will show support at its buy point. The level of prior resistance will become a new level of support, much like the support a winning stock would find at its 10-week moving average.
The idea behind a breakout is that institutional investors pile into the stock. Institutional investors are what will make the advance work. With millions to spend, institutions can sustain demand for a stock for months.
To gauge if there is demand from institutional investors, study volume. On a breakout, volume should be at least 40% above the stock's 50-day average.
When the stock breaks out, the higher the volume the better. The best breakouts often see volume 100%, 200% and more above their average.
Boston Beer Company (NYSE:SAM - News) was an example of a good breakout last year.
The maker of Samuel Adams beer formed a flat base with a buy point at 40.12.1 On Nov. 6, the stock surged past the buy point in volume 444% above average following a strong earnings report. 2
The stock receded on the day of the breakout, but still finished above its buy point. The fact that Boston Beer closed above the buy point showed the market favoring the stock.
Its rally had begun.
Shares continued to trade above the buy point.
By January the stock was trading as high as the 49.38, but the market was about to pull back, bringing Boston Beer down with it. When the stock receded, it did so in light volume. This was another chance for investors to buy 3. Today, investors who bought at the November buy point have a profit of about 70%.
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