jeopardy. This is especially true if the horn appears after a longdowntrend when prices are beginning to move up again (they are retracingsome of their losses). Often the retrace signals a trend change. You will be buying into a situation in which you believe prices will fall and retest the low, butprices will dip slightly then head higher.Be cautious when selling short after a long downtrend and be especiallycautious if the downtrend has ended and the horn seems to mark the end of anupward retrace. Do not expect prices to fall far. They do occasionally but themajority of the decline has already passed.In the Statistics section I point out the interesting result that spikes withvolume below the 2 5-day moving average show substantially lower failure rateswhile keeping the average decline at 21%. That is worth considering beforeyou place a trade.Even if a horn top fails and prices either drop by less than 5% or movedirectly higher, there is a chance that the horn is a premature signal of a bear-
ish trend change. Therefore, whenever youend of an uptrend may be just a few months
Sample Trade
You might be saying, "Those bromides arereally trade it?" Consider the situation inwatched the complex head-and-shoulders fowned. Volume on the far left shoulder waexpected, and volume on the far right shouall, it was setting up to be a dire situationforming on the right shoulder, she knew dieTwo weeks after the right horn spikethe stock for a tidy profit. But she was notshorted the stock at 34'A. Her calculations usand-shoulder formation indicated a declinepredicted by die measure rule because shebreakout point (which was not reached yet sWidi the stock selling at 34, a drop towatched widi glee as die stock plummetedbefore meeting support. Sandy scanned the
Figure 23.5 A horn top appears as part of thand-shoulders formation.
342
Horn Tops
\.'
24
levels and noticed one during October at about 24:/2 and one during June ataround 233/4. Together, these two levels and the round number of 25 probablyspelled a difficult time for the stock to continue lower.When the stock headed back up in late May, she decided to close out herposition at 27. She pocketed about $7 a share in just over 4 months. When shereturned to the chart a year later, she saw that it did descend lower as thehead-and-shoulders formation predicted. During early November, it reacheda low of 20'/8, still well above the calculated 16 target she used and the 12 predicted by the measure rule. The flip side of this is that after she sold the stock,it climbed to 303/4, just 10% below her sell point.
Inside D
RESULTS SNAPSHOTUpside BreakoutsAppearance
A daily price range
Reversal or consolidation
Short term (up to 3
Failure rate
56%
Average rise
13%, with most lik
Surprising findings
Many, for both up24.3 in the Statistic
Downside BreakoutsAppearance
A daily price range
Reversal or consolidation
Short term (up to 3
Failure rate
51%
Average decline
10%, with most lik
Surprising findings
Many, for both up24.3 in the Statistic
This formation had me perplexed for the lostruggling to answer is, how do you measure sumation? The answer seems obvious now, bresearching this chart pattern.
344
Tour and Identification Guidelines
Inside Days
The theory behind the formation says an investor can expect a large pricemove the day after an inside day; that is how I ended up measuring success orfailure. You can see in the Results Snapshot that the performance (the failurerate) is essentially random—near 50%. About half the formations have largeprice moves immediately after an inside day and half do not.Some analysts may argue that if you try to depend on a large move thevery next day, you are subject to disappointment. One must be open-mindedand have patience, a large move will surely come along eventually. Myresponse is, how long should I wait? Two days? A week? A month? When willthe large price move occur?Yes, several of the formations do experience a large price move 2 or more
days after an inside day, others do not. I decided to measure the performanceimprovement when a large move is expected within 2 days. The results? Theupside failure rate improves to 46% (from 56%), whereas downside failuresdecrease to 43 % (from 51%). That is an improvement but still well shy of the20% maximum for reliable formations.If I waited a week for a large price move, there would be even moreimprovement. Of course, waiting a year would show an even larger improvement. So I ask again: How long should I wait? I settled on the more conserva-
tive measure and expect a large price move the next day. You are certainlyfree to continue the analysis for various time periods to see how the patternperforms.
I separated inside days into two types: those with price trends moving
345
Table 24.1Identification Characteristics of Inside DaysCharacteristic
Discussion
Lower high
The daily high must be below the prior daily high. No ties allowed.
Higher low
The daily low must be above the prior daily low. No ties allowed.
