How to Spot Potential Breakouts in Growth Stocks
Today, I want to dive into a simple but powerful growth stock chart lesson that can help you identify low-risk entry points, or at the very least, inform you that the stock is acting properly. I’m seeing a lot of it these days.
I’m talking about tightness in a stock price’s movement, and I’m seeing a lot of it these days. Tightness refers to when a stock does nothing—meandering around in a narrow price range on light volume—for two to four weeks (much longer than that isn’t as positive). Most investors look for action—big price moves up or down. But, almost by definition, few investors are paying attention when a potential leading stock is doing nothing. If more investors were paying attention, the stock would be moving!
Why is tightness bullish for growth stocks? Two reasons.
First, it’s a sign that there’s no more supply coming into the market. Thus, when an investor wants to buy the stock (especially an institutional investor who wants to accumulate a few hundred thousand shares over the next few weeks), it drives up the price, often rapidly!
The second reason is that tightness itself can be a sign of accumulation. If mutual funds are telling their traders, “I want to buy 200,000 shares, but I want them between 45 and 48,” guess what? The stock tends to trade between 45 and 48.
Look for These Stock Chart Patterns
I look for three specific tightness patterns. You can look for them yourself as you flip through stock charts on the weekend (like I do).
The first pattern is basing tightness. This occurs as the growth stock is rallying off its lows but is still within a larger consolidation; it usually occurs when the stock is 10% to 20% off its highs but is heading higher lately. It’s generally not buyable, but it’s a good sign the stock is coming under accumulation.
An example of this is Workday (WDAY), a leading cloud software stock that nosedived more than 40% from year-end to its lows in February (capping off a larger two-year 60% decline) before snapping back on huge volume thanks to a great fourth-quarter report.
Notice that after the massive-volume rally on March 1 (volume is indicated at the bottom of the chart), the stock traded very tightly for most of March, hovering between 70 and 73, giving up none of its prior gains as volume dried up. WDAY still has lots of overhead, so I wouldn’t say it’s buyable right now. But I’ve flagged the stock for more research.
The second pattern is called possum tightness. This occurs after the stock has basically completed building its launching pad and is ready to break out and begin a new run. Often, the growth stock will go quiet for two or three weeks—playing possum with investors—and just when most investors take it off their radar screens, the stock comes to life and gets going.
A good recent example is Sabre (SABR), whose global distribution network for airlines, hotels and aggregators is the most popular in the world. The stock fell like everything else to start the year, but then found humongous-volume support on earnings and rallied back to within a couple of points of its old highs.
Shares then meandered for three weeks, with the ranges getting tighter and volume drying up markedly. When a few investors decided to buy, SABR popped a bit, and still looks primed for higher prices.
The third tightness pattern I look for is PBJ tightness (PBJ stands for post-breakout jump). This occurs when a growth stock has recently leapt to new highs, often on a bullish earnings report, and then goes tight right afterward—a sign that the stock is still under accumulation by big investors.
You can see PBJ tightness in Texas Roadhouse (TXRH). As you can see on the weekly chart, the stock built a big launching pad for a full year, and then gapped to new highs on huge volume following earnings in February. After such a strong move, TXRH went very tight before popping higher last week.
How do you put these tightness patterns to use? It depends.
As I wrote above, basing tightness is more of a flagging mechanism. When I see it, I do some more research on the company or place it further down on my watch list.
When we see possum tightness or PBJ tightness, we like to play things halfway.
Here’s how: Let’s suppose you were looking to buy SABR; you could buy a small (half-sized) position during the tight area with a stop close by (maybe 5% or 6% below your purchase price). That way, if the stocks sags, you take on hardly any water; but if the stock gets going, you can buy the other half of your position above the recent high (in the SABR example, 28.5 to 29).
You could do the same with the TXRH example—buy a half-sized position in the tight area, and buy the rest of your position if the stock lifts off.
A real-time example of all of this could be with HD Supply (HDS), which is showing signs of possum tightness after a big run from its lows earlier this year. The company is one of the best ways to play the rebound in construction and infrastructure, as it’s a top supplier of thousands of products in a variety of industries. Earnings estimates are huge, too (up 45% this year and 21% next), which always catches my eye.
As you can see in the chart, it’s still early—the stock had a big run from 22 to 33, but notice how, despite the recently-choppy market, HDS has been cool as a cucumber, meandering sideways around 33. It’s still too soon to definitely call this a tight pattern; it’s only been seven trading days. But if HDS continues to trade like this for another week or so, it’s likely to set-up a lower-risk entry point. Watch for it.
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Chief Analyst, Cabot Growth Investor and Cabot Top Ten Trader