the right of the decimal.”I thought for a moment. “How’s your debt, Jake? Better check youranswering machine. I thought I heard a voice say something about amargin call, but I could be mistaken.”
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I heard the patter of feet pounding the pavement. I smiled. “Jakehas left the building!”
2. Pipe Bottoms• Average rise rank: 4• Breakeven failure rate rank: 5• Change after trend ends rank: 4What happens when the valleys in a double bottom are close together?The answer to that question led me to discover pipe bottoms, horn bottoms, and their top counterparts. Pipe bottoms rank second for performance. They have a breakeven failure rate of 5%, meaning that 5% ofthe 926 patterns I looked at climbed less than 5% after the breakout.The average rise is a mouthwatering 45% (for perfect trades, remember),but if you are on vacation after prices peak and the trend changes, pricesdrop an average of 33%, so you may lose a major portion of what yougained.Identification
What should you look for when searching for pipes? Here are the guidelines:• Use the weekly chart to select pipes. Pipes on the daily chart donot perform as well.• Find two downward, adjacent price spikes that look like parallellines.• The bottom of the spikes usually has a small price variation (theaverage is $0.24).• Look for spikes longer than other spikes during the past year.• The two spikes should have a large price overlap (66% is theaverage).• Volume is high (above the 30-day average) 87% of the time onone or both spikes.• The pipe should be obvious on the chart.
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Most of these guidelines are self-explanatory. Pipes appear likeweeds growing in a vacant lot: Some children collect and press their colorful petals between pages in a book, but the city mows down the otherswhen they grow too high and violate ordinances. Distinguishing the collectables from the weeds is one reason for the many guidelines.Figure 6.3 shows examples of several pipes. Look at the pipe on theright, during July 1996. The twin downward price spikes appear as parallel lines on the weekly chart and in this case, the low prices in the twinbottoms are the same. That happens infrequently as the chart shows, andperformance usually suffers when it does occur.Switch to the arithmetic price scale and look for spikes that arelonger than are those over the past year. They perform better (46% average rise versus 35%). The inset in Figure 6.3 shows what I mean by longspikes. The spike length is the difference between the two horizontallines, which is the difference between the higher of the two pipe bottomsand the lower of the two weeks adjacent to the pipes.After the breakout—meaning that price closes above the higher ofthe two spikes, confirming the pattern as a valid one—prices climb toNovellus Systems, Inc. (Semiconductor Cap Equip., NASDAQ, NVLS)2UltimateHigh
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FIGURE 6.3 Look for two parallel lines well below the surrounding priceaction on the weekly scale.
THE TOP 10 PERFORMING BOTTOMS
82ultimate highI determine theultimate high bylooking after thebreakout for thehighest peakbefore pricesdecline by 20% ormore, measuredfrom the highestpeak to the close. Istopped looking ifprice closed belowthe formation low,assuming that astop-loss orderwould be placedat that location.
point 1 and pause there. This is a common feature with pipes—prices climb to the prior highand stall or reverse. Point 2 shows another resistance location where price reversed at the ultimatehigh.Trading and Trading Tips
Pipe bottoms are common so you can be selective.You will usually find pipes at the bottom of a pricetrend, many times forming a V-shaped bottom.For swing traders, they represent an excellentprofit opportunity. After the right price spike,switch to the daily scale and buy when price closesabove the highest peak in the two-week pattern.That will get you in sooner than trading on theweekly scale.For position traders and longer-term holders,usetheweekly scale for the buy signal. Wait forpositiontradingprice to close above the higher of the two spikes betrading thatfore buying. In downtrends, many times pipe botholds a securitytoms will not confirm (price does not close aboveovernight, somethe highest pipe high) and price will continuetimes maintaininga position forlower. Figure 6.4 shows an example of an unconweeks, months,firmed pipe in late September 1999. Price neveror longer, but notbuy-and-holdcloses above the pattern’s high before resuming theforever.downtrend.Here are some additional trading tips:• Pipes with a long-term (over six months) downtrend leading tothe pipe perform substantially better than intermediate- or shortterm downtrends (79% average rise after a long-term downtrendversus 57% for intermediate-term and 21% for short-term).• Avoid overhead resistance on both the daily and weekly scales.Resistance may cause a throwback that hurts performance (38%average rise with throwbacks versus 51% without).• Tall patterns perform better than short ones (52% average riseversus 40%). Measure the height from the highest peak to thelowest valley in the pipe and then divide by the breakout price(the price of the highest peak). If the result is above 11.64%, thenyou have a tall pipe.
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FIGURE 6.4 The peak before a pipe bottom often becomes a resistancelevel, halting or delaying the price advance, as the numbers show.
• Pipes with long spikes (longer than mostover the prior year) perform better than dothose with short ones (46% rise versus35%). See the discussion of Figure 6.3 todetermine the spike length.• Select pipes with a large price difference between the lows (average rise 50% versus41% for price differences smaller than the0.83% median).• Volume heavier on the left spike comparedto the right suggests better performance(50% average rise versus as low as 42% forthe other combinations).• Pipes with a lower left spike tend to perform better than do those with a lower rightspike (47% average rise versus 44%, and42% rise for pipes with even bottoms).• Pipes that are inside weeks (the right spikehas a lower high and higher low than the
tall or shortpatternsI measure theformation heightby taking thedifference between the highestpeak and thelowest valley inthe chart pattern,and then dividingthe difference bythe breakout priceto get a percentage of height toprice. I use themedian value asthe differencebetween short(values below themedian) or tall(values above themedian).
