Breakout buying is a popular investing strategy among individual investors, which refers to buying a stock just when the price breaks out of a period of consolidation and reaches a new high, because it marks a major increase in demand which ensures further increase in capital gain. However, not all breakouts are genuine, as a stock might just barely touches a new high and falls back. How do you tell whether a breakout is genuine? You can use the acronym BOAT, in which each letter represents an important criteria for measuring the reliability of the breakout.

B for “Breakout Volume” – the More the Merrier

Volume is the key of understanding the desire for a stock, and it is like petrol to a car: if the petrol meter is showing a high reading, you can expect the car to accelerate, and so should a breakout with high volume be expected to soar higher.

When the stock price charges up from a consolidation, the volume should increase for more than half than usual, and if in case of a young leader of its industry, it’s not uncommon to show volume spikes of more than twice of the average daily volume. A large volume indicates a strong buying desire of the stock, and it is usually contributed by professional investors with large purchasing power.

The moment of breakout is the best moment to buy, because it ensures enough demand behind the stock and further increase in price. If you buy before this moment, you run the risk that the stock price might never get beyond its breakout point and fall back, and on the other hand, if you buy at more than 5% beyond the breakout point, you would probably be buying late and get caught in the next price correction.

O for “Overbought” – the Best Time to Buy

You read it right, my friend: the best time to buy a stock is when it is “overbought”!

There may be some truth in the old adage of “buy low, sell high”, but studies in the stock market has demonstrated that the stocks with the strongest fundamentals are often the most “expensive” in terms of both the P/E ratio as well as yearly range, and they usually go even higher before you have an opportunity to buy in a dip. Conversely, the cheap stocks are those which are fundamentally weak and do not reward the investors well. In other words, the stocks which seem too expensive and risky to buy are, paradoxically, actually the best offers from the market.

Therefore, it is absolutely unregretful to buy stocks at recent high, as long as they are supported by strong fundamental growth. Of course, by “buying high” it does not always mean to buy at the previous all-time high, it could be 5%-10% below that peak, or when a downward trend line is broken through. In any event, you should not aim to buy at the cheap, but to buy right, which means to wait for a stock to surge up to prove its strength to you, even if it looks too scary to buy at new high.

A for “Accumulation” – A Crouch before the Pounce

Just as a tiger crouches before it pounces, the price of a stock often corrects and dips a little before a major advance.

The “crouch” (or accumulation) usually occurs after the price advances to its recent high, so that prior to the breakout, the price falls back slightly for two to three weeks before the advance resumes. The reliability of the breakout could be predicted by the following characteristics of the “crouch”:

  • A good breakout usually follows a “tight” accumulation, where “tightness” could be defined as small price variations from high to low for the week, with several consecutive weeks' prices closing very near to each other. The “tighter” is the accumulation, the better is the breakout.
  • Volume may dry up near the low of the accumulation before the price surges. This does not always happen, but when it does, it means that the sellers are exhausted and the professionals are ready to buy in large quantity.
  • The accumulation area almost always above the 50-day moving average, and if it could not get above the moving average, it means the demand is not strong enough to ensure a long-lasting thrust.
  • If the “crouch” wedges up in price, instead pulls back slightly as usual, it is likely that distribution, instead of accumulation, is in place, and the consequent breakout is likely to fail.
  • A pullback of an accumulation should be limited to 12% off its peak, and exceeding this percentage increases the risk of buying the breakout. However, an exception to this is a bear market bottom, where the limit is extended 20%.

However, accumulation is not always necessary. Although a breakout without accumulation is less reliable, some volatile stocks might actually pull it off when there are surprising fundamentals or crazy investors in a high-flying bull market.

T for “Time of the Market” – Cycle is Crucial.

The stock market is definitely a realization of the 80/20 principle – you make 80% of your money in 20% of the time.

Not all years in the market cycle are created equal. The really big money is usually made in the first one or two years of a normal new bull market cycle. It is during this period that you must not miss any opportunity presented. The rest of the bull market would be much less energetic before the bear market comes.

You need to recognize the leaders in this short period as quickly as possible, and you should pay particular attention to a general market correction. In the first or second year of a new bull market, there should be a few temporary corrections for some months in which the market indices drop for 10%-15%. Even though the best stocks you are looking for may decline for a larger percentage than that, those that decline the least percentagewise are usually your best selections, and those that drop the most are normally the weakest.

Once the correction is over, the first stocks that bounce back to new price highs are almost always your authentic leaders, and they usually come out in the first month after the correction. This is the ideal time to go after your desired stocks in huge bets.

Conclusion

To summarize it in a sentence, the BOAT method indicates that, for a fundamentally sound stock, if a breakout:

  1. Accompanies high volume;
  2. Occurs near the top of the recent range;
  3. Follows a tight accumulation; and
  4. Happens in the early years of a bull market;

Then it will be time to invest your valuable money into it.

Author's Bio: 

Victor Chan Wai-To is an active trader in Hong Kong.