5% in the breakout direction to classify as successful.The average rise or decline is 32% for upside breakouts and 17% fordownside ones. Both figures are a bit shy of the benchmark; a well-performingbullish formation typically scores about 40%, whereas bearish formations
return about 20%. So, not only is the failure rate higher than it should be, theperformance is subpar too.A frequency distribution of the gains and losses gives a better perspective
on what an average investor can expect to earn. Most of the formations havegains of just 5% to 10%. A few larger gains pull the overall average upward.Figure 29.3 shows the results of the frequency distribution for both typesof breakouts. The tallest column represents the gain or loss with the highestfrequency. This turns out to be the first column (up to a 10% return) for both
types of breakouts. Adding the columns with similar breakout directionstogether, we see that 56% of the formations with downside breakouts havelosses less than 15%. Upside breakouts perform marginally better with 52% ofthe formations having returns of 20% or less. In essence, your chances of having a poorly performing formation is comparatively high.
411
For successful formations, it takes 4 months (120 days) to reach the ultimate high and 49 days to reach the ultimate low, on average, for upside anddownside breakouts. That sounds about right. It takes upside breakouts abouttwice as long to travel twice as far.
Where in the yearly price range do outside days occur? Those with upsidebreakouts usually occur within a third of the yearly high. This is also true fordownside breakouts, but the range is closer to a third for each. Mapping performance over the three ranges, we discover the best performing outside daysare those with breakouts within a third of the yearly low. They have gains
averaging 49%. Downside breakouts are more evenly split, but the center thirdof the yearly price range performs best with losses averaging 20%.A review of the volume statistics turns up no surprises. The day before theoutside day scores 86% of the 25-day volume moving average. The outside dayshows slightly higher volume, 112 % of the average, and the following day registers 115%. I did not separate the volume statistics according to breakoutdirection.Do outside days showing a large number of shares traded mean a morepowerful move? Yes, and no. Formations with upside breakouts having volume
over 1.5 times the 25-day moving average (that is, at least 50% above normal)show gains of 37%, above the 32% registered for all formations with upsidebreakouts. Downside breakouts are similar, with losses of 18% versus 17%after ignoring volume.In comparison, low volume shows a different trend. Upside breakoutsperform worse (with a 29% gain) but downside breakouts perform better,
with losses of 20%. For this test, formations with volume levels 50% belowaverage qualify.
Table 29.3 shows some surprising results for outside days. Does the closing price the day before the outside day predict the eventual breakout direction? Yes, and no. I divided the daily price range into three segments, the
upper and lower segments representing 2 5 % of the price range with the center section representing 50%. Then I compared the closing price in the upperor lower segments with the breakout direction. When the stock closes within
2 5 % of the daily high the day before the outside day, the stock shows an upsidebreakout 46% of the time—less than correctly selecting the side of a coin flip.However, when the price closes within 2 5 % of the daily low, an upside break-
30
35
Percentage Gain/Loss•
Figure 29.3
Cains
D Losses
Frequency distribution of gains and losses for outside days. The
tallest column shows the most likely return, the one with the highest frequency,and it is 10% for both gains and losses.
out occurs 61 % of the time. I admit that this is a strange result, but that is whatthe statistics show. By the way, this is for all formations, even those with 5%failures, not just those with successful breakouts.Does the closing price of the outside day predict the breakout direction?Using the same methodology, an upside breakout when the outside day's closeis within 25% of the daily high predicts correctly 66% of the time. Similarly, a
downside breakout when prices are within 2 5 % of the daily low is correct 62 %of die time.
412
Outside Days
Trading Tactics
413
Table 29.3Surprising Results for Outside DaysDescription
Results
Does closing price of day before outside day predictbreakout direction?
Maybe
Does the closing price of the outside day predict thebreakout direction?
Yes
Does closing price of outside day versus prior daypredict breakout direction?
Yes
Do outside days result in larger price ranges thenext day?
17% have larger price ranges
The smaller the daily price-range ratio betweenthe day before and the outside day, the largerthe rise or decline.
Result is random
Shorter formations are more powerful.
