declines often follow quick rises, and you can see how price slid like a caron ice, giving back all of the gains from the two-day rise.Expecting a short-term trend change, I sold the stock at 13, pocketing$19,500 for a net gain of over $5,000 or about 35%, including dividends.
Descending Broadening WedgeFigure 7.2 shows the next type of broadening pattern, a descendingbroadening wedge (DBW). It’s similar to the ascending variety that I discussed in Chapter 6, but this one has trendlines pointing downward.
Texas Industries (Cement & Aggregates, NYSE, TXI)
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FIGURE 7.2 A descending broadening wedge led the way to riches butonly for a few weeks before a bull trap became clear.
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Identification
The following tips identify a descending broadening wedge:• Look for two downsloping trendlines that broaden out—a megaphone tilted down.• Price should touch each trendline at least twice.• Price should cross the pattern from trendline to trendline.• Volume trends upward 66% of the time.Trading and Trading Tips
I found 47 DBWs with downward breakouts and 270 with upwardbreakouts in a bull market. Since downward breakouts are so rare, I onlydiscuss those with upward breakouts.Research from the second edition of my Encyclopedia of Chart Patterns (John Wiley & Sons, 2005) reveals that you should avoid tradingDBWs that are both short and wide. By short, I mean the measure from thehighest peak to the lowest valley in the chart pattern divided by the breakout price. Patterns both shorter than the median 21.77% in a bull marketand wider than the median 52 days perform substantially worse than theother combinations of height and width. The average rise for short andwide patterns is 22%, but tall and narrow patterns showed prices climbingan average of 49% postbreakout. Keep that in mind the next time you aresalivating over a descending broadening wedge. Choose wisely.• For swing traders, trade between the trendlines. The best profitcomes from the short side with this pattern because both trendlines slope downward. Short at the top trendline and cover whenprice bounces off the lower one.• The best postbreakout gains (39% average rise) come after anintermediate-term rise leading to the DBW, followed by the longterm (35% rise) and short term (33% rise).• Sixty percent have breakouts above the 30-day average volume andprices climb 38% postbreakout. Light breakout volume showsworse performance with rises averaging 28%.• Volume trends downward 34% of the time and those patternsshow postbreakout rises averaging 35%. DBWs with upward volume trends average 33% rises postbreakout.
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• A partial decline correctly predicts an upward breakout 87% ofthe time.• Prices throw back 53% of the time. Throwbacks hurt postbreakout performance (37% average rise postbreakout versus 30%without throwbacks).• The median height divided by the breakout price is 21.77%. TallDBWs perform much better than short ones, with rises of 43%versus 26% respectively.Measuring Success
Use the measure rule to set a price target. For DBWs, the target is the topof the pattern (point E in Figure 7.2). Price reaches the measure rule target 79% of the time, so be conservative in your estimates, especially fortall patterns.Case Study
In a study I unearthed 464 DBWs and found that 79% broke out upward. So I decided to trade on that. Here’s my notebook entry for thetrade shown in Figure 7.2, during March:3/8/00. I bought 400 shares at market this morning after thestock inched up from its low of 29.88. Filled at 30.06. In 10days or so, the company will announce earnings. I thinkthis will be stronger than expected because steel sales in thefourth quarter of 1999 improved, and I expect cement trendsto be heavy as well. Looking forward, the economy may slowand this will hurt the company, as the Federal Reserve is intenton raising interest rates. Still, I expect this stock to recoversomewhat, maybe completing a head-and-shoulders complextop. That’s the time to get out. The target price for the MMDis 29.50.The measured move down (MMD) is a stair-step pattern from A toD with the corrective phase B to C. In well-behaved patterns, the declinefrom C to D matches the drop from A to B. After reaching D, pricesoften return to the corrective phase as they did at E.
