5.13.”I lost $45 on the trade. That’s excellent. Imagine the stock tumblingto 23 (the price near point A), or lower.
Double TopsMany investors recognize the name double top, but only the lucky onescan accurately pick it out of a lineup. What they miss is that price mustconfirm the pattern. That means price must close below the valley between the two peaks before any twin-peak pattern becomes a true doubletop. More about that later—first, let’s talk about identification.Identification
Figure 7.6 shows two double tops (DTs), Eve & Eve and Eve & Adam. DTssplit into four combinations of Adam and Eve peaks, just as they did fordouble bottoms. Eve peaks are wide and rounded appearing. Adam peaksare narrow, usually composed of a long, one-day price spike. The insetshows an Adam top, and you can see how tall and narrow it is. Eve appearsmore rounded and wider. Here are the identification guidelines for DTs:• Price trends upward to the double top. As I mentioned before,price must have something to reverse, and double tops act as reversal patterns.
Double Tops
145
Ameren (Electric Utility (Central), NYSE, AEE)49
Eve
Eve48
47
ConfirmationLine
46
45
44
Eve
Adam43
42
41
03
Nov
Dec
Jan 04
Feb
Mar
Apr
May
Jun
Jul
Aug
40
FIGURE 7.6 An Eve & Eve double top acts as a reversal of the upwardprice trend. Price confirms the pattern as a true double top when it closesbelow the confirmation line.
• Adam peaks are narrow, usually composed of one or two longprice spikes.• Eve peaks are wide and more rounded looking. They may havespikes, but the spikes are numerous and shorter.• The valley between the two tops usually drops 10% to 20% ormore.• Peak to peak price variation is minor, usually 0% to 3%. The twopeaks should appear near the same price.• Most peaks are two to six weeks apart, but allow variation, especially on the top end. Performance deteriorates for tops spacedmore than about two months apart.• Price must close below the lowest valley between the two peaks;otherwise, it is not a double top. This is called confirmation, and Ishow the price as a line in Figure 7.6.• Volume is usually heavier on the left peak than the right. OnlyEve & Adam DTs have volume consistently heavier on the rightpeak.
COMMON PATTERNS FOR THE TOOLBOX
146
Technically, the Eve & Eve double top in Figure 7.6 does not qualify as a true double top. Why? Because the decline between the two peaksmeasures just 5%, half what it should be, but you get the idea of what anEve & Eve double top should look like.Figure 7.7 shows the other two combinations of Adam and Evetops. The Adam top has a tall, one-day price spike, and Eve is morerounded and wider. When trying to determine whether you have anAdam or Eve peak, ask yourself if the two peaks look similar. If so, thenyou have an Adam & Adam or Eve & Eve double top. If not, then youhave the other two varieties: Adam & Eve or Eve & Adam. The leftAdam top of the Adam & Adam pattern, if you ignore the one-day pricespike, could be called an Eve top when you broaden the view a few weeksto the left.Sometimes, looking at the base of the top will help differentiate between and Adam and Eve peak. It is not easy but Adam will usually remain narrow over much of its height. Eve will grow wider as you scandown the top toward the base. The inset shows this. Adam remains comparatively narrow but Eve broadens out. Figure 7.6 shows this clearly inthe Adam peak.Air Products and Chemicals, Inc. (Chemical (Diversified), NYSE, APD)Adam AdamA
4948474645
ConfirmationLine
B
44434241
Adam
40
Eve
3938373635343301
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
32
FIGURE 7.7 Shown are the other two combinations of Adam and Eve tops.