True, for upside breakouts only
Does the closing price of the outside day versus the prior day predict thebreakout direction? This is a bit confusing so let me explain. I divided the daybefore the outside day into three sections: 25%, 50%, and 25% of the dailyprice range. Then I compared the closing price of the outside day with thosethree sections. When the outside day's closing price is higher than 25% fromthe daily high of the prior day, then an upside breakout correctly signals 65%of the time. Similarly, a downside breakout happens 62% of the time. I do notattach any cosmic importance to this finding simply because the outside day iswider than the prior day, so a close 25% from the prior day's high (low) orhigher (lower) is comparatively easy to reach.Of the three findings, I place the most importance on the belief that theclose of the outside day predicts the breakout direction. If the close of the outside dayis within 25% of the daily high or low, then prices are likely to move higher(upside breakout) or lower (downside breakout), respectively.Do outside days result in larger price ranges the next day? No. Only 17%of the formations show a wider price range the day after an outside day. Thisis really no surprise since an outside day by definition is a wide animal, so it isonly natural that the daily price range narrows somewhat the next day.With inside days, there appears to be a relationship between the daily pricerange of the 2-day formation with the ultimate gain or loss. Smaller daily pricerange ratios perform better than larger ones. With outside days there appearsto be no such relationship. A scatter plot of the results shows the relationshipto be random.The last surprising finding is that smaller formations appear to be morepowerful. Figure 29.4 shows the relationship. I computed the height (the difference between the intraday high and low) for the outside day and drew a scat-
Figure 29.4 Scatter plot of daily price range versus percentage gain. Shorter formations perform better by scoring larger gains. This applies to upside breakoutsonly.
ter plot of the range with the resulting percentage gain (for upside breakoutsonly). The chart shows that shorter formations have larger price gains. Forexample, the highest gain from a formation with a daily price range over $2 isless than 75%, while the best gain for formations under $2 is over 350%. Manycomparatively short formations have gains over 100%.As you look at the figure, you can count the number of dots over 100%.There are 20. There are 185 short formations (meaning a daily range of lessthan $2) with upside breakouts, so the chances of any given short formationscoring an outsized gain is small—about 11 % (that is, 20/185). If your outsideday has a price range of just $0.50, then the likelihood of showing a gain over50% is about one in three (33%). That is not bad, but the bottom line is: Don'thold your breath. The relationship for formations with downside breakouts israndom.
Trading TacticsThere are few trading tactics for outside days, so I do not present them in tableform. The first real question you need to answer is if you want to trade this formation at all. Almost half the formations (42%) with downside breakouts fail.Upside breakouts perform better (25% failure rate), but they still fall short of
414
Outside Days
V ;
Sample Trade
415
the benchmark 20% maximum for reliable formations. Do you really want totrade this one?
If the answer is still yes, then stick to outside days with upside breakouts.Remember that a closing price within the top 25% of the daily price range during the outside day correctly predicts an upside breakout two out of three times(but does not address the failure rate, so be careful). If the outside day happensto have a narrow daily price range, say less than $0.50, that is also an advantage.Shorter formations with upside breakouts perform better. Justin's trade in theSample Trade section also poses additional ideas.
Sample TradeJustin is a successful doctor. When he is not seeing patients, he toys with newinvestment techniques both on paper and in real-time. After reviewing theoutside day formation, he derived five rules that the formation had to meetbefore he would invest in it.1. The formation must have an upside breakout. This is due primarily to
the poor showing of downside breakouts coupled with the largergains possible with upside breakouts (32% gain versus 17%).
Oct 92
Nov
Dec
Jan 93
Feb
Mar
Apr
May
Jun
jul
Figure 29.5 Outside day with upside breakout Justin bought the stock after theoutside day appeared and broke out upward. He more than doubled his money.The day he bought was an inside day.
