How to Trade Stocks That Hit All-Time Highs

Each phase of an uptrend has unique factors that need strategic shifts in risk management and profit objectives. This is especially true when a security rallies to a new high that hasn't been traded in its long-term history. This scenario can build wealth quickly but requires special technical rules to capitalize on the mechanics in play. (For related reading, see: Five Minute Investing: Stock Picking.)

Momentum dynamics shift when a security reaches uncharted territory. The new high print signals very favorable conditions in which there's no oversupply in the form of shareholders who need to sell at a loss or to get even. This lopsided equation can translate into rapid gains that often exceed logical price targets but can also generate unexpected behavior that encourages emotional decision-making. (See also: Avoid These Common Investing Psychology Traps.)

Resistance disappears when a security hits an all-time high but hidden obstacles remain, ready to surprise unwary longs with reversals and shakeouts. While the breakout completes the digestion of prior supply, the security undergoes additional testing that can last weeks or months. This process has the power to trigger sizable losses that can be avoided with the first special rule, which categorizes the uptrend positioning in relation to the breakout.

Breakouts to new highs tend to unfold in three distinct phases. First, price thrusts above resistance, attracting higher-than-average volume. This marks the "action" phase. Rally momentum eventually fades, with weak hands getting on board near the rally highs. This imbalance triggers the second or "reaction" phase, which tests the durability of the breakout. Support either holds, triggering a rally above the prior high that confirms the breakout, or it rolls over in a failure swing. Both outcomes complete the third or "resolution" phase.

Ambarella, Inc. (AMBA) broke out above resistance at $36 in September and rallied to an all-time high in the mid-$40s. This action phase gave way to a contrary reaction phase that dumped the price back to new support and undercut it for two sessions, shaking out weak hands. The security then recovered all of its losses and posted another round of all-time highs, completing the resolution phase.

Accumulation/distribution as measured by on-balance volume (OBV) determines the path of least resistance, favoring rapid upside resolution when it hits new highs and whipsaws when it lags price development. This makes sense because a security at an all-time high should generate widespread interest that translates into enthusiastic buying pressure. When it doesn't, the trend needs to pause and find missing sponsorship or gravity can take control, unraveling the breakout. (For more, read: Uncover Market Sentiment With On-Balance Volume.)

Sidelined participants should avoid new long exposure during this testing phase, except at the range extremes where the risk/reward equation will work in their favor. These opportunities typically present themselves in the form of pullbacks to new support. Those already positioned have little choice but to set stops and let the market decide their fate.

Now categorize price structure leading into the breakout. Take defensive measures when a) the breakout marks the third rally wave off a deep low within the prior range or b) price runs straight up into the breakout level from a deep low and keeps on going without building a consolidation pattern. Both scenarios raise odds that the rally wave above the breakout level will exhaust the uptrend and yield a sizable correction.

A more bullish price structure will show a basing pattern below the breakout level but not too deep in the prior trading range. Look for these price bars to carve out rounded or square bottoms that show several failed attempts to a break support and send the security lower. This sturdy price action builds strong support that's unlikely to break during the inevitable reaction phase.

Next, stretch a Fibonacci grid from the low of the trading range to the breakout level, and mark out harmonic extensions at 1.270, 1.618, 2.000 and 2.618, as illustrated on the Mylan N.V. (MYL) chart. Then look for the first major high after the breakout to exceed 27% of the distance between the low and breakout price, or the 1.270 harmonic. A high exceeding that level raises the odds that the breakout will succeed, while failing to reach that level raises the odds for failure. (For more information on grid placement, see: Placing Fibonacci Grids Is Key to Your Trading Strategy.)

Higher harmonic levels will mark hidden resistance as the uptrend gathers force and can be used to take profits, unless a buy-and-hold strategy intends to keep the position indefinitely. The highest extension at 2.618 marks a lofty goal that can signal a significant top, so at least consider re-evaluating profit goals when a position reaches that level.

Now connect prior highs that line up in three or more points, denoting rising highs trendlines that mark hidden structural barriers. Be wary if you find trendlines that have contained uptrend progress for the past six to 12 months because they expose weak momentum that could undermine the current rally. On the flipside, consider additional exposure when the uptrend thrusts above one of these lines because it indicates escalating momentum. (See: The Utility of Trendlines.)

Let's assume that the security has confirmed the breakout and cleared all hidden barriers. Special rules now shift into profit protection and enhancement mode. Start by setting a minimum profit that will be taken aggressively if the uptrend reverses. You can establish this number using a simple percentage gain like 10%, 20% or 50%, or a psychological level like $5000, $10000 or $25000. Technical-oriented market players can establish a mental stop that meets these objectives or just choose an actual number.

Avoid physical stops because the May 2010 flash crash showed us they can be targeted at any time by the predatory algorithms that move modern markets. There's no reason to let all your hard work go to waste, building a big profit and then losing it when the chaos hits the ticker tape, as it does on a regular basis. Just make sure your magic number is well out of the way of current price action and will get hit only if the worst-case scenario plays out. (For more, see: Three Types of Profit Protection Stops.)

Additional exposure can supercharge your profit at a new high, but buying at the wrong time will have the opposite effect, destroying the profit you've already built. As a general rule, only add to the position when it falls into an advantageous risk/reward location, like a sell-off into a weekly or monthly moving average, or when it clears a fresh barrier like a rising highs trendline or Fibonacci harmonic. These broad-based scenarios will occur infrequently, often yielding just one or two favorable entry points over the course of a year.

A security at an all-time high can exceed logical price targets after it finally escapes gravity at the prior breakout level. Apply special management rules to these uptrends, getting out of the way as price lifts into uncharted territory while ensuring that hidden traps are avoided and the core profit is protected. (For additional reading, check out: Risk Management Techniques for Active Traders.)