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An earnings announcement sent prices gapping upward at E. BecauseI called this perfectly, it would have made a good swing trade: Buy where Idid and sell on the earnings news. Did I sell? No. I held on expecting priceto climb back to 39 or 40, forming another shoulder of a complex headand-shoulders top (not shown). Picture a head-and-shoulders chart patternin your mind and add additional shoulders for the complex variety. Complex patterns are rare, and I should not have bet on one happening.In August, I bought more. Here’s my notebook entry for that purchase:8/3/00. I bought 300 shares at 33.0625 this morning. Reasonsfor purchase: It has made an upward breakout, on weak volume, from a descending broadening formation. The FederalReserve is going to impose antidumping penalties as high as95.29% on imports of certain types of coated-steel sheet. Thismay help the company. After reviewing statistics in my book,Encyclopedia of Chart Patterns, for descending broadeningwedges, it looks like a good trade. Upside is 36, downside is30, evenly split from 33. I think this will continue movinghigher, maybe to the old high at 43.38.The dreaming almost turned into a disaster as prices rounded overin a bull trap. That is when price breaks out upward and bullish tradersjump into the stock. Everyone that wanted to buy the stock already has,so there is little buying demand to send the stock higher. Price drops,trapping bullish traders into a losing position. You see this on the chartsas a curling action after a trendline break. If this happens to you, sell immediately and if you are an experienced trader, short the stock.Here’s how I handled it according to my notebook: “8/23/00. I sold700 at 33.56. I think the stock is heading down as it is following theother stocks moving down. All are off their peaks by 1.50 to 2.50 points,and I don’t see a turnaround.”On the two trades, I made 7% or over $1,500, including a dividend. That is not bad considering the massive loss I could have sufferedhad I not chewed off my leg and freed myself from the bull trap. Thestock bottomed at 20.88 for a decline of 38% from where I sold.Before we move onto the next pattern, look at the failed partial rise.A partial rise signals an impending downward breakout. The signal failswhen price bounces off the bottom trendline instead of punching
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through. In a study of 270 patterns, a partial rise failure occurs 10% ofthe time. Just remember, the probability is not zero.
Right-Angled Broadening Formations,Ascending and DescendingFigure 7.3 shows two right-angled broadening formations, one is ascending (RABFA) and the other is descending (RABFD). Notice that one ofthe trendlines is horizontal and the other slopes away, forming a broadening pattern.A partial rise or decline at the end of the pattern predicts an immediate breakout when price returns to the trendline. Partial rises and declines are early trading signals that I’ll discuss in a moment.Identification
Look for the following in the ascending variety of broadening patterns:• The top trendline slopes upward (ascends).• The bottom trendline is horizontal.Hughes Supply Inc. (Retail Building Supply, NYSE, HUG)
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RABFA
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Bought14
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FIGURE 7.3 The figure shows a right-angled broadening formation ascending (RABFA) and descending (RABFD) along with a broadening top (BT).
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• Prices broaden out over time.• Prices should near or touch each trendline at least twice to assurea properly selected broadening pattern.• Patterns with upward breakouts have volume that trends upward51% of the time. Downward breakouts have upward volumetrends 55% of the time.The following are identification guidelines for the descendingbroadening pattern. Many are the same as in the ascending variety.• The bottom trendline declines (descends).• The top trendline is horizontal.• Prices broaden out over time.• Prices should near or touch each trendline at least twice to assurea properly selected broadening pattern.• Patterns with upward breakouts have volume that trends upward54% of the time. Downward breakouts have upward volumetrends 59% of the time.Trading and Trading Tips
In the inset to Figure 7.3, I show a broadening top (BT) with a downwardbreakout. Price enters the chart pattern from the bottom, hence the topcharacterization. The broadening top precedes a descending right-angledbroadening formation in this example.The RABFD pattern is typical except for the partial decline. Pricesleave the top trendline and head lower but do not touch or come close tothe bottom trendline before curling upward and soaring out the patterntop. A partial decline correctly predicts an upward breakout from anRABFD 87% of the time in a bull market.When looking for a partial rise or decline, be sure the RABFA orRABFD pattern is established—the pattern must meet all of the identification guidelines. Also, the partial rise or decline never occurs after thebreakout.One way to verify a partial decline is to use a Fibonacci retrace ofthe prior up move. If price turns about 62% of the way down to thelower trendline, then assume it is a partial decline and buy. Pauses at38% and 50% are also effective, but more risky, as price could continuelower instead.