2. The formation must be near the yearly low. Outside days within a third
of the yearly low handily outperform (49% average gain versus 32%)the other two ranges (center third and highest third).3. The outside day must have volume 50% above the moving average. Highvolume outside days score larger gains (37% versus 29%) than lowvolume outside days.4. The daily close must be within 25% of the daily high. This suggests an
upside breakout that, in turn, suggests prices will climb.5. The daily price range must be less than or equal to fifty cents. Outside dayswith a narrow price range perform better than those with a very widedaily range.Justin knew that it was only a matter of time before the formationappeared in a stock he was familiar with and that met his five rules. He was notgoing to chase the formation and search for it in stocks he did not know. Inearly November, the formation finally appeared in a stock he followed (Figure29.5).Working the five rules backward, the outside day has a daily price rangeof $0.32 (17.13 - 16.81), well outside the prior day's high (17) and low (16.94).This satisfies rule five. The stock closed at the daily high, meeting conditionfour. Number three passes as well since the 25-day volume moving average (up
to, but not including the outside day), is about 95,400 shares, whereas the vol-
ume during the outside day is 273,600 shares. This is well above the 50% minimum (that is, 50% above the moving average or 143,100 shares). Theformation must be near the yearly low, rule two says. The yearly high up to this
point is 21.31 and the low is 15'/8. The close, at 17.13, just slips beneath the17.19 level that marks the lowest third of the yearly price range. The first rulesays that the formation must have an upside breakout.
All Justin could do at this point was wait. While waiting, he plotted thestock quotation each day and 2 days later, another outside day appeared. This
did not seem to contradict his analysis so he ignored it and waited for a clearbreakout signal. He received the signal when prices moved above the outsideday's high and closed there. The following day, he bought the stock at I7l/i, thelow for the day. When he checked in with his broker, he recognized the newchart pattern as an inside day and hoped that this meant the stock would continue higher. Eventually, that is just what happened.Since Justin is a long-term investor and believed in the fundamentals of thecompany, he saw no reason to take profits anytime soon. There were bumpsalong the way, sure, but as a buy-and-holder, he was unconcerned. On theweekly chart, he drew up-sloping trendlines, then had to redraw them as thestock climbed even faster in 1995. Then prices pierced the upward trendline,
416
Outside Days
V-'
30
moving down. To Justin, this was a big negative and coupled with some changesat the company of which he disapproved, he decided to sell. In late January1996, he sold the stock at 41, below the daily high of 42 but well up from thedaily low of l&A. He more that doubled his money on the trade even though ittook just over 3 years to do it.Justin was early. If he had held onto the stock for 4 more months, hecould have sold at 66. Of course, a month after that the stock was down to 45.
Pipe Bottoms
RESULTS SNAPSHOTAppearance
Two adjacent, downward price spikes on the weeklychart
Reversal or consolidation
Long-term (over 6 months) bullish reversal
Failure rate
12%
Average rise
47%, with most likely rise being 20%
Surprising findings
See Table 3 0.3
See also
Horn Bottoms
After researching the performance of horn tops and bottoms, the natural thingto do is to remove the intervening week and test the pattern again. That iswhere the pipe formation comes from. Pipes bottoms are an exciting discoverywith a low failure rate (12%) and a high average rise (47%).I conducted an in-depth study of pipe bottoms on daily price charts and
came up disappointed. The statistics show that daily pipes have a failure rate of18% with an average gain of 33%. Both numbers are respectable but whatreally bothers me is the most likely gain, which is just 10%. Almost half the formations (45%) have gains less than 20%. However, there are a number of large
gains; almost a quarter of the formations (23%) have gains over 50%.I began to believe that an investor trading daily pipes would either pick aformation that fails or one that has such a small gain as to be unprofitable, so I
417
418
v
Pipe Bottoms
Identification Guidelines
-'
discarded the research and looked at the weekly chart. As you can see from thepreceding numbers, the performance is quite good. Even the most likely riseholds up well, being 20% (but it can range from 10% to 40% almost equally).Almost 40% of the formations have gains over 50%. Not only is this formationworth exploring further, it just might be an outstanding performer worthadding to your technical toolbox.
419
Identification GuidelinesHow do you correctly identify pipe bottoms? Table 30.1 outlines the identification characteristics. Although there are a number of guidelines to consider,
they are really quite obvious. Consider the pipe shown in Figure 30.2. The firstguideline suggests that you use weekly charts. Although pipes appear on dailycharts, they do not perform as well as pipes on weekly charts. Two, adjacent
downward price spikes compose the pipe bottom, and it looks like two parallel
Tour
lines on the chart. The price difference from the left low to the right low is
Figure 30.1 shows a pipe formation and the price appreciation that results. Thechart is on the weekly scale and you can see that prices begin dropping in midOctober, 1993, down to the pipe pattern. Prices make a straight-line rundownward from a high of 2 9 to the left pipe low of 2 0 l/i. Volume picks up during the left pipe spike and is even higher the following week. The two downward price spikes, of almost equal length and overlapping, mark a turningpoint, a signal that the decline is over.
minimal. A significant number of formations (414 or 94%) have low-to-lowprice differences of $.25 or less. Figure 30.2 shows no difference in the twopipe lows.
