April 28th, 2008

Buy on the Breakout or the Retest? SOHU, a Perfect Example

I don’t know about you but I’ve always been confused as to whether I should buy a stock on a breakout or wait for the “herd’s remorse” pull back. What, you may be asking, exactly is a “herd’s remorse” pull back.

A stock chartist is a visual sort so the best way to explain is show you a chart on one of today’s big movers into new high territory, the Chinese internet company Sohu.com (SOHU) because it contains several perfect examples of “herd’s remorse” (where, after a breakthrough, a stock reverses and test the resistance trendline as support):

What a terrific chart for learning about breakthroughs and “herd’s remorse”. Note the nearly perfect double bottom extending over two years with a breakthrough the resistance trendline forming the neckline early in 2006. And this is where “herd’s remorse” occurs.

Ofter after the breakthrough of a long-term resistance level, the herd stampeding into the stock has second thoughts, waiting while it regains the strength (the momentum) it lost while finally breaking through the resistance level. The pause may last a quarter, 6-months, even perhaps a year. The patter formed during this pause may can take several forms including, as was the case for SOHU during 2006 and the first half of 2007, a symmetrical triangle, a downward-sloping channel or any of a number of conventional consolidation patterns. Once the herd regains its strength, there is another breakthrough from the consolidation pattern.

The herd had another huge hurdle to push through, the resistance trendline extending from the previous all-time high in 2003. Again, that push (labeled Third Breakthrough) consumed much momentum so a consolidation pattern formed. I labeled it a cup-and-handle but it could just as easily be a horizontal channel through which the stock broke today:

Today’s move will probably also be followed over the next several months with a reversal and testing as support the resistance trendline at 62 before the stock can go much higher.

Mostly, these consolidation patterns resulting from “herd’s remorse” result in regained momentum. At times, however, the herd loses interest, finds greener pasture elsewhere (another stock or industry group) or the weather becomes stormy and the herd runs for cover (over-all market turns bearish). The support test fails and the stock falls below the trendline which then becomes resistance again.

Even though I’ve seen this happen thousands of times, I’m still torn between buying on the breakout and waiting to buy after a successful test or the trendline as support:

  • If you wait, you may run the risk of having a shallow retest and wind up losing a significant move up
  • If you don’t wait, you run the risk of having a retest fail being stuck with a stock that doesn’t regain momentum for months or years.
  • Breakthroughs are relatively easy to trigger as contrasted with the challenge of tracking stocks that are bouncing off a retest.

Anybody out there have any answers or solutions?

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