Daily range
The daily high cannot equal the daily low. In other words, theremust be some sort of daily price range.
interpret the definition. Some technical analysts allow ties of the daily high orlow, but I do not. I also imposed a further restriction: The inside day needs a
daily price range. In other words, the intraday high and low cannot be the sameprice. There is no real significance to this except for thinly traded stocks.Thinly traded stocks have hundreds of inside days over the 5-year period understudy. It is bad enough that even with the stipulations shown in the table, thenumber of formations is well over 100 for many stocks in the database. In the
Statistics section, I detail how I trimmed die number of formations to a moremanageable level.The many black dots in Figure 24.1 highlight inside days. Although I designate the inside day to be the day with the narrower price range, die chart pattern is really a combination of 2 days. As an example, consider the inside dayhighlighted by die text in die figure (late October).
upward (upside breakouts) and those moving lower after the inside day (downside breakouts). The determination of whether the formation is a reversal or
Alcoa (Aluminum Company of America) (Aluminum, NYSE, AA)
not depends on die trend before and after the formation. Inside days withupside breakouts usually continue the upward, short-term trend, whereas thosewith downside breakouts seem to mark the end of the upward trend (acting asreversals).
The average move is small (13% and 10%) and the most likely gain orloss is less than 5% for each breakout direction. With other types of formations, any move less than 5% classifies as a failure (the so-called 5% failure).However, since the price moves from inside days are usually of small impact
and duration (many post lower lows the day after the inside day only to beginmoving higher; or the reverse: a higher high followed by a downward move).
Thus, the average gain or loss includes the many small moves as well as thelarger ones.
Tour and Identification GuidelinesOct 95
Table 24.1 outlines the identification characteristics and Figure 24.1 showsnumerous examples of inside days. An inside day is so-called because the dailyprice range is inside the range of the prior day. At least, that is how I chose to
Nov
Dec
Jan 96
Feb
Mar
Figure 24.1 Numerous examples of inside days, which are highlighted by theblack dots. The one in late October marked the start of a measured move upformation.
346
Inside Days
The first day of the chart pattern has a high of 50% and a low of 48H. Thefollowing day—the inside day—the range is 50 to 485/s. The inside day has alower high and a higher low than the prior day, and the daily price range is notzero (meaning that the high and low are different values).The primary belief is that there will be a large price move after the insideday. You can see in Figure 24.1 that the day after the chart pattern prices moveup smartly. One could argue that the inside day acts as a reversal of the downward price trend (while the inside day that happens 3 days before is a consolidation of the downward trend—prices continue moving down after the
formation). Prices rise from a close of 491/4 to 54'/8, pause for a week, then continue up to reach a high of 59 !/8 in late November. Astute readers might recognize the price pattern as a measured move up.
Focus on Failures
347
business of making money. Our job is to find formations that make the mostmoney in the shortest possible time, so a time limit in which a formation mustperform also makes sense.Exactly what constitutes a failure (alternatively, what does a large movemean)? As mentioned in the Identification Guidelines section, a failure is whenprices do not move very far the day after an inside day. Figure 24.2 highlightstwo failures. The first failure comes after an inside day in late January. The
inside day has a price range of 15'/4 to 143/4. The following day the range isexactly the same. Clearly, a large price move does not immediately follow theinside day. The second failure is similar in that die daily price range does notchange much from the inside day, nor do prices move very far. Yes, the low is
One has to ask the obvious question and that is, is an inside day a realchart pattern or is it just a name attached to a random event? That is a good
lower than the inside day but by less than 3/i6—not a very compelling move.Contrast the two failures with the move following the inside day in midAugust. Prices gap (a breakaway gap, incidentally) upward and the daily low is
question and one for which I am not sure I have the answer. If you believe
above both the highs of the prior 2 days (which makes up the inside day forma-
in the strict version of the theory, that a large price move follows the dayafter an inside day, then the formation is just a random event. With failurerates over 50%, it is more accurate to say a small price move follows the day afteran inside day.If you are not so strict and simply say that a large price move follows (withno time limit), then the price pattern works out better. This is really no surprise when you consider that we begin with a comparatively narrow pricerange. Eventually we will get either a wide price range or prices will move upor down. The real question is, what does the term large price move mean?I define the term to mean that prices the day after an inside day eitherclimb or descend beyond the high or low posted the day before the inside day(of the 2 -day formation, that is the day with the larger price range). If this doesnot happen, then a wider intraday price range, one that appears to be a multiple of the inside day's range, is also acceptable. If both these conditions are notmet, then the formation is a failure.