The pipe spikes should appear as a large price drop and wide price rangefor 2 weeks in a row. The week before and after the pipe should have low pricesnear the top of the pipe. This makes the pipe stand out on the price chart as aneasily recognizable formation. For example, the pipe shown in Figure 30.2 hasa prior week low of 1 !5/g, somewhat near the left pipe high of 129/i6 (certainly
From the low, prices move up smartly and reach a new high of 447/g in
early November, which is a climb of almost 120% in just 9 months. For thisformation, such large gains are not unusual. Almost 20% of the pipes have
Table 30.1Identification Characteristics of Pipe Bottoms
gains over 90%.
Ann Taylor (Retail (Special Lines), NYSE, ANN)
O
N
Figure 30.1 A pipe bottom on the weekly chart. Pipes commonly form after aretrace in an uptrend or at the bottom of a prolonged downtrend.
Characteristic
Discussion
Weekly chart
Pipe bottoms on the daily price chart exist, but pipeson the weekly charts perform better. Use the weeklychart.
Two downward adjacent spikes
Locate two downward price spikes that are next toeach other.
Low-to-low price variation
The price difference between the two lows of the pipeis small, about $0.25 or less, but you should allowmore variation for higher priced stocks.
Large spikes
Prices should spike down unusually far during the 2weeks, more than most downward spikes during theyear. The pipe stands alone as the prior week and thefollowing week have low prices that are near the pipehighs.
Large overlap
The 2 weeks composing the pipe should have a largeprice overlap between them.
High volume
Not a prerequisite, but most pipes show aboveaverage volume on at least one or both spikes.
Obvious pipe
The pipe should be obvious on the chart. If it doesnot stick out like a sore thumb, then you should lookelsewhere. The best performing pipes appear at theend of downtrends.
420
Pipe Bottoms
Focus on FailuresConseco Inc. (Insurance (Life), NYSE, CNC)
421
prices resume their downward trend. This particular formation just clears the5% failure cut with a gain of 5.5% (as measured from the average of the high
and low price the week following the right pipe to the ultimate high, whichhappens to be the same day in this case).
Focus on FailuresPipes do not have a breakout point, thus there are no upside breakout failures.With pipe bottoms, there is only the 5% failure. A 5% failure is when prices do
not move higher by more than 5% before reversing the trend. Figure 30.3shows two such failures. The two pipes in April and May show good definition.They look like pipes, but they do not act like pipes. After the pipes complete,
prices should move up smartly, but they head lower instead. Why? Volume onthe left spike of both pipes is below the 25-day moving average of the volume.O
N
D
92
F
N
D
93
F
M
A
M
Figure 30.2 Another example of a pipe bottom on the weekly chart. Point A isanother pipe bottom with less spectacular results.
well above the low of 105/i<;). The right side does even better. It sports a low of12'/4, near the right pipe high of IZH.The spike decline should be unusual. The length should be well above the
However, the right side shows higher than average volume in both formations.Still, the volume pattern is unconvincing, as it usually appears most brisk at
pipe bottoms. As a contrast, look at die pipe on the far left side of the chart.Both spikes show volume that is well above average.Perhaps the best clue to the failures lies buried in die guidelines outlinedin Table 30.1. Prices should drop unusually far during the 2 weeks, more thanAtlantic Richfield Co. (Petroleum (Integrated), NYSE, ARC)
average downward spike length over the past year. It must appear as a large
decline on the price chart, not just another 2-week blip in a sea of long downward price spikes. The pipe has a large price overlap. This is clear in Figure30.2 as the left side of the pipe is just slightly taller than the right side. As aselection guideline, what you do not want to see is a large left side and a shortright side.The volume for the week of each pipe spike is usually above average butneed not be. Pipes with above average left volume and below average right vol-
ume perform better than all other combinations. However, I would notexclude a pipe simply because it does not obey the volume characteristics.The last guideline is perhaps a summation of all others. The pipe must beunusual enough to jump out of the price chart. Usually, this is because pipesform at the end of a decline and mark the turning point, such as that shown inFigures 30.1 and 30.2. Less frequently, pipes act as a consolidation of the
upward trend. They spike downward for 2 weeks, then prices continue rising.If you look closely at Figure 30.2, you should be able to see another pipe.I have made it easy for you by marking it as point A. The pipe is not quite as
well defined as the other pipe and the price appreciation is certainly not asspectacular. Prices rise from the right pipe low of 15;/s to a high of 18J/8 before
A S O N D 9 3 F M A M J J
Figure 30.3 Pipe bottom failures. Clues to these two pipe failures are in the spikelengths and volume trend. The best performing pipes form when prices are trending down.