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The RABFA pattern shows a partial rise, and Bought points to itin Figure 7.3. A partial rise is when price touches the bottom trendlineand begins moving up before curling over and heading down. In wellbehaved patterns, a downward breakout follows 74% of the time, likethat shown here.For both RABFAs and RABFDs, try buying into the stock whenprice touches the bottom trendline for the third time and begins climbing. If a partial rise occurs or if price closes below the lower trendline,then sell immediately.Watch for price to stall at the top trendline, but you might get luckyand have an upward breakout.Consider these additional trading tips for RABFAs:• Sixty-six percent breakout downward, so this is a bearish pattern.• The best postbreakout gains (30% average rise) come after a shortterm rise leading to the pattern, followed by the intermediate-term(29%) and the long-term (26%) rises.• The samples are few for intermediate and long term, so do not relyon the numbers being solid. Downward breakouts show declinesaveraging 20%, 11%, and 12%, respectively, for the three terms.• Those with upward breakouts near the yearly high perform best(31% average rise, postbreakout), and the other two-thirds tie at18% each, but the sample size is small. For downward breakouts,the declines are 10%, 15%, and 21% for patterns with breakoutswithin a third of the yearly high, middle, and low, respectively.• Patterns with upward breakouts on heavy volume perform best:30% average rise postbreakout. Light breakout volume has risesaveraging 22%. Downward breakouts have declines averaging17%. Light breakout volume shows postbreakout declines averaging 11%.• Patterns with downward volume trends from pattern start to endperform better than do those with upward volume trends, onaverage.• A partial decline correctly predicts an upward breakout 81% ofthe time.• A partial rise works 74% of the time.• Prices throw back (upward breakouts) 47% of the time and pullback (downward breakouts) 65% of the time. Throwbacks hurt
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postbreakout performance (23% average rise versus 35% withoutthrowbacks). Pullbacks are similar, with postbreakout declines averaging 15% for those with pullbacks versus 16% for those without.• The median height divided by the breakout price is 13.24% forupward breakouts and 14.70% for downward breakouts. Tall patterns perform better than short ones for both breakout directions.Upward breakouts from tall patterns have rises that average 36%postbreakout versus 23% for short ones. Downward breakoutsdrop an average of 16% for tall patterns and 15% for short ones.Also consider these additional trading tips for RABFDs:• Fifty-one percent break out upward.• The best postbreakout gains (31% average rise) come afterintermediate- and long-term rises leading to the pattern. Pricesafter a short-term rise climb 28% postbreakout. The samplesare few for intermediate- and long-term rises, so don’t rely onthe numbers being solid. Downward breakouts show declinesaveraging 13% (short term), 23% (intermediate term) and 16%(long term). Again, the intermediate- and long-term declineshave few samples.• Those with upward breakouts in the middle ofthe yearly trading range perform best (37% average rise, postbreakout), the highest third comesyearly pricerange or yearlyin second with a 27% rise, and the lowest third istrading rangelast with an 11% rise, but the low and middlethe price rangeranges have few samples. For downward breakthat the securitytraded over theouts, the declines are 16% (for middle and highprior 12 months.thirds), and 14% (lowest third). The middle andTo determine thehigh ranges have few samples.yearly tradingrange, start from• Upward breakouts perform better after a lightthe day before thevolume breakout (37% average rise versus 26%breakout and findthe highest peakfor breakout volume above the 30-day average).and lowest valleyDownward breakouts show heavy breakout volover the prior 12months. I dividedume leading to larger declines postbreakout, butthe yearly pricethe performance difference is minimal and therange into thirdssamples few.and compared thebreakout price• A partial decline correctly predicts an upwardwith each third.breakout 63% of the time.