tion). This inside day leads to a large price move.What about a formation that is not so obvious? For that I needed toestablish some rules. I consider the formation a success if the day after an insideday has a higher high or lower low than the day before the inside day (and not
by just a little either). In other words, a price trend should develop. If prices fail
Acclaim Entertainment Inc. (Computer Software & Svcs, NASDAQ, AKLM)
Focus on FailuresWhen considering a formation such as an inside day, the normal gauges of failure really does not apply. The notion of a 5 % failure, when prices move less
than 5% in the direction of the breakout, is meaningless when the formationlasts just 2 days and the ultimate move might constitute a higher high or lowerlow the very next day.Instead, I chose to rate the formation on how well it obeys the theory thatprices make a large move the day after an inside day. Why the time limit? Tworeasons really. First, eventually a stock is going to make a large move, so plac-
ing a time limit in which to expect a move makes sense. Second, we are in the
|an 93
Mar
Oct
Figure 24.2 Two failures among the many inside days (black dots). A large pricemove does not follow the two inside days and so they are failures. A breakawaygap appears after the August inside day.
348
Inside Days
to move higher, then a larger intraday price range, one that is a multiple of theinside day, constitutes a winning combination.For example, point A in Figure 24.2 shows what I consider to be a largeprice move after the inside day. The daily low of 14'/2 matches the low of theday before the inside day and the high matches the inside day's high. The pricerange looks like a large price move when compared with the inside day.Perhaps my rules are too strict because the failure rates are abnormallyhigh. In the next section, Statistics, I discuss the numerical results.
Statistics
349
Table 24.2General Statistics for Inside DaysDescription
UpsideBreakout
DownsideBreakout
Number of formations in 52 stocksfrom 1991 to 1996, limited to 10formations per stock
243
277
Reversal or consolidation
151 consolidations,92 reversals
123 consolidations,
Failure rate
137 or 56%
141 or 51%
154 reversals
Statistics
Average rise/decline of successfulformations
13%
10%
Figures 24.1 and 24.2 illustrate one important fact: Inside days are plentiful.They are so numerous that I chose to limit the number of formations I wouldexamine (many stocks have over 100 formations in 5 years). Fortunately, thisformation is easily recognized by the computer with complete accuracy.
Most likely rise/decline
0-5%
0-5%
For successful formations, days toultimate high/low
2 months (65 days)
22 days
Percentage of formations occurringnear 12-month low (L), center (C),or high (H)
L24%, C24%, H52%
LI 7%, C34%, H49%
Percentage gain/loss for each 12month lookback period
L27%, C6%, H11%
L11%, C11%, H8%
Volume day before to day after versus25-day moving average
140%, 83%, 93%
140%, 83%, 93%
Percentage gain/loss for volume1.5x 25-day moving average
10%
13%
Percentage gain/loss for volume0.5x 25-day moving average
22%
9%
Instead of tabulating the performance of just five stocks (for about 500
formations), I chose to spread the selections over many stocks. To do this Ilimited the number of formations to 10 per stock by counting the number offormations in the stock and skipping the appropriate number.For example, if a stock has 20 formations, I tabulate every other formation. A stock with 100 formations means that I use every tenth pattern. Notonly does this technique spread the formations over the 5-year span, but it
enlarges the number of stocks from about 5 to 52. The large number of formations tabulated and the spreading of the formation in both time and across
many stocks ensure that the sample pool is diverse and representative of theperformance of any one formation.I separated the formations into those with prices trending up after the
formation (upside breakouts) and those with trends moving down (downsidebreakouts). An upside breakout means a higher close or a higher high the dayafter the inside day. A downside breakout means a lower close or a lower low.If none of the three (high, low, or close) change, then I examine additional daysuntil a trend determination can be made.Table 24.2 shows performance statistics for inside days. I included 243
formations with upside breakouts and 277 with downside breakouts from 520formations in 52 stocks over 5 years. Formations with upside breakouts usuallyact as consolidations of the short-term upward trend (151 versus 92 reversals),whereas a slight majority of formations with downside breakouts (123 consolidations versus 154 reversals) mark a reversal of the upward trend.The failure rate, which gauges whether there is a large move the day afteran inside day, is 56% and 51% for upside and downside breakouts, respectively. I consider failure rates below 20% to be acceptable, so this is well into
the twilight zone. Thus, it is more accurate to say that most formations makea small move the day after an inside day.The average gain is only 13% and die average loss is 10% for die twobreakout types. This is well below die 40% for upside breakouts and 20% fordownside breakouts that formations commonly share. The reason for this poorshowing is probably because of the way the ultimate high or low is determined.In the case of the ultimate high, die rule is diat when the trend changes, theultimate high is the highest high posted between the formation and die trendchange. Additionally, if prices break out upward dien dip below the formationlow, that truncates die period used (the reverse is true for downside breakouts).With a formation as short as an inside day, there is not much latitudebefore prices move below die formation low. Most other formations have awider price range that allows the stock plenty of room to recover before dropping below the formation low and calling an end to the search for die ultimatehigh. The narrow formation height sometimes penalizes performance.
