Active trading isn’t for everyone—it increases costs and makes portfolios vulnerable to volatility. But regardless of the problems it may create, investors might still go ahead and give it a try in order to quickly gain that extra percentage point on their portfolio.
To make quick gains, investors may employ many different strategies, but often, they look for breakouts—when the price of a certain stock or commodity breaks above a resistance level followed by heavy volume and increased volatility—and breakdowns—when the price breaks below a support area and further declines.
While trading on breakouts can be profitable—very profitable in some cases—predicting when they will happen is much more difficult. As a result, in anticipation of a breakout, novice traders might take on a position without any confirmation, buying a stock or commodity that isn’t breaking out.
Consider the chart of iShares S&P Global Technology (NYSEArca/IXN) below.
Chart courtesy of www.StockCharts.com
This exchange-traded fund (ETF) experienced a technical chart pattern called the ascending triangle, meaning the ETF trended higher but was unable to break above the resistance area around $71.00. As a matter of fact, after reaching that level in early 2012, the price touched the area again in September but failed to break higher.
If an investor bought iShares S&P Global Technology in September of 2012 in anticipation of a breakout, thinking the price will go higher, they were left with a long period of misery. The stock price dropped, and the breakout didn’t occur.
Instead of buying iShares S&P Global Technology early, investors could have simply used a special type of buying order called a buy stop order.
Going back to our example of the ascending triangle in iShares S&P Global Technology, when a stock experiences this pattern, the breakout can’t be confirmed until the price breaks above the resistance, which in this case is $71.00.
A buy stop order is simply a buy order that doesn’t come into play until the price reaches a certain point. In the iShares S&P Global Technology ETF, if an investor just placed an order for a price above $71.00 in September, they would not have been stuck with a position, as the breakout didn’t occur until recently.
With all this said, oftentimes, an investor might see a breakout and buy into it; but after they do so, the price starts to decline. This phenomenon is very common, and just like every other investment they would make, investors should have loss protection in place. Remember: when a resistance level breaks, it becomes the new support; if a support level breaks, it becomes the new resistance. Investors should use a buy stop order to place their stops.
Waiting for a breakout to happen, rather than predicting when it will occur can take a severe toll on your portfolio. If you are saving for the long term, avoid waiting for a breakout—you might be risking more than you should.