Shakeout Before The Breakout: Why Stocks Often Shape Handles
The final days and weeks of a base serve as a launch pad for the success or failure of a stock. Many successful bases take this time to form a proper handle. A handle forms before a stock breaks out to new highs. It is shaped by the natural supply-and-demand dynamics in the stock market.
The Final Shakeout
As a leading stock corrects in price, institutions step in to buy shares and the stock works its way higher along the right side of the base. At some point, higher prices attract a few remaining sellers coming in to cash out quick profits from the lows of the base, or trying to get out near break-even for those who bought near recent highs.
This halts the stock's advance and leads to a pullback.
The price action in the pullback should be light in manner relative to the rest of the base. Volume should dry up at some point, showing an exhaustion of supply coming to market. The handle in most cases should correct no more than 8% to 12% in price unless it is part of a very large cup, or if the handle was formed during a bear market. In these cases, the decline can be larger.
A proper handle should also form in the upper half of the overall base. That shows the stock has enough power to rise significantly off the lows of the base before starting this final pullback.
Stocks that run up straight from the lows of the base into new high ground without pausing to form a handle are more failure prone. On a chart, the base adopts a 'V' fashion.
For example, if a stock corrects 25%, it will need to rise 33% to get back to its recent high. A stock that rallies 33% without pausing will be more prone to a sharp sell-off than a stock that has gone through a proper final downward drift in price.
Price action should drift lower along the handle's price lows to mark a proper shakeout; volume should be mostly below average. Handles that wedge upward toward new highs, or see excessive selling volume should be avoided.
Handles most commonly form on cup bases, but can also form on other patterns such as double-bottom and saucer bases.
In January 2013, LinkedIn (LNKD) broke out from its first proper base about 18 months after its IPO.
The pattern ran for 16 weeks and had a constructive rounded cup with downward-sloping handle. Six straight weekly gains on the right side (1), many of which closed near the high for the week, showed healthy demand for the stock.
When volume dried up sharply in the week ending Dec. 28, 2012 (2), it showed there was very little supply of shares coming to market. The next week, LinkedIn closed virtually unchanged, setting the stage for a powerful breakout.
Volume surged 55% above average on Jan. 10, 2013, when the stock cleared the 117.42 buy point, which is exactly what you want to see. Once the stock broke out, it never again closed below the buy point, showing the handle served as a proper setup and launch pad.
The stock advanced 119% over the next eight months, pausing to build a successful second stage base along the way.