350
Statistics
Inside Days
Both upside and downside breakouts have likely gains of less than 5%.Figure 24.3 shows a frequency distribution of the gains (formations with upsidebreakouts) and losses (downside breakouts) for the inside day chart pattern.Both upside and downside breakouts have the highest column in the zero to5% range. Almost half (49%) of the formations with downside breakouts havelosses less than 5%. Two-thirds (or more) of the formations have returns lessthan 10%. Such meager returns suggest it is unwise to depend on this formation for any substantial lasting move.Oddly enough, it takes almost three times as long to reach the ultimatehigh after an upside breakout (65 days) than the low in the downside breakout(22 days). A review of die data shows that there are a number of long durationclimbs to the ultimate high. The large numbers unfairly pull the averageupward. Removing all triple-digit durations (of which there are 13) results inan average climb to the ultimate high of just 13 days. A similar computation forthe ultimate low reveals prices reach the low in 1 7 days.Do inside days occur near the yearly high, low, or somewhere in between?A frequency distribution of the closing price to the prior yearly price rangereveals that those formations with upside breakouts occur predominately in theupper third of the price range. A similar situation exists for downside breakoutswith 49% of the formations residing within a third of the yearly high.Mapping the performance onto the yearly price range is only revealingfor upside breakouts. The best performing inside days with upside breakouts
351
are those with closing prices within a third of the yearly low. They have gainsaveraging 27%. The worst performing upside gain is for those with closingprices in the center third of the yearly price range. They have average gains ofjust 6%. Downside breakouts are unexciting, scoring losses within 3% of eachother. The numbers suggest that if you are going to trade inside days, then youmight pay attention to where they occur in the yearly price range. Choose oneswith upside breakouts near the yearly low.The volume pattern is what you would expect. The day before an insideday shows the highest volume at 140% of the 25-day moving average. A highernumber of shares change hands when a large price range occurs as comparedto the inside day when the volume drops to 83% of the average.I looked at the performance for inside days with high and low volume separated by their breakout direction. For inside days with upside breakouts andvolume that is half the 25-day moving average, they score gains of 22%, wellabove those inside days with volume 50% (1.5x) above average. However, thereverse is true for downside breakouts. Inside days with high volume performbetter than those with low volume. Therefore, the breakout direction and volume pattern can be a clue to the performance of inside days.Table 24.3 lists surprising findings for inside days. The failure rateexplains the first finding, that of whether the formation lives up to expectations. The belief is that a large price move follows an inside day. Over half theformations fail to show such a move.The next several table entries determine whether the breakout directionis predictable. Does the closing price the day before the inside day predict thebreakout direction? No. I divided the intraday price range into three parts,25%, 50%, and 25% of the range. Then I tagged in which part the closing priceresides. I looked to see if an upside or downside breakout relates to whether theclosing price is in the top 25% or bottom 25% of the daily price range. Theresults hover around 50%—essentially random.Table 24.3Surprising Results for Inside DaysDescription
Results
Do inside days predict a large price move the next day?
No
Does the closing price of day before inside day predict breakoutdirection?