422
Pipe Bottoms
Statistics
most downward price thrusts during the year. As you look at the chart, you can see
Table 30.2
several downward, 1-week spikes (December and February, for example) thatnearly equal the length of die two pipe formations. The entire chart seemsfilled with ragged price spikes of varying lengths. For this reason, you shouldbe skeptical of investing hi these two pipes.Incidentally, before we leave Figure 30.3, it is a good time to illustrate asomewhat common feature of pipes. Since pipes often appear at the end of adownward price trend, prices sometimes rise up, loop around, and retest thelow. The pipe in early December 1991 is an example. Prices top out at 124H(not shown) in late October then plunge downward. In just 6 weeks they reachthe pipe low of 99'/s. Prices bounce upward, round over, and fall back on themselves, forming a new low at 98'/s. The retest of the original low completes inlate March.Pipe bottoms seem to exhibit support at their lows. Rarely do prices dropmore than Vi point or so below the pipe low before recovering and beginningan extended upward trend. The !/2 point is not an absolute rule as it depends onthe price of the stock (the one shown in the chart is a $100 stock and it drops
General Statistics for Pipe Bottoms
$1 below the prior low).
So even though you may buy into a stock above the top of the pipe andwatch prices fall, hold on. Do not sell until prices drift below the pipe low. Idiscuss trading tactics later in this chapter.You might ask why the March 1992 low is not a pipe formation. The reason is the same as the one cited earlier. The downward price spikes do notdescend far enough to differentiate them from normal price behavior. Thetwo downward price thrusts are not obvious enough to qualify them as a pipe(and the volume is weak too).
Description
423
Statistic
Number of formations in 200 stocks from
1991 to 1996
442
Reversal or consolidationFailure rate
179 consolidations, 263 reversals52 or 12%
Average rise of successful formations
47%
Most likely rise
20%
Left pipe volume versus 25-day moving average
130%
Right pipe volume versus 25-day moving average
117%
For successful formations, days to ultimate high
9.5 months (296 days)
highest frequency, followed by 30% and 40%. Thus, you might believe thatthe 20% column represents the most likely gain. You can see from the charthow the tall right column, with gains over 90%, pulls the average upward. Ifyou sum the values over 50%, you discover that 39% of the formations havegains over 50%. That is quite good.The left and right pipe volume numbers are 130% and 117%, respectively, of the 25-day volume moving average. These values emphasize that volume is higher on the left spike and diminished on the right spike but still aboveaverage.
StatisticsTable 30.2 shows general statistics for pipe bottoms. These formations are soplentiful (442) that I stopped searching at 200 stocks. Most of the formationsare reversals (60%), whereas the remainder are consolidations of the prevailingtrend. The failure rate at 12% is quite good. I consider values below 20% to bereliable. The 52 formations that fail are of the 5% failure variety, that is, pricesfail to continue rising by more than 5% before the trend reverses.The average rise at 47% is exceptionally high. As a conservative measure,I averaged the high and low price the week after the right pipe spike and usedit as the base in computations to the ultimate high. This assumes an investorbuys sometime during the week after the pipe and receives a fill in the middleof the weekly price range.I use a frequency distribution of gains to find the most likely rise (see Figure 30.4). If you ignore the rightmost column for a moment, the figure showsthat the first four columns are almost the same. The 20% column has the
90
>90
Figure 30.4 Frequency distribution of gains for pipe bottoms. The most likelygain is 20%, but it may be pulled higher by the tall right column.
