Breaking-out, then falling back but hitting support. What happens next?

Commentary: It is always important to assess the current market conditions when deciding what type of trading setup to focus on. While it is important for a trader to keep things simple and not over trade, they should have at least a handful of different trading setups in order to deal with different market conditions. With the markets beginning to work off some of the recent buying pressure while still trending strongly on longer time frames, this may be a good environment for finding stocks pulling back to a support level. Typically, when a stock clears a base, that base will act as a strong support level as traders who missed the initial breakout jump at another opportunity, or as shorts who were overrun take the chance to cover near the breakout level.

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Crocs (Nasdaq:CROX), for example, cleared a base on a surge in volume late in April. The base had been building since December, and traders were accustomed to CROX failing at $19 and buyers stepping back in near $16. However, CROX gapped above that level and ran toward $21, catching any trader shorting the $19 level in a squeeze. Any traders who were playing the range also likely missed the breakout as they sold into the top of the range. Now that CROX is pulling back to this level, there are at least two groups of buyers that may be looking to get long. CROX should be on your radar to see if this level holds as support. (For more, see Support And Resistance Reversals.)

Source: StockCharts.com

ONYX Pharmaceuticals (Nasdaq:ONXX) is in a similar position. ONXX had been following a clear-cut channel since it consolidated a strong breakout last December. It finally broke free of this channel late in April, although the channel sloped downward, making the support level a little more difficult to pin-point. However, the $38 level remains a key resistance area as ONXX backed off of it a few sessions ago. Now that ONXX is pulling back toward that breakout level, it’s possible that buyers will step in expecting a retest of $38, leading to a possible breakout.

Source: StockCharts.com

Endo Pharmaceuticals Holdings (Nasdaq:ENDP) has experienced a lot of volatility over the past few weeks after breaking out above a strong resistance level near $37. This level has actually held as resistance since last October, and thus the level takes on even more importance. It appears that ENDP is headed back toward this area and that traders should monitor ENDP to see if it finds buyers. (For more, see 5 Strong Stocks Poised For A Breakout.)

Source: StockCharts.com

HCP (NYSE:HCP) is also in the process of pulling back to a prior breakout area. HCP had been trading in an ascending triangle pattern through most of 2011 before breaking out in April. It rallied past the $40 level before encountering some selling pressure. It has been pulling back toward its base and could end up near $38 at some point this week. Traders should watch HCP to see if it can stabilize near this area and find some buying support. If it does, it may provide a fairly low-risk entry into a stock trying to break out on longer time frames.

Source: StockCharts.com

The Bottom Line
The pullback to support is a very valuable trading tactic in a market that’s trending upward. We often stress how important it is that traders remain patient and avoid chasing stocks too high past a breakout point; this is one of the reasons why. Many stocks that looked fantastic a few days ago are now pulling back with the markets. The key is for traders to remain patient and not just buy these stocks because they are down. Wait for some clues that the stock is stabilizing near a support level and then look for the first signs of strength. It is during this time that the safest entries emerge as a stock rebounds from an area of strength. Sometimes the stocks will fail and continue to head lower, but by waiting for the stocks to stabilize, traders will likely be able to keep their risk well-defined and very tight. Risking a small amount for a large possible reward is really what this is all about. (For more, see Analyzing Chart Patterns.)