Double Tops
147
Why the emphasis on peak shape? Because performance varies depending on the type of pattern you are dealing with. Eve & Eve doubletops are the classic chart pattern, the one people think of when they visualize a double top. Adam & Adam has the highest average decline afterthe breakout and the lowest failure rate of the four combinations, butstumbles when the trend changes, meaning that price does not recover asfar. For that reason, Eve & Eve has a better overall performance rank,placing second. Adam & Adam places fourth. The other two are downthe list at 13 (E & A) and 15 (A & E). Encyclopedia of Chart Patterns,2nd ed. discusses the full range of performance statistics on the patterns.Trading and Trading Tips
One quick statistic about double tops. I did research and found that ifyou sell your holdings before the double top confirms, you will bemaking a mistake 65% of the time. That’s how often price resumes theuptrend before confirming the twin peak pattern as a true double top.For beginning traders, wait for confirmation before selling an existingposition unless you have a compelling reason for selling immediately.For tall patterns, compute the decline from the current price to theconfirmation price. If the potential decline is a large one, then considerselling immediately, especially if the market or stocks in the industry aremoving downward. If the stock drops to the confirmation price before reversing, you may save a bundle. Look for support areas between where thestock is trading and the confirmation price. Price may reverse at thosesupport areas.The worst (smallest) decline, postbreakout, comes from an Eve &Adam double top. Prices drop an average of 15% below the confirmationprice (the best is an 18% decline, so the other combinations are similar).Can you tolerate a loss of that size? If not, then sell once the DT confirms. Since this is an average of 212 perfectly traded DTs in a bull market, your results will vary. Again, look for support zones where pricemight reverse and recognize that you can always sell now and buy backlater at a lower price.If you have a DT appear after a long-term decline, confirmation ofthe pattern may mean that the end of the trend is near (10% to 20%above the turning point and perhaps less than a month away). However,don’t use that as an excuse to avoid selling. Just be aware that the trendmay reverse soon.
148
COMMON PATTERNS FOR THE TOOLBOX
Switch to a higher time scale than what you trade. For me, thatmeans switching to the weekly scale. If you see a double top standing liketwo redwoods on a flat plane, expect price to return to ground level. Intechnical terms, price will often return to the flat base from which it grew,especially if the rise to the DT is a steep one.The following are additional tips pulled from my spreadsheet of Eve &Eve double tops (EEDTs), the most plentiful of the four combinations.Much of what you learn here is applicable to the other combinations.• Short-term trends leading to the pattern suggest better postbreakoutperformance than intermediate- or long-term trends. Short-termrises leading to the pattern yielded 20% declines postbreakout;intermediate-term trends averaged a 15% decline, and long-termtrends had postbreakout declines of 16%.• Avoid underlying support because it can cause a pullback. EEDTswith pullbacks have postbreakout performance that suffers; 16%decline for those with pullbacks versus 22% for those without.• Select EEDTs narrower than the median 43 days. Narrow patternsoutperform wide ones with losses of 20% versus 16%, respectively,after the breakout. In fact, all four combinations of double tops perform better when the pattern is tall or narrow. For EEDTs, tallmeans the height from the tallest peak to the lowest valley betweenthe two peaks divided by the breakout price (the lowest valley). Ifthe result is above the 17.13% median, then you have a tall pattern.Measuring Success
Since measure rule performance for double tops is so poor, I changed itto be half the height subtracted from the breakout price. For EEDTs,prices reach the predicted target 73% of the time.For example, the EEDT shown in Figure 7.8 has a higher right peakat 9.06. The valley low between the peaks is at 7.63. Take half of the difference to get the height (0.72). Subtract the result from the breakoutprice (7.63) to get a target of 6.91. The stock does not hit even this meager target as prices stop declining at 7.20.Case Study
I use double top chart patterns in my trading as sell signals for long positions. When a double top confirms, I know that price is going down, but
Double Tops
149
Bed Bath and Beyond (Retail (Special Lines), NASDAQ, BBBY)10
SoldEve
Eve9
8
7
Bought
6
97
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Jan 98
5
FIGURE 7.8 I bought after a short-term downtrend and just after pricereversed.
how far depends on underlying support. If the market is weak, I’ll sellimmediately. Rarely will I hang onto a stock, knowing that additionallosses are coming. Here’s an example from my notebook about how Iused a double top:7/22/96. I purchased 800 shares at 5.81 today, at the market.Yesterday, I was reviewing my trend channel trades notebookand noticed that MACD forewarned me not to purchaseVarco the first time and to wait on Health ManagementSystems. This indicator parallels the on-balance volume(OBV) & Bollinger band indicators. So, I compared its signalwith Bed Bath and it said buy. OBV & Bollinger bands saidthe purchase was okay, too. Price just bounced off the trendchannel bottom three days ago after hovering there for a while.Although I am late off the channel bottom in buying thestock, I trust it will continue rising. I did not buy earlier because general market conditions were horrible (general downturn), and I believed that the stock would continue down.
