How do you know if a breakout is real or not? First off, despite what any of the so called experts will tell you, the fact is that you don't. Okay, now that we have that behind us, we can look at it a bit more objectively.
When a stock has banged it's head up against a resistance level in the past, and failed to execute the breakout, there are several factors working at the same time. One of those factors is that some of the people that bought the stock at the breakout level are still holding it. Some of them are nervous. They start to think that "if that stock gets back to where I got it, I'm outta here". So, that creates some overhead pressure. Then of course you have the professional short sellers lurking.
The short sellers watch resistance levels too. At the very first signs that a stock won't break out, they pile on the shorts, and that extra pressure will often lead to the stock failing it's move. Between the "bag holders" that are stuck in it, and the shorts looking to crush it, you can see there's some warfare going on. The driving factor behind why it's challenging it's breakout in the first place has to be pretty strong to overcome it all.
So, lets say the line in the sand is at $60. The stock has hit it twice in the past and now it's at 59.90 and "trying" again. If it gets to say 60.10, how on earth do you know it will hold? You don't. Some will tell you that you need to watch the volume to prove it or not, but that's not always reliable. As the "warfare" rages, the volume will indeed be higher as the bag holders, shorts and new buyers all exert their forces. So, there is indeed going to be higher volume anyway.
We have 2 ways to at least try and help the situation. First off, watch how far the stock exceeds the breakout area. In our example, if 60 is the breakout line, and the stock gets to 60.50, chances are better that it's going to stick than if it only gets to 60.08 and can't seem to get further. Secondly, is the stock going to close above that breakout level?
Over the years we've found that stocks that close above a past resistance level have a 75% greater chance of holding the
breakout. Why? All those professional shorter's have to look at themselves and say "hmm. it broke out and now it's going to close above the breakout. If some big stock outlet picks up the breakout, it could roar and we'd get fried. I better close out my short now, then be sorry later."
Breakouts that hold into the close are the "most" reliable predicter of a true breakout that we've found. Even then they aren't perfect as we've seen them gap down the next morning, but in general, overall terms, it's about the best indicator we've found.
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