No
Does the closing price of the inside day predict the breakout direction?
Yes
Does the closing price of the inside day versus prior day predictbreakout direction?
Yes
Do inside days result in larger price ranges the next day?
56% have
larger ranges
Figure 24.3 Frequency distribution of gains and losses for inside days. Bothupside and downside breakouts from inside days have moves typically less than 5%.
The smaller the daily price-range ratio between the day before and theinside day, the larger the rise or decline
N/A
352
Inside Days
I applied the same test to the inside day instead of the day before and theresults change. When the close is within 25% of the daily high, 61% of the formations have upside breakouts. When the close is within 25% of the daily low,60% of the formations break out downward.
Next, I compared the close of the inside day with the prior day's pricerange. When the price of the inside day closes within 25% from the prior day'shigh, an upside breakout occurs 58% of the time. That result is not much better than a random event (50%). However, when the close is within 25% of theprior day's low, a downside breakout occurs 70% of the time. Thus, if you havean inside day that closes near the prior days'1 low, expect a downside breakout.Do inside days result in large price ranges the next day? The averagedaily price range is $1.05 the day before the inside day, then it drops to $0.47during the inside day and climbs to $0.64 a day later. A frequency distribution
of the results says 44% of the days after an inside day have an equal to orsmaller daily price range. Alternatively, 56% have larger daily price ranges.
The last finding in the table deals with the ratio of two daily price ranges.I computed the daily price range the day before the inside day and divided it by
the daily price range of the inside day. Then I compared the ratios with the ultimate gain or loss. A scatter plot of the results indicates that chart patterns withsmaller ratios perform better than those with larger ones. Figure 24.4 shows
Trading Tactics
353
what I mean. Of the two charts, one for upside and one for downside breakouts,the figure shows the more pronounced effects of the two; it is for inside dayswith downside breakouts.At first, Figure 24.4 looks like a random splattering of dots. But, uponreflection, you can see that as the price-range ratio gets smaller, performanceimproves. By this I mean that there are more dots in the lower portion of thegraph extending to the right than in the left portion extending upward. Thegraph for upside breakouts is similar, but the effect is less prominent.Why is this the case? I compare the situation to symmetrical triangles.Those formations are like coils, tightly winding until the spring releases andprices shoot upward or downward in an explosion of activity. An inside day is
just a 2-day triangle.The analysis considers the ratios of the price range for the inside daywith the prior day. What if the real effect is the formation height? Do shorterformations perform better than taller ones? Here the effect is just the reverse.Formations with downside breakouts have a scatter plot that is essentially random with dots all over the chart. However, the chart of upside breakouts showsa slight tendency for shorter formations to perform marginally better thantheir taller counterparts. By shorter formation, I am talking about the height(daily price range from high to low) of the day before the inside day. Using
inside days instead of the day before shows an essentially random relationshipfor both upside and downside breakouts.
Trading TacticsWithout degenerating into a discussion of the random walk and the likelihood
of tomorrow's price being higher is just 50-50, there are scant trading tacticsthat I can offer, certainly not enough to fill a table. If you still need a bromide,then let me say this: If you are going to rely on an inside day to place a trade,then trade in the direction of the trend. Wait for prices to stage a breakout byclosing either above the top or below the bottom of the inside day. If the breakout is upward, then go long; if it is downward, then short the stock, run to your
Figure 24.4 Price range versus ultimate loss. The graph shows the ratio of theprice range the day before to the inside day's range compared with the resultingpercentage decline for downside breakouts. The graph suggests smaller priceratios perform better.
favorite place of worship, and pray!In the Statistics section I briefly mention the next two suggestions. Thebest performing inside days, with upside breakouts, occur in the lowest third of theyearly price range (with gains averaging 27%, well above the 13% average).Downside breakouts show no meaningful performance difference whereverthey break out in the yearly price range. Pay attention to the volume characteristics of inside days. Upside breakouts on low volume and downside breakouts onhigh volume often perform better than other combinations. See Table 24.2 andthe Statistics section for more information.
354
Inside Days
should the stock pierce the up-trendline ahis short.Each day he plotted the stock and watcwhen the stock closed above the trendlinNathan decided it was time to check out. Hfill at 127/id, making him about two grand
snorted.