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• A partial rise works 54% of the time.• Prices throw back (upward breakouts) 52% of the time and pullback (downward breakouts) 51% of the time. Throwbacks hurtpostbreakout performance (21% average rise versus 36% withoutthrowbacks). Pullbacks are similar with postbreakout declines averaging 15% for those with pullbacks versus 16% for those without.• The median height divided by the breakout price is 13.13% forupward breakouts and 14.20% for downward breakouts. Tall patterns perform better than short ones for both breakout directions.Upward breakouts from tall patterns have rises that average 35%postbreakout versus 23% for short ones. Downward breakoutsdrop an average of 18% for tall patterns and 13% for short ones.Measuring Success
Use the measure rule to predict a target price. The rule is the same as forbroadening tops—the height added to or subtracted from the breakoutprice. For upward breakouts from RABFAs, price reaches the measure ruletarget 68% of the time. For downward breakouts, the success rate is just32%. For RABFDs, upward breakouts hit the target 63% of the time anddownward breakouts meet or exceed the target 44% of the time.I consider the performance poor, so be conservative in your projections. Look for overhead resistance and underlying support to bettergauge where price is likely to reverse. As with many other chart patterns,you can try using half the pattern height in the computation to find atarget price.Case Study
Figure 7.3 shows the sample trade in a RABFA. Here are my recollections:On the expectation of price zipping across the pattern to thetop trendline, I bought 800 shares at 13 once it was clear thatprice was moving up. At that time, I purchased stock in a minimum of $10,000 lots, so this buy was for $10,400. Whenprice curled around and dropped below the horizontal trendline, that was the sell signal. I was stopped out of 600 shares at12.38 and the other 200 at 12.34. I lost just over $500 on thetrade, or 5%, but a massive $34 dividend boosted the return.Okay, so it wasn’t massive, but it was an unexpected gift.
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“I love free money,” Jake said, “especially when it’s a qualified dividend that’s subject to a lower tax rate.” This dividend didn’t qualify because the hold time was too brief.The stock tumbled to a low of 8.94, for a decline of 28% below mysell price.If a chart pattern doesn’t work as expected, then close out the tradeand do it quickly! If you were trading this stock, would you have sold orridden the stock lower?
Diamond Tops and BottomsSome years ago, I wrote a romance novel in which the main characterwalks into a jewelry store with his girlfriend and picks out a diamondring priced at $25,000. Later, he returns to the store alone and tells theowner to substitute the diamond rock for cubic zirconium. She finds outabout the switch, learns how much he makes—a quarter million—andcalls him cheap, starting a fight that propels the story forward.His feelings about diamonds echo my own. Both the rock and theones on the computer screen are pretty, sure, but both can be difficultto trade.Figure 7.4 shows two diamond patterns. In early November, priceplunges after point A then consolidates and forms a diamond bottompattern before shooting upward to B. Notice how the price at A and Bare about equal. A quick rise/decline often follows a quick decline/rise.The diamond top pictured in the inset shows the same situationflipped upside down, although the rise and decline take longer to form.Price begins the rise at D and ends at E. Point C is a pullback, whereprice returns to the breakout price briefly before continuing down. Notice the premature (false) breakout on the top. Because price turnedaround and broke out downward, the chart pattern is a busted diamond,suggesting lower prices ahead.As an end-of-day trader, I would have missed the diamond bottomby buying into the situation a day after the breakout—the day beforeprices peaked at B. If you are a nimble swing trader, diamonds might betrading candidates, but for everyone else, I’d steer clear. Use them asguideposts lining the way along the price path.One last comment about diamonds. They have a high performancerank (downward breakouts are ranked 1, best, tied with head-and-shoulderstops), but I discarded them because of few samples.
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Florida Rock Industries, Inc. (Cement & Aggregates, NYSE, FRK)22
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FIGURE 7.4 A diamond bottom appears after a quick decline. A quick riseoften follows, returning prices back to the launch point.
