Using Breakouts In The William O’Neil Methodology

Studying price breakouts is a key part of the O’Neil Methodology. It gives investors clues on both individual stock direction as well as overall market direction. For example, a strong price breakout on a sharp increase in volume of an individual stock can be an indicator of future price gains. Similarly, when the overall number of individual stock breakouts expands, it can be an indicator that the whole stock market may be getting ready to move higher.

How does William O’Neil define a stock breakout?

Step 1-Building of a ‘Base’: For a stock to breakout, it must first create a base. This occurs with the establishment of a stock price low and then a defined trading range without going above the prior price peak or making a new stock price low for a minimum of five weeks. This process may take up to a year. We have built a proprietary system for recognizing base types including:

• Flat Base
• Consolidation
• Cup
• Saucer
• Cup-with-Handle
• Saucer-with-Handle
• Double-Bottom
• Ascending Base
• IPO Base

Step 2-Breaking out above the ‘Pivot’: We define a “pivot” as an inflection point – after a stock has built a base – where the stock’s price exceeds its prior price peak (also referred to as the “left side of the base”). Cups-with-Handle, Saucers-with-Handle, and Double-Bottom bases tend to see their price pivot a bit earlier than other patterns, essentially above a middle peak within the base.

Generally, we favor buying stocks or adding to already established positions as they break above their pivot price. Also, typically the longer the base in length (i.e., weeks, months), the more significant the breakout. In the ideal case, the pivot is also a break into all-time highs. The rationale for waiting for highs to buy relates to the prior highs being a possible resistance as initial buyers at those levels may be inclined to sell once previous losses have been recouped. But, once into highs, there is no such resistance from underwater positions. In real-time, buying above the pivot intraday can be effective. A more conservative approach is to wait until the close of the day to make sure the stock closes above the pivot price.

Another key technique is counting bases as they appear throughout the lifecycle of a stock’s move higher. First stage bases are by far the most common. These are considered stage one because the stock price has undercut the low from a previously established base. Stage two, three, four, and so-on occur after a breakout from the previous stage, and a new trading range is built at a higher level. A current example, which shows a base count reset, a stage one base and breakout, followed by a move higher to a stage two base and breakout is from Axon Enterprises (AXON).

Axon Enterprises (AXON)

Below are the total individual stock weekly breakouts for the US and global markets that we track (all base types and all base stage counts) from 2015-2023. We can see the numbers have improved significantly from late-2022 and in the first few weeks of 2023 after languishing for about a year. Looking at the past three market bottoms (2016, 2019, 2020), a return to a high breakout number has been a good signal for continued market strength.

In addition to a stock breaking out, there are other factors that we believe can lead to outsized forward returns. As mentioned before, the longer the base, the more significant the breakout. Our quantitative research team at O’Neil has studied stocks making new highs and has concluded that higher volatility-adjusted excess returns (defined as stock price vs the market average) can be expected for stocks making new three-month highs. From there, returns improve significantly for the stocks making six-month, one-year, and finally five-year highs as shown in the chart below.

Further, when looking at the five-year high subset, the more rare the occurrence the better. When very few stocks are making new five-year highs, those that do should be paid close attention to.

Other factors that are important at the time of the breakout include Relative Strength (RS™) and money flows. If a stock is breaking out of a range, but its RS line versus the benchmark is not, and/or if the volume on the breakout is low, we would view these as a red flags. In general, volume is a confirming indicator for price moves. The higher the volume, the more the price action should be “trusted”.

Putting it all together, here are a few of the best recent breakouts, which are nearly making five-year highs, have RS Ratings of 85+, and have solidly positive net money flows. Chart markups for two examples, VisteonVC
and Proya Cosmetics, follow.

There is also the subset of recent breakouts that are not as close to five-year highs but instead breaking out of more recent ranges. This group is especially important, as the number of stocks are much higher here and need to continue acting well for overall market strength to persist. A few global examples which also have high RS Ratings and have solidly positive net money flows are shown below. Chart markups of UberUBER
and Sika to follow.

Conclusion

Breakouts are another tool investors can use in their technical tool basket. They help increase the odds that a stock will rise in price in the future. In addition, they are a key indicator of the overall robustness of the stock market. Generally, strong market gains are preceded by a large increase in the number of individual stocks breaking out. At O’Neil, we are studying this carefully for a sign a new bull market is beginning.

Kenley Scott, Director, Global Sector Strategist at William O’Neil + Company, an affiliate of O’Neil Global Advisors, made significant contributions to the data compilation, analysis, and writing for this article.