This was a very positive week for the markets in several respects. All indexes closed up by at least 2.5%, volume was above average, buying accelerated towards the close on Friday and most importantly, our market model issued an entry signal for the NASDAQ on Wednesday. We initially took this signal as being tentative as it was issued on a day when the NASDAQ rose only 0.3% and volume was not particularly strong. This reservation seemed justified on Thursday when the index erased its gains of the previous 2 sessions. But on Friday, the markets interpreted the economic signals for the week as indicating that the economy is growing steadily at a sustainable rate with little fear of wage-push inflation, and finished strongly. Fears of the potential damage that could be wrought by the trade deficit, the budget deficit, the falling dollar and oil prices seem to have receded for the present.

The NASDAQ is now just 1% away from its 50 day moving average at 2108. As we saw in last weeks newsletter, this could represent a hurdle. If it clears that bar, then the next point of resistance will be the high for 2004 set on December 31 and so we could expect a near term target of another 4%.

As could be expected in this rising market, the number of successful breakouts this week rose from 31 last week to 48 this week. The shooting star of the week was DHC which broke out of a nicely formed handle on Tuesday to close with a gain over its pivot of 50.5% after peaking at a gain of 61%. We'll take a closer look at this stock in our TopTip this week which deals with improving the risk/reward ratio when assessing breakout alerts.

The Healthcare sector again produced the most breakouts this week with a total of 5. Followers of our site will know that Healthcare has been our top ranked industry for several weeks.

The site suffered a hard drive failure on Tuesday and the site was taken down for reconstruction after the market closed. It was back later that evening although alerts were affected for the following day. As is our customary policy when major service interruptions occur, all subscribers were credited with an extra day to compensate for any loss of service.

Improving the Risk/Reward Ratio when assessing breakouts.

Each day, as our breakout alerts hit our inbox, we are faced with a decision as to whether or not to act on the alert. Hopefully, you will have already done your due diligence on stocks on our watchlists and already have a list of those that you will act on. This will allow you to act quickly and buy close to the pivot.You may also have set a filter so you will only receive alerts on stocks that meet your minimum investment criteria. One of the criteria you should consider is the risk/reward ratio of any investment. Managing your risk is necessary to control your drawdawn, minimizing your draw down is critical to staying in the game. This week we will look at how to assess the risk to reward ratio from our charts and watchlist statistics.

To assess the risk/reward ratio, we obviously need to know two things: firstly what's the downside, also know as the drawdown, if our investment turns out wrong, and secondly, what's our realistic potential gain.

First of all, lets look at the risk for a typical cup-with-handle chart.

Measuring Risk

The chart at the right shows a stylized cup-with-handle chart representing a fairly typical situation in which the handle forms above the 50 day moving average line. Let's assume that an alert is received and on checking the current price we find it is above the pivot price. We now want to know what our risk is. Our risk is the difference between the buy price and the support level for the stock. Theoretically, the pivot price, which was resistance, has now become support, so that defines our minimum risk. Usually, however, we want to be more cautious so we will asses our first realistic support level as the lowest price in the handle. This gives us a first level of risk shown by the line A in the chart. Depending on our tolerance to risk we may want to be more cautious and look for the next level of support, which in our stylized example is the 50 day moving average line. So our more cautious level of risk is shown by line B. Sometimes the 50 dma passes through the handle and in that case the first level of support is the 50 dma level and the next level is the handle low. We will see a real life example of that later.

The first level of risk, shown by A, is found by looking at the handle depth statistic on our CwH watchlist. The second level of risk must be determined by looking at a chart, which is directly accessible by clicking the CwH link in the emailed alert.

Measuring Reward

Now we have measured our risk, we want to know our reward. There are several methods for doing this but I will discuss just two. Others include Fibonacci Ratios and Gann Analysis.

Breakoutwatch.com has developed a model that measures the expected gain (EG) if a stock breaks out. This model is based on technical and fundamental information known about the stock at the time of breakout and was discussed in our newsletter of 10/31/04. The expected gain is published on our site and is also included in each alert we send for a cup-with-handle breakout. This provides our first estimate of our expected reward. Because the expected gain may take some time to be realized (up to 180 days), I recommend using a percentage of the expected gain, lets say 50%, as the reward estimate.

Bukowski has also proposed a formula in his Encyclopedia of Chart Patterns whereby the expected reward will be 50% of the cup depth. I call that the geometric reward, because it is based purely on the geometry of the chart pattern. You can see it shown on the chart as the distance between the left cup high and the mid-point of the base.. You could use the geometric reward or 50 % of our EG figure ( to be very conservative) as a reasonable reward estimate.

To buy or not to buy, that is the question

The usual recommendation made in the literature is that the risk to reward ratio must be in the ratio of 1:3. A commonly recommended stop-loss is 7-8% which is a money management rule not related to the specific stock under consideration, or risk/reward ratio. If the risk was more than 7%, then under his guideline, you may choose to eliminate the stock from consideration unless the reward is at least 22%.

An Example: DHC

This chart shows DHC as it was on 01/31/02 just prior to breakout on 02/01/05. An alert was issued at a price of $8.88 (already 11c above the pivot) and an expected gain, EG, of 72%.

In this case the 50 day moving average passed through the handle, so that provided the first level of support (A) and a risk of 9.2%. The second level of support was the handle low at 10.4% below the alert price (B). The geometric reward was 24% and the conservative EG reward 36%. Based on the geometric reward, this was not a buy, but based on the conservative EG reward it was a buy with a reward to risk ratio of 3.5:1. On looking more closely at the chart, however, we can note how closely this stock (or more precisely the players in this stock) used the 50 day moving average as a support level. On this basis we could have reasonable confidence that support would be at the 50 dma level limiting our risk to 9.2% and making our reward to risk ratio a more interesting 4:1.

In fact, the stock went on to gain close to the expected gain of 72% in just four days, peaking at a gain of 60.1% and closing the week for a gain of 50 5%.