One of the most important things any options trader can learn is how to buy on a breakout and sell on a breakdown. It is at these moments that the best opportunity for a gain often lie.
But you have to be quick! When a stock makes a big breakout or breakdown on heavy turnover, traders everywhere notice. If you’re late to the party, you’ll either feel regret or jump on board just as the stock reverses course. The psychological effects can linger, causing you to make even more mistakes.
How to buy on a breakout or breakdown
Here are a few things to keep in mind when you’re learning how trade on a breakout or breakdown:
- Stocks move over time, but our minds think in the moment. This divergence can cause use to miss great trading opportunities, so always keep an open mind.
- Look for institutional participation. Without that support (and liquidity), a stock has little chance to rise.
- Distribution is not a short-term event; it happens over time. When a stock is breaking down and big money is fleeing, these are often great times to jump on board and ride the stock lower with a bearish trade.
A case study
Sanchez Energy is a small (relatively speaking) natural gas company that broke out on very heavy turnover.
On August 8, it enjoyed a one day move that was its biggest in months; at one point, it was up over 33% on the session. The stock surged so powerfully in such a short period of time that it was nearly impossible to catch up to it. The next day saw no followthrough, but volume was substantially weaker, indicating institutional support was still there and that the low from August 8 was yet not tagged.
Over the following days, the stock moving sideways to higher. Last week, the stock lifted above its intraday high and into levels not seen since April. As you can see on the chart, the stock continues to look strong and is not giving back any ground.
So, is it too late to jump on board?
As a momentum trader, my answer is “No, it is not too late.” And while you may have to hold your nose while buying options after such a strong price move up, let’s remember that we don’t care where a stock has been, we only care where it’s going. If buyers are still engaged (remember, institutions move slowly into stocks, not all at once) and demand is strong, then we should see rising prices continue.
The best stocks don’t often give you a chance to get in on the action. Sanchez Energy is a case in point, but keep an eye on the next modest pullback – it may be your opportunity to catch it before it runs higher yet again.
This article was updated on May 11, 2023.
