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When Breakouts Don't Work, Consider Cutting Bait Faster

Sometimes, a growth stock does exactly what it's supposed to do after a .

It follows through in heavy . Or it holds gains, trades tightly and moves sideways, giving no sell signals whatsoever. Price action like this tends to happen in a healthy bull market when new money is coming in from the sidelines.

But breakouts aren't always easy to .

Sometimes, they run into trouble quickly, reversing in heavy volume soon after the breakout. When this happens, you don't have to wait for IBD's flagship key sell rule to trigger.

The rule says to always cut losses 8% below your purchase price, but failed breakouts are a reason to keep losses even smaller. Don't wait around to see how a stock responds after a heavy-volume reversal. Recognize institutional selling when it happens and play defense. Cutting losses at 3-4% below your purchase, or cutting bait at breakeven, is perfectly acceptable when a stock doesn't "act right" after a breakout.

Focus your buys when the odds are in your favor to make money — that is, when major averages are in a confirmed uptrend.

A market uptrend under pressure, however, means that distribution days, or higher-volume declines, are starting to increase in frequency in the indexes. If you buy a breakout in an environment like this, the breakout is less likely to bear fruit. So keep the overall market's health in mind. If you buy a breakout when there are four or five distribution days in the indexes, cutting losses quickly is often a good strategy.

On April 12, 2004, Align Technology (ALGN) broke out powerfully from a cup-shaped base over 22, soaring 10% in more than double-average volume. In the next day's IBD, the Composite Rating was 91, the EPS an 81, the RS 90.

Yet instead of extending gains the following day, it fell 4%. Not ideal action but no reason to sell either because it closed at 21.50, only 2% below the . However, distribution days were piling up on the Nasdaq.

Align rallied back in light volume over the next few days and briefly hit a new high, but on April 20, the stock reversed in heavy volume, falling 9% in fast trade. (1) It was a sign of unequivocal institutional selling. Even though it closed 5.6% below the 22 entry, there was no need to hold the stock any longer because of abnormal price action so soon after the breakout. Align lost 60% over the next 6-1/2 months.