150
COMMON PATTERNS FOR THE TOOLBOX
When it turned around, I bought. With its 30% annualgrowth rate in new stores and other fundamental factors, thisstock could be a good holding for the long haul. If they cancontinue store growth with internally generated cash flow, thiswill be a good stock to own. If they get ahead of themselves,then the stock will suffer.Nearly a decade ago, I fell in love with trend channels and did muchresearch on them. Now, I rarely look at them. Your trading style willevolve over time, and you’ll find that you toss off indicators and methodslike spare change into a Salvation Army bucket. OBV and MACD areexamples. I don’t use them anymore because I found that they don’t addvalue to my trading style. I recently added Bollinger bands back into mytoolbox. These indicators are beyond the scope of this book, but I examined prior trades to see what worked and applied the lessons to this trade.That’s important. If you can’t learn from your mistakes, you won’t beable to recognize them when they happen again—that’s a joke.The trend channel I write about in my entryis a channel of two parallel lines, each two standarddeviations away from a centerline which I foundlinearregressionusing linear regression on prices. The problem witha mathematicaltrend channels is locating proper starting and endmethod to fit aing points. By selecting different points, you canstraight line to aseries of nummake the channel look much different (both chanbers; the slope ofnel slope and width).the resulting lineWhen price touches or nears the bottomgives the trend.channel line, it means that the stock is oversold, soit’s a buy signal. I bought soon after prices bouncedoff the bottom, upsloping channel line.I also mentioned checking the general market. I think a weak market is the major reason trades do not work out. Always check the marketand industry trends before trading and learn to predict the future pricedirection of them.I show the buy side (July 22, 1996) in the inset of Figure 7.8 on thedaily scale. But on the weekly scale, the buy is at the bottom of the corrective phase of a measured move up chart pattern, suggesting furthergains. I bought an additional 800 shares at 6.22 on October 31, 1996.I held the stock for over a year. During that time, it moved up justafter I bought then planed out like a speedboat and went horizontal. In
Flags and Pennants
151
early 1997, the stock started to make its move, but I did not get nervousuntil I saw a double top. From my notebook:Sunday, 10/4/97. I placed an order to sell half my holdings atthe market tomorrow (800 shares). Why? A budding doubletop formation. I know that you should wait for confirmation,but the decline to 7.63 from the current 9.06 is just too far towait (16% drop). If the stock continues to rise (fundamentallyspeaking, the prospects are bright), then I still have half myholdings. If it declines to the formation base, at 7.63, or continues down for another 18% (average for a double top reversal), then I’ll have the opportunity to buy more.Figure 7.8 shows where I sold the stock (filled at 8.88), the day afterprices peaked at the second Eve top. For a swing trade, that was a goodcall, but this was a long-term holding. The stock did drop as I predictedand even confirmed the double top (which I consider lucky because theodds of it happening are slim, one in three), but prices soon recoveredand vaulted to new highs—doubling in price.I made $2,400 on the double top trade, or 52%. For the 800 sharesI held onto, I sold them at 15.84 on February 1, 1999, for a profit of$7,650, or 153%. By selling before the double top confirmed, I was saving money in the short term but sacrificing it in the long term. In 2003,the stock reached a high of 45, almost 8 times my 5.81 purchase price.Along the way, the stock did have two spectacular dips of 45% that makepotholes look like dental cavities by comparison, the first just threemonths after I sold.Jake shook his head. “You’re book is still boring. You need a jokeright here.” He jabbed his finger at my computer screen. “If a train station is where a train stops, then what’s a work station?”“There are three types of people in this world, Jake. Those who cancount and those who can’t. I have to get back to work.”