Identification
What should you look for when prospecting for diamonds? Glue abroadening top or bottom with a symmetrical triangle and you’ll haveforged a diamond. At the start of the pattern, prices broaden out, forming higher peaks and lower valleys (a broadening top or bottom). Thenthe price action reverses, forming lower peaks and higher valleys (a symmetrical triangle). If you draw trendlines along the peaks and valleys, youshould get something like that shown in Figure 7.4. Your diamond is aptto be lopsided as perfect ones are rare.The identification guidelines for diamonds include the following:• Look for a quick price rise or decline. Diamond tops have prices entering the diamond from the bottom and bottoms have prices entering from the top. The quick rise or decline, a straight-line run, is key.Yes, you will find other diamonds forming as a normal congestionpattern, but the ones when prices race forward are easiest to spot.• Look for prices to broaden out (higher peaks and lower valleys) thennarrow forming a diamond shape. The diamond usually tilts to oneside.
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• Price should touch each trendline one or twice, but it depends onhow you draw the diamond and whether prices cooperate withyou. Don’t be alarmed about cutting off price tails when youdraw the trendlines. Sometimes you have to use your imaginationto see the actual diamond shape.• Sixty-six percent have a downward volume trend within thediamond.Trading and Trading Tips
Here are some trading tips. One of these I want to pass on applies to allchart patterns that act as reversals of the prevailing price trend, but especially diamonds. Price must have something to reverse. If price is movingsideways for a month or two and bumps up two bucks and then a diamond reversal appears (meaning it has a downward breakout, reversing therise leading to the diamond), expect price to return to the base two bucksbelow. Don’t expect a larger decline because there is little price rise to reverse. A larger decline does happen on occasion, but that’s not how to finesse the probabilities.When the diamond acts as a continuation or congestion pattern,meaning that price exits the diamond traveling in the same direction thatit entered, the diamond can act as a half-staff pattern. That means therise (decline) after the diamond mirrors the rise (decline) after the breakout in price change, elapsed time, and slope. Look for overhead resistance or underlying support as locations where price is likely to stall asthe target price approaches. The postbreakout move will not be as longas the move leading to the diamond, so keep that in mind, too. For example, my study of 69 diamond bottoms had a decline before the diamond of 24% and a postbreakout drop averaging 21%.Another idea I tested concerned velocity. A high velocity move leading to the pattern resulted in better postbreakout performance than did aslow velocity move. For example, prices climbed 26% after the breakoutfrom a diamond top with velocity below the median 7 cents per day.Those with higher velocity leading to the diamond climbed 29% postbreakout. Diamond bottoms were similar. Low velocity trends saw postbreakout drops of 17%, but high velocity trends suffered declines of23%. High velocity moves leading to a chart pattern result in high velocitymoves after the breakout. This assumes that the chart pattern is a continuation pattern (not a reversal).
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Here are additional trading tips:• Diamonds with short-term price trends leading to the patternperform better than intermediate- or long-term trends. Diamondtops with downward breakouts show the best results: Short-termdeclines leading to the pattern yielded 24% declines postbreakout; intermediate-term trends averaged a 22% decline, and longterm declines had postbreakout declines of 15%.• Avoid overhead resistance or underlying support. Diamonds withthrowbacks or pullbacks have postbreakout performance that suffers. For example, diamond bottoms with upward breakouts andthrowbacks show rises averaging 30%. Those without throwbacksclimb 43%.• Select tall patterns for the best performance. Compute the heightfrom highest peak to lowest valley in the pattern and then dividethe height by the breakout price. For diamonds bottoms, patternsabove the 13% median are tall. For tops, use an 11% median.• Diamonds with upward volume trends do better postbreakoutthan do those with falling volume trends. For example, diamondbottoms with upward breakouts and rising volume trends withinthe diamond soared 41% after the breakout but climbed 35%when volume receded.• Diamond bottoms perform best when the breakout is near theyearly low (42% rise) and worst is near the yearly high (26%rise), regardless of breakout direction.Measuring Success
