How do you know when a breakout has legs?
You don’t, until it does. But traders can take steps to keep the odds on their side.
“If the volatility fits, wear it” touched on ways to help determine if a market in a trading range may be getting ready to make a move. Now let’s take a look at a situation where the breakout has already occurred.
Yesterday provided a good example. A LiveAction scan showed traders were buying a lot of call options—almost 10 times more than usual—in Electronic payments processor Total System Services (TSS):
The fact that the stock—despite ending the day with a big gain—nonetheless gave back around half of its rally yesterday may give some traders pause about its ability to sustain its breakout. That’s understandable; markets often retrace some of their steps after such apparent “blow-off” moves. And in this case, some traders demonstrably thought the move was overdone, at least on an intraday basis.
But this behavior, under the right circumstances, can offer opportunities for patient traders. Here are a few things to consider in this example:
●The stock, as shown in the weekly chart below, entered its recent range after an uptrend dating back to late 2016. A basic premise of breakout trading followed by many traders is that, barring other factors, prices are expected to exit ranges in the same direction they entered them. A range, until proven otherwise, is considered a pause in the prevailing trend.
●Analysis of 30 quarters of TSS earnings dating back to October 2010 showed the stock was up five days after earnings 65% of the time, and had a positive average return at that point.
●The majority of those gains came in the first two days after earnings; the stock tended to pull back over the next two days.2
Given these factors, bullish traders who didn’t capture the breakout move in this type of situation—but who still saw the upside breakout as a sign the uptrend could continue—may choose to wait for a pullback, possibly to the breakout level, possibly in the next few days.
Such patience won’t be rewarded every time, as the stock may not pull back as much as anticipated—or at all—but traders never get an edge by chasing extreme momentum.
You may not get the whole enchilada trading that way, but there’s also a smaller chance you’ll end up with a bad case of market indigestion.
Market Mover Update: A second-straight month of weak housing data (yesterday’s new home sales number was the latest to miss estimates3) sent some homebuilding stocks below long-term support levels, including KB Home (KBH), Toll Brothers (TOL), and LGI Homes (LGIH).
Near-term implied volatility (IV) in Urban Outfitters (URBN) options remained elevated for a second-straight day: Yesterday, a LiveAction scan showed 30-day IV for URBN options was up more than 45% from a week earlier—the biggest increase among actively traded stocks.
1 StreetInsider. Total System (TSS) Earnings. 7/25/18.
2 Supporting document available upon request.
3 Econoday. New Home Sales. 7/25/18.