Stock Trading Strategies > Technical Analysis > Chart Patterns

Volume in Breakouts

In its purest form, a breakout is the period immediately following a consolidation. It is that point in time where consensus is reached and those that were on one side of the market are overwhelmed by those investors on the other side. For that small moment in time investors agree on price direction.

Most traders say that stocks are mired in some form of consolidation pattern fully 70-percent of the time. The other 30-percent brings dramatic price breakouts -- both up and down. Obviously traders are looking for breakouts because it is during this period that the majority of successful (predictable) trades occur.

Upside Breakouts

Consider this upside breakout for Dial Corp. (DL). For several months the soap maker was largely ignored by both traders and investors alike because fundamental prospects were thought to be less than exciting. The company was a steady, if not spectacularly slow grower but there was no immediate reason to buy or sell the stocks.

By now you should recognize the pattern created by the price action for Dial Corp. (DL). It is the dreaded wedge. These longer-term patterns are characterized by dramatic declines in both volatility (trading range) and volume. That was certainly true of Dial Corp. from late December 2000 through the middle of July 2001. After hitting a low at $10.10 in the middle of December the stock surged to $15.50 in mid-January, fell back to $12 in the middle of March through late April, rallied toward $15.25 in early June, only to fall back to $13.50 in the middle of July. In late July Dial Corp. began to rally toward $15 on increased volume. Several sessions later volume increased dramatically and the stock had a breakout to a relative new high. Note that both volume and volatility contracted dramatically during the consolidation phase and exploded as the upside breakout occurred.

Understanding the importance of volume in an upside breakout is fairly simple, volume must expand on the breakout if the move is to be considered valid. Volume and downside breakouts are more complex.

This is because volume is not necessarily required. This makes sense because unlike rallies where increased volume is needed to absorb normal selling pressures, in a decline stockholders become demoralized and that emotion leads to inactivity. Yes, there will be downside breakouts that are characterized by dramatic surges in volume but these events will always be at the end of the move lower as stockholders capitulate. This makes sense because the longer the decline proceeds the more volume becomes the ally of buyers, not sellers. Indeed, as mentioned in our previous sections, traders need to be wary of increased volume after a longer-term decline because very often it means the end of that move is near.

Downside Breakouts

Let's consider the downside breakout of natural gas distributor Enron (ENE). Once considered a broadband play because of its foray into the Internet infrastructure business, Enron fell on hard times in February of 2001. Indeed, during the span of just seven months the stock had two noteworthy downside breakouts.

During December 2000 through the early part of March 2001 Enron was mired in a large wedge formation. The stock had lows at $65, $66 and $67.50 in December, January and March respectively. The top part of the wedge was defined by highs at $83.50, $82.50 and $81.75 in December, January and February respectively. The downside breakout occurred in early March at $67.50 amid very subdued volume.

Despite this the stock sank to $52 in less than two weeks and it was not until volume increased that the decline subsided. The second wedge began with the $52 low in the middle of March. After several tests of that support level, Enron shares fell through $52 in the early part of June. Once again, volume was relatively light but this downside breakout ultimately led to a decline that would see the Enron shares sink to less than $35 just a week later.

Conclusion

Generally, volume follows trend, that is in a rising trend volume should expand on rallies and contract on declines. In falling trends volume should expand on declines and contract on rallies.
When volume contracts after an extended rally, or expands sharply after an extended decline a dramatic reversal will normally transpire.
Volume and volatility contract in consolidation patterns because investors cannot reach consensus, they are undecided.
Volume should expand significantly for upside breakouts. If volume does not expand the breakout is considered illegitimate.
Volume may not expand for a downside breakout because falling share prices cause demoralization and inactivity among stockholders. During such circumstances, fewer shares are required to drive prices lower.

With an understanding of all of the basics under our belt let's get ready to tackle the fun stuff, reversal chart patterns.

volume in consolidations reversal chart patterns