Flags and PennantsFlags and pennants are the workhorses of the swing trader. They appearas black little knots where price movement hangs in the balance, tryingto decide whether to explode upward or plummet to earth. Often, theyare called half-staff formations because they appear midway in the price
COMMON PATTERNS FOR THE TOOLBOX
152
trend—in theory. Unfortunately, price sometimes reverses just to keeptraders guessing, and when the chart patterns do break out in the anticipated direction, they only hit their targets two out of three times at best.Identification
How do you identify a flag or pennant and what’s the difference betweenthe two? Figure 7.9 shows the six varieties. Pennants occupy the top threefigures and flags the bottom three. Pennants have two trendlines thatconverge but flag trendlines are essentially parallel. Both flags and pennants form after fast price moves, either upward or downward, when momentum pauses to catch its breath. The slope of the flag or pennant canbe in any direction, but is usually against the prevailing price trend. Thatmeans if price is falling, the flag or pennant is likely to slope upward.Here is what to look for when trying to identify flags or pennants:• Look for price action bounded by two trendlines. If the trendlines converge, then it’s a pennant. If the trendlines are essentiallyparallel, then it’s a flag.HorizontalPennant
UpslopingPennant
DownslopingPennant
HorizontalFlag
UpslopingFlag
DownslopingFlag
FIGURE 7.9 Pennant price action follows two converging trendlines whileflags have parallel trendlines. Flags and pennants can slope in any directionbut usually form against the prevailing price trend.
Flags and Pennants
153
• Pennants and flags are shorter than three weeks. Patterns longerthan that are channels, rectangles, symmetrical triangles, or wedges(rising or falling).• The flagpole, the price run-up or -down leading to the flag orpennant, should be unusually steep and quick.• Eighty-eight percent have a downward volume trend measuredfrom the flagpole end to the day before the breakout (that is, theflag or pennant portion of the pattern, excluding the flagpole).Trading and Trading Tips
As I was researching flags for this book, I read that a prominentauthor recommends buying before the flag or pennant breakout. Abreakout occurs when price moves above (upward breakout) or below(downward breakout) the flagpole or trendline boundary on the flag orpennant. The case study in this section shows what happens when youfollow that advice and buy before the breakout: You increase your risk ofa loss. For that reason, I recommend you wait for a breakout before placing a trade. My numerous trades in an earnings flag reinforces the waitfor-breakout trading style.Do flags and pennants that slope with the price trend predict improved performance? I researched this and found that the answer is no.Figure 7.9 shows examples of this scenario in the middle picture for eachpattern (“Upsloping” flag or pennant). Contrast the upsloping patternwith the more prevalent downsloping ones (on the right of the figure).Remember, the price trend can also be down—imagine each pictureflipped upside down.I looked at 526 flags and 470 pennants and found that when theflag or pennant slopes in the direction of the prevailing price trend, performance suffers. For example, the postbreakout rise to the trend end ina downsloping pennant in a price uptrend is 24%. Those pennants withupsloping patterns climbed 17%. Flags were closer (20% versus 17%).Thus, select flags or pennants that slope opposite the prevailing price trendfor the best performance.If the flag or pennant appears near the top (upward breakout) orbottom (downward breakout) of a flat base, then expect the move to be alarge one. This also applies to any chart pattern near the breakout from aflat base. A flat base, as you will recall, is when price trades in a horizontal
154
COMMON PATTERNS FOR THE TOOLBOX
(or near horizontal) range for months, bouncing from the high of the rangeto the low. When the breakout from this range occurs, prices often take off.A chart pattern forming just before or just after the breakout are areaswhere price seems to rest, gathering strength before resuming the trend.Some additional trading tips include the following:• This bears repeating: Trade flags and pennants only after pricehas made a sharp, quick move. Figure 7.10 shows an example inthe January flag. Prices shoot up four points in four days.• Pennants are more reliable than flags. In other words, the averagerise after an upward breakout from a pennant is longer than onefrom a flag. That gives you more opportunity to profit from thetrade, even if you are late to the game.• Tight flags and pennants perform better than loose ones. By loose,I mean prices in the flag or pennant that poke outside the trendline boundaries or contain white space and look jagged. Tightflags or pennants are solid blocks of black. Figure 7.10 shows anexample of a loose and tight flag in the inset. Think of loose andtight as the difference between baggy pants and hip huggers. Embrace the huggers and lose the baggies.• Avoid overhead resistance or underlying support. Patterns withthrowbacks or pullbacks have postbreakout performance that suffers. For example, when a flag with an upward breakout has athrowback, prices rise 14% after the breakout. Those withoutthrowbacks climb 26%, on average.