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How Pro Traders Use Charts to Hunt for 'Breakout' Stocks

March 21, 2000|WALTER HAMILTON

At first glance, the gain in Oracle Corp.'s stock last Nov. 1 didn't look all that noteworthy.

Shares of the database software company had been stuck in a two-month trading range, and the $1.81 rise that day barely pushed the stock over that range.

But to active traders who study stock charts, Oracle shares had just flashed a resoundingly bullish sign.

The closing price was a new high, and it was reached on a huge jump in trading volume--two signals that a big move might be underway.

Sure enough, Oracle rose 3.5% the next day and 8% the day after that on continuing heavy volume. Suddenly the stock was up more than 20% in three days--and was on its way to an almost 228% surge over the next 4 1/2 months.

Have you ever wondered how professional traders find stocks just before they begin to soar? Here's one way: They pay attention to market action on days like Nov. 1.

Many investors who piled into Oracle that day and over the next few weeks did so by following its price and volume patterns--a practice known as technical analysis.

As Oracle showed, technical analysis can yield distinctive clues about the immediate direction of stock prices. Many professionals use it as a timing tool to supplement their fundamental research. The goal: to buy good companies at the right moments.

One of the most vocal practitioners of technical analysis is William O'Neil, the founder of Investor's Business Daily. This article is based largely on his strategies.

Two central concepts of technical analysis were at play in Oracle's stock last year: "bases" and "breakouts."

Stocks sometimes trade in recognizable patterns known as bases. As the name implies, a base is simply a period of relatively poor price performance during which a stock lays the groundwork for a potential future advance.

Bases can occur at both new lows and new highs in a stock's price. This story focuses on bases that follow a sharp rise in a stock's price, to new highs or near new highs.

Two common bases of this variety are "flat" bases and "cup-with-handle" bases.

Technical analysts study bases because they're looking for breakouts. That's simply the term given to the surge in a stock as it rockets out of a base.

Breakouts sometimes are spurred by good news, such as an earnings report. But it's very bullish when a breakout occurs with no obvious news to explain it.

That could suggest either that savvy investors see something that most others don't, or that many investors have been eager to own the stock for some time, and now are making their move, for whatever reason--perhaps because of a general rise in market bullishness.

To be sure, technical analysis isn't foolproof. Stocks don't go up just because their charts say they should. Some breakouts fail--in other words, the stock drops sharply shortly after a surge.

"Not all breakouts follow through, of course," said John Murphy, a well-known technical analyst and president of Murphymorris.com. "Otherwise, we'd all be rich."

Nevertheless, breakouts can mark the start of a powerful advance in a stock's price.

*

To understand bases and breakouts, consider the accompanying chart of Oracle.

The stock traded in a narrow range during September and October. That was a classic flat base.

In a flat base, a stock's price fluctuates within a relatively tight range--normally no more than 15% to 20% from top to bottom. On a chart, the stock appears to be moving sideways.

"The better [flat bases] are in a fairly tight trading range where the highs and lows are pretty well-defined," Murphy said. "You could almost draw two flat lines, one over the prices and one under them, and spot when the breakout is."

Technical analysts generally don't want to buy a stock during a base. Instead, they want to look for signs that it's a "proper" base that may set the stage for a future advance.

A proper base has several characteristics. First, daily trading volume must dry up at key points. In a flat base, for example, volume should be light and steady.

That shows that most "weak" shareholders--those most likely to sell the stock--have probably already exited, thus leaving the stock in the hands of more committed holders.

In general, the longer a stock's basing period, the more bullish it is. Only investors with the most conviction about a stock will hold it for a long time rather than redeploy their money elsewhere.

Why is it so important to know there are committed investors? Because if the stock breaks out, those investors will be reluctant to sell. Incoming buyers must bid up the stock price significantly to coax it out of the hands of committed investors. In simple terms, demand far outstrips supply.

In a true breakout, trading volume should be huge--at least 50% higher than the recent daily average, and preferably the heaviest in several months. Indeed, without high volume, most analysts wouldn't buy into a price breakout.

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