Figure 24.5 Inside day with a hanging man formation. Nathan successfully position traded this inside day for a $2,000 paper gain. A hanging man formationappears in mid-December.
Sample TradeNathan has a conservative job in the banking industry but in his spare time helikes to take out his aggression by paper trading stocks with the hope of one daybecoming a full-time position trader. When he saw the inside day develop inAirgas, he decided to paper trade it from the short side (see Figure 24.5). Widithe knowledge that the closing price of an inside day might suggest the break-
out direction, he believed that the stock would tumble—or so he hoped. Theday after the inside day, he sold the stock short and received a fill at 14M>.
As predicted, the stock closed lower for the day but quickly retraced itsprogress over the next 3 days. Just as he was about to cover his position and get
out, the stock reversed direction and turned down. Three days later it slippedbelow 13, for a tidy paper gain on his 1,000 shares.
Then, die stock jumped upward (point A on the chart) but Nathan wasnot aware of the sharp move until well into the following day. He drew adown-sloping trendline along the minor daily highs and saw that the up-movehad but just barely pierced the trendline. This signaled a possible trend change.However, when he got a quotation from his broker, the stock was already moving back down.
He flipped a coin and decided to hold on to the position a little longer. Atthe end of the trading day, the stock closed lower, back below the trendline.Realizing that his decision was little more than a crap shoot, he decided that
Tour
25Island Reversals
357
The performance of island reversals is perhaps surprising only for its mediocrity.Failure rates for both tops (13%) and bottoms (17%) is quite good, below the20% threshold that I view as the maximum allowable for reliable formations.For tops, the average decline is a very respectable 21%, but the mostlikely decline is less than 10%. This suggests you would not want to make ahabit of trading this formation. For bottoms, the average rise is 34%, reasonable for bullish formations but still not up to the caliber of other bottomreversals. The most likely rise is less than 20%, about average for bullishformations.Fullbacks and throwbacks are prevalent, suggesting that the gap after theisland completes closes quite quickly. Investors can make use of this behavior
to delay their investments until the pullback or throwback completes and pricesresume their breakout direction.
TourRESULTS SNAPSHOTTopsAppearance
Prices gap up to the formation then gap down at thesame price level, leaving an island.
Reversal or consolidation
Short-term (up to 3 months) bearish reversal
Failure rate
13%
Average decline
21%, with most likely decline less than 10%
Volume trend
Downward
Fullbacks
65%
Percentage meetingpredicted price target
78%
Figure 25.1 shows what island reversals look like. The first island, shown onthe far left, is a one-day reversal. In the study of islands, I did not tabulate suchnarrow formations, but the figure shows an example of a small reversal. Thecenter formation is an island bottom. Prices gap downward in mid-September,reach a new low in early October, then gap upward later in the month. The
BottomsAppearance
Prices gap down to the formation then gap up at thesame price level, leaving an island.
Reversal or consolidation
Short-term (up to 3 months) bullish reversal
Failure rate
17%
Average rise
34%, with most likely rise being 20%
Volume trend
Downward
Throwbacks
70%
Percentage meetingpredicted price target
85%
356
Aug 91
Sep
Figure 25.1 A one-day reversal, island bottom, and island top. You can see theprice change that results after each reversal.
358
Island Reversals
two gaps appear at about the same price level, 11'/2. From that point, pricesclimb quite rapidly and reach a high of 2ll/2, well above the lllA price postedthe day before the breakout. Notice that the breakout is on very high volume.The last island highlighted on the chart is near the top. It is an island top andprices head down from about 20 to less than 8. This formation is a traditionalisland top because of its compact size. I did not count it in my tabulationsbecause the gap on the right is less than the K point I used to filter such formations. Still it does emphasize a trend reversal with excellent timing. Nothighlighted is a very large island top. The island bottom shares the left gap(point A) while the right gap is the large price decline in mid-June (point B).The large island is almost 8 months long.
Identification GuidelinesIsland reversals are easy to identify and Table 25.1 shows the identificationcharacteristics. Both types of reversals, tops and bottoms, are set off by gaps.The first gap is usually an exhaustion gap (or a breakaway gap if the move isstrong enough) and the second one is a breakaway gap