• Prices move up more than twice as far after tall patterns thanshort ones. Compute the height from highest peak to lowest valley in the flag or pennant (exclude the flagpole that is the movefrom A to B in Figure 7.10) and then divide the height by thebreakout price. For both flags and pennants, patterns above the6.68% median are tall. That is the difference between B and C inthe figure, divided by C.• Pennants with heavy breakout volume perform substantially better (30% versus 20% average rise postbreakout) than do thosewith breakout volume below the 30-day average. Flags show marginally better performance, 18% versus 16%.• Flags and pennants act as half-staff patterns (the measure rule).Statistics show that the move from the trend start to the top of
Flags and Pennants
155
the flag averages 22% in 15 days, but the move from the flag lowto the trend end measures 23% and takes 19 days. Pennants aresimilar but the rise is 27% in 14 days before the pennant and25% in 23 days after. Because these numbers are averages, do notexpect the flag or pennant to hit the target. Be conservative andchoose a closer target. The next section describes this in detail.• Pennants throw back 47% of the time and pull back 31% of thetime.• Flags throw back 43% and pull back 46% of the time.Measuring Success
Flags and pennants have a measure rule and you already know what it is.Since flags and pennants often appear midway in a price trend, projectprice in the direction of the trend to get a target. For example, the flag inFigure 7.10 has a peak high (B) of 26.50, a low price where the trendstarts of 22.50 (A) for a height of 4. For upward breakouts, the targetwould be the height added to the flag low (C at 25) for a target of 29.Flowserve Corp. (Machinery, NYSE, FLS)
302928
Bought27
B
26
C
25
TrendChannel
24
RecentDip
LooseFlag
A
D
F
Sold
Oct
Nov
Dec
Jan 96
22
21
FD
E
95
23
TightFlagE
Feb
Mar
20
Apr
May
Jun
Jul
19
FIGURE 7.10 This flag unexpectedly broke out downward, creating alosing trade.
COMMON PATTERNS FOR THE TOOLBOX
156
Since the breakout is downward, subtract the height from the high priceat the end of the flag (just above C at 25.50) for a target of 21.50.The inset to Figure 7.10 gives the following measure rule equationsthat might help you understand the measure rule. For downtrendingflags or pennants, use F – (D – E). For uptrending patterns, use F +(E – D). D is the start of the flagpole; E is the end of it; and F is the endopposite the breakout direction.The measure rules work 64% of the time for flags with price trending up, and 60% for pennants, so be conservative in your estimates. Ifprice stalls as it nears the target, assume the move is over and considertaking profits. Using half the height in the target computation will improve your chances of a profitable trade.Case Study
I don’t consider myself a swing trader, so I don’t actively trade flags. I do usethem to project price movement (using the measure rule). Here’s an example of the trouble you can get into when trying to trade a flag. Figure 7.10shows the trade.1/14/96. The stock is forming a flag formation. The measureof this is $4. The flag also happens to be on the bottom of thetrend channel. I am going to buy 400 shares and pray. Ifthe flag succeeds, that should net me about a $1,500 profit. IfI hold for the duration of the channel swing, the profit couldbe $3,000. The stop-loss level, at $22.25, is just below the lowof the recent dip [point A]. I think this might be a better channel play than a flag play.I show the three trend channel lines, the middle of which is the linear regression line of prices. The outer two lines are two standard deviations away from the middle one. Because price was at the bottom of thechannel, it was a good bet that price would rebound to the middle ofthe channel (where it often pauses) before continuing on to the topof the channel. Here’s what my notebook says:1/17/96. I expect to be stopped out of this stock tomorrow asit closed at 22.75 and my stop is for 22.25. There is a lessonhere, and that is, if the formation and your expectations of itsperformance go wrong, sell it. In this case, the flag broke down
Head-and-Shoulders Top
157
on high volume when the stock dropped 75 cents after purchase. I should have sold. Selling would have saved me about$900 (for a $300 loss including commissions). Instead, I willtake a $1,200 loss.1/23/96. I was stopped out of the stock today at $22. I lowered the stop by 1/8 point to 22.13. The decline seems to havecaught me. As I watched the stock each day, it rose in themorning and fell in the last hour (except today: it sank fromthe beginning). It looked to me like manipulation as somemutual fund sold shares in the afternoon forcing the pricedown for whatever reason. Well, I should have sold the stockafter the flag broke down. Instead, I now have a loss of $1,361.Live and learn.The exit on this trade was bad for so many reasons. If a chart pattern doesn’t do as you expect, then sell it and look for another morepromising situation. I even refer to this on January 17, but I did nothingabout it. If you feel that a stop is going to trigger, why not sell now andsave yourself some money? Instead, I lowered the stop—somethingtraders should never do—and lost even more money. I threw away 9%on the trade.