As Figure 7.4 shows, price after the breakout often retraces the moveleading to the diamond, but not always. When a quick, near verticalprice move precedes the diamond, look for price to return to thelaunch point (assuming the diamond is a reversal like those shown in thefigure).The measure rule for diamonds is no different than for other chartpatterns. Measure the height (highest peak to lowest valley) and add it tothe price of an upward breakout or subtract it from the breakout price ofa downward breakout. A breakout occurs when price closes outside thediamond trendline boundary. The following list shows how often themeasure rule works:
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• Diamond tops, upward breakout: 69%• Diamond tops, downward breakout: 76%• Diamond bottoms, upward breakout: 81%• Diamond bottoms, downward breakout: 63%Because the numbers fall well short of 100%, be conservative in selecting your price target. Look for nearby support or resistance and expect price to reverse there. It may not, but it pays to be prepared. Tryusing half the pattern’s height as it applies to the measure rule to get acloser target.Case Study
I searched through my notebook of trades and found an example of adiamond trade I made (Figure 7.5). Here is my notebook entry:8/18/03. I bought 450 shares at market, post split, filled at25.17. This is an earnings flag trade, but I’m a few days late tothe game. I hope for a 29.11 target with a downside of 24+where it should meet support. Must sell is the bowl low ofabout 23.33 or so, but try to estimate an exit at 24. Upside isbased on a 19% average rise of an earnings flag (EF) from theformation high.Although this has risen only 10% from the day before theearnings announcement to the formation high, about half theaverage, I’m still hoping for a continued rise. However, thisone makes me nervous, and I did not want to trade it becauseI feel it will throw back as most EFs do. With the economyturning around and this making new yearly highs, it is a riskytrade that I am willing to take. I have to monitor it, however,and if it starts to slip, then I will consider selling.A three-for-two split occurred since I made my notebook entry, so Ishow the split-adjusted prices. That is why the amounts seem unusual. Iillustrate the earnings announcement during July in Figure 7.5. Priceclimbed in a straight-line run up and then formed a pennant (which I callan “earnings flag” as the generic name for it). A buy signals when pricecloses above the highest peak in the chart pattern, point B in this case.
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Graco Incorporated (Machinery, NYSE, GGG)DiamondTop
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FIGURE 7.5 This diamond top scared me out of the stock because Ithought price would decline back to the launch point at A.
The mention of a few days late in my notebook entry is because Ibought two days after I should have. A better entry would be to have anexisting order to buy the stock at the price of B so that when pricereaches it, the order executes automatically.The target price is point B multiplied by 19% to get a target of 29.11.Downside support at 24 was a good call as that’s where price stalled in lateOctober. The bowl low I refer to is the rounded turn at point A.Here is my next notebook entry:9/29/03. The market has tumbled for almost a week straightand this stock is down to my breakeven point. A head-andshoulders top has confirmed, suggesting a sale. September isalmost over, the worst month of the year, historically. Octoberisn’t much better though. Support from the July top at24–24.67 should stop the downturn. I expect a decline to thatlevel. My hope is that the market will turn around today andpush the stock up—probably as a pullback to the head-andshoulders top.
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When the diamond top appeared, I suspected a downwardbreakout and retrace of its gains, but decided to go with thehope of a continued uptrend. Oops. The stock is up by apenny at 10 this morning (EST). I expect a continued declineto 23.33 where the stock will stall and move in a trading rangebetween 23.33 and 24.67. If it drops below 23.10, then sell.I show on the chart the left (LS) and right (RS) shoulders with thehead of a head-and-shoulders top at the price peak between the twoshoulders. When price closed below the valley low, between the head andright shoulder, that was the sell signal. I guessed right about a pullback tothe head-and-shoulders, too. As I mentioned in the notebook entry, thebreakout from the diamond top was a bearish omen that I chose to ignore. Hope will not make a stock rise. Here’s my notebook entry: “I soldthe stock anyway. Why wait for it to decline and take a $1,000 loss?Since I know it’s going down, sell now near breakeven and buy in later ifI think it’s a good deal. Sold at 2