424
Pipe Bottoms
The time from the right pipe spike to the ultimate high is long, almost 10months. This follows what we have seen in other formations. Small gains complete quickly but an average rise of 47% takes time.Table 30.3 shows a number of unusual results for weekly pipe bottoms. Idid not use any of the ideas presented in the table while searching for pipe bottoms. The reason is that I did not want to fit the results to the data. So, Ilocated the formations then found what parameters worked best (I verified theresults in out-of-sample tests).The benchmark is a 47% gain, measured from the average of the high andlow prices the week after a weekly pipe bottom to the ultimate high. The gainassumes you buy the stock sometime during the week after seeing a pipe andsell just before a major trend reversal. Changing the starting point to the rightpipe low boosts the average gain to an amazing 60% and expands the mostlikely gain to a range between 20% and 50%.Most pipe bottoms, by choice, have little or no difference between thelow prices composing each spike of the pipe. I divided the results into thosethat have a difference between the two lows and those that do not. Pipe bottoms with a price difference have a 49% gain, whereas those with no differenceshow gains averaging 43%.Table 30.3Surprising Results for Pipe BottomsDescriptionBenchmarkRise for pipes with price difference between lowsRise for pipes with no price difference between lows
__
Average Rise
Failure Rate
474943
12
Percentage that lower left (L) pipes work better thanlower right (R) pipes
L50, R47
Right pipe as inside week
50
Percentage of high volume left (L) pipes, right (R)pipes, both (B) pipes that score better
LSI, R47, B51
Percentage of low volume left (L) pipes, right (R)pipes, both (B) pipes that score better
L42, R47, B44
High left pipe volume, low right pipe volume
53
High right pipe volume, low left pipe volume
40
Linear regression price trend: 3 months up
41
Linear regression price trend: 3 months down
51
28
Large price spike (5x average)
58, 33 samples
Large price spike (4x average)
55, 62 samples
1211
High volume left spike, low volume right spike,down-sloping 3-month price trends
52, 28 samples
25
Since a pipe with an unevenlower left or right side? It turnssuperior gains at 50% versus 47%high price? I did not do a thorougexamine how an inside week perfois below the prior high and the lorange is inside the prior week's rait scores a gain of 50%.How does volume play intoof three categories: volume on thon both sides. High volume onaccompanying pipes with gains aegories show that the performanright side, scoring a 47% rise.Knowing that the left side wvolume score best, how does dscores an average gain of 53%,unfortunate to locate a pipe witvolume and high right), then theWhen searching for this forof a downward price retrace, soindeed the case. I measured theing prices for the 3 months leupward, the average gain is a palter with gains averaging 51%. Tafter prices have been moving dotion is signaling a climactic endupward and score outsized gainsLastly, I observed that largsured the average spike lengthadjacent 3-week period. If the cence from the low to the lowessuring the smallest difference inadded the difference to all the oage. Then, I compared this averthe pipe spike is at least five timis 58%, but there are only 33 fortiple to four times the average ltions make the grade.Lest you try to read too mwhile the average percentage gTable 30.3 shows some of thesured). For example, if you com
426
Sample Trade
Pipe Bottoms
a downward price trend over 3 months, you discover an average gain of 51%for pipes showing those characteristics (only 28 formations qualify) but the failure rate zooms to 25%, above the 20% maximum failure rate for which I consider a formation reliable.
Trading TacticsTable 30.4 lists pipe trading tactics. Perhaps the most critical feature of a pipebottom is what happens in the third week. While you can easily spot two adjacent downward price spikes, toss the formation aside if prices do not rise thethird week. The third week, the week following the second pipe spike, shouldleave a well-defined dual spike visible on the price chart. The 4-week pair(which includes the weeks before and after the pipe) is V-shaped and is evenmore clear when combined with a downward price trend.As mentioned in Table 30.4, a downward price trend is usually where youwill see these formations, at least the best performing ones. Prices move down,reach the pipe bottom, then turn around and start climbing. Figures 30.1 and30.2 are good examples of this behavior.Once you have identified a pipe bottom on the weekly