Head-and-Shoulders TopWhen I used to work for Tandy Corporation, I followed its stock dailyand discovered a head-and-shoulders top (HST) standing by itself. It reminded me of a tall English castle surrounded by a moat. The run-up tothe chart pattern was swift and steep and so was the return to the swamp.I liked the pattern so much that I printed it out and pasted it up on myoffice wall. At the time, I had no idea what to look for in a HST, but thepattern intrigued me.Identification
Figure 7.11 shows an excellent example of an HST. Three peaks appear likethe spires of a cathedral, the middle one soars above the other two. TheHST confirms when price closes below the neckline. That’s a problem
COMMON PATTERNS FOR THE TOOLBOX
158
ChevronTexaco (Petroleum (Integrated), NYSE, CVX)47
Head46
LS
45
RS
444342
A
41
Neckline
403938
37
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Jan 01
Feb
Mar
36
FIGURE 7.11 A head-and-shoulders top is a three-peak pattern with themiddle peak towering above the others. The pattern confirms when pricecloses below the neckline.
with steep-sloping necklines like the one shown. Price never closes belowthe neckline and a breakout never occurs. For HSTs with downslopingnecklines, use a close below point A—the lowest armpit—to signal abreakout and confirm the pattern as a valid HST.Here’s a list of characteristics that you should look for when searching for HSTs:• Look for two shoulders flanking a head. The head must towerabove the shoulders.• The shoulders should top out near the same price, but allow variations. Imagine that the HST were your newborn child. Wouldyou want one with lopsided shoulders?• The shoulders should appear similar in shape.• The shoulders should be near the same distance from the head.Symmetry is key.• Volume is higher on the five days (two days before the peak totwo days after) surrounding the left shoulder 43% of the time, onthe head 40% of the time, and 18% on the right shoulder.
Head-and-Shoulders Top
159
• Sixty-three percent have a downward volume trend measured between the shoulder peaks.• The pattern confirms when price closes below an upslopingtrendline or below the lowest valley in the HST for downslopingtrendlines.Trading and Trading Tips
As I was looking at HSTs, I came up with the idea that a high velocity moveleading to the HST seemed to propel prices downward after the breakout.Diamonds often show this behavior—quick declines follow quick rises. I researched velocity and found that when it rose above the median six cents perday, the postbreakout declines averaged 25%. Low velocity rises showedpostbreakout declines of 18%. The test involved 605 HSTs, so the numbersshould be rock solid. However, after a high velocity rise, a pullback is morelikely to occur. It happens 54% of the time in a bull market.I measure the velocity from the trend start to the chart pattern. Usually, you can look at the chart pattern and find where the trend starts, butsometimes not. I use a more rigorous definition (a 20% price change), sosee the Glossary for details on finding where the price trend starts.A short-term rise leading to the HST gives better performance afterthe breakout than intermediate- or long-term ones. I found that HSTswith a short-term rise declined 26% postbreakout; intermediate- andlong-term rises both dropped 19%.Additional trading tips include:• Pullbacks occur 50% of the time.• Patterns with pullbacks have postbreakout performance that suffers—an average decline of 20% postbreakout with pullbacksversus 24% for those without pullbacks. If you want to short astock showing an HST, avoid those with underlying support.• Patterns taller than the 17.27% median height divided by thebreakout price perform better than short ones (24% decline versus 20%). I measure height from the tallest peak to the lowestvalley in the HST. Avoid trading HSTs that are both short andwide (wider than the 49-day median). Prices decline just 17% after the breakout.• HSTs with upsloping volume (as measured between the twoshoulder peaks) tend to perform better postbreakout than dothose with downsloping trends, 24% decline versus 21%.
COMMON PATTERNS FOR THE TOOLBOX
160
• The neckline slopes upward 51% of the time, is flat 4%, andslopes downward 45% of the