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left spike) perform better (47% average rise versus 43% for outside weeks).If price closes below the lower of the pipe bottoms then exit yourposition. If things go right and price advances, raise your stop to just below the prior valley (a trailing stop).Measuring Success
Notice in Figure 6.4 that price stalls or reverses at the peak before thepipe. Thus, the last peak represents the price target (called the measurerule). Price may continue higher as it did after the June 2000 pipe (pausing briefly at point 3), but do not stake your life on it. Consider sellingif price stalls near the level of the old peak. Notice that price sometimes does not make it up that far, as the right peak opposite points 2, 3,and 4 show.Case Study
“Margin call, bull!” Jake said.I shrugged. “Guess I heard wrong.”“Let me show you a trade I made using a pipe bottom.” He shovedme out of the chair. The only reason I let him get away with this is becauseI needed an example, which Figure 6.4 shows for the March 2000 pipe.He had to wait for price to close above the highest peak in the pattern before buying. That took a month (point A).Price moved up as it does in most trades that work. “But when itapproached the old peak, I got nervous.” I show that as point 2. Pricewas making new highs but the rate of change oscillator was showinglower peaks. “Bearish divergence—a sell signal.”He sold when price closed below the prior week (B). “If I had to doit again, I’d put a sell order just below the old high. Even if it was a buckbelow, that would have saved me money.”
3. Inverted and Ascending Scallops• Average rise rank: 5• Breakeven failure rate rank: 4• Change after trend ends rank: 5
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Few people have heard of ascending scallops and even fewer have heard ofthe inverted variety. Inverted and ascending scallops (IASs) are patterns that Ifound when considering what ascending and descending scallops looked likewhen inverted. I went fishing and found hundreds of them swimming inthe price ocean. They rank third for overall performance with an average riseof 43%, breakeven failure rate of 4%, and 32% decline after the trend ends.Identification
What does an IAS look like? Figure 6.5 shows three scallops swimmingupstream. Notice how the scallops narrow the farther up the price trendthey appear. That is not always the case, but if you see that behavior, itwarns that the end of the price trend may be near. This is especially truewhen the start and end of the scallops have nearly the same price. Hereare the selection guidelines:• On the daily chart, find an upward price trend.• Look for an inverted and backward J-pattern. Price should startby moving up in nearly a straight line (sometimes leaning to theright), round over smoothly at the top, and then decline.American Power Conversion Corp. (Computers & Peripherals, NASDAQ, APCC)
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FIGURE 6.5 These three inverted and ascending scallops narrow as theyappear in a price uptrend. Point 2 should retrace about half the distancefrom points 3 to 1.
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• Price at the end of the pattern usually retraces 55% of the priorup move. Avoid any pattern that retraces more than 100% (dropsbelow the start).• The pattern becomes valid when price closes above the highestpeak in the pattern.• Volume trends downward 71% of the time from the start of thepattern to the end.You can see what the inverted and backward J-pattern looks likefrom Figure 6.5. For larger patterns (points 1, 3, and 2 in the figure), therounding turn at the top of the pattern is usually not smooth. For narrower IASs, the turn may appear squished in a vice, more of an invertedV-shape than a J. I prefer to see a gentle, rounded turn. In all cases, thestart of the pattern (point 1) must be below the end (2).Trading and Trading Tips
Here are a few tips to make trading scallops easier and more profitable:• For swing traders, buy when price makes a higher valley aftercompleting the inverted and backward J (a 50% or higher retrace) with a price target of the scallop high.• For other traders, buy when price closes above the highest peak inthe pattern.• If the pattern end points follow an existing upsloping trendline,buy when price rises above the trendline after the second IAStouch. The inset in Figure 6.6 shows this scenario.• If prices drop below the start of the pattern, then avoid trading thepattern. That means point 2 drops below point 1 in Figure 6.5• If price forms a distinct right valley and then price drops below thevalley, sell. Figure 6.6 shows this as a tiny IAS AB. Price climbs,leaving a distinct valley at B, and then doubles back and moves below B at C. Sell when price drops below the price level of B.• IASs both tall and narrow perform better than other combinations of height and width (56% average rise versus 35% forshort and wide patterns). Tall means higher than 22.51%(height divided by the breakout price) and narrow means lessthan 34 days.
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• Patterns with a rising volume trend do better postbreakout, gaining 48% versus 40% for patterns with falling volume.• Breakout volume above the 30-day average means a larger averagegain, 44% versus 38% for light volume breakouts.Figure 6.6 shows how to use the first tip. Afterconfirmationprice makes a higher valley on the right side of thepoint, price,scallop, buy. This works well if it looks like the patlevel, or linetern has completed, meaning that price has retracedalso known as theover 50% of the prior up move on the left side ofbreakout point,price, or level—athe scallop and is now heading back up. The sellprice or locationtarget is the top of the pattern unless price is adthat validates achart pattern.vancing in a straight-line run. Under that condition, hold on until your other indicators say sell.The usual confirmation price is a close abovethe top of the pattern (see the confirmation line in Figure 6.6). Buywhen price closes above the line. This works well if price is trending up atnearly the same angle as during the left side of the scallop, especially if itAnadarko Petroleum Corp. (Petroleum (Producing), NYSE, APC)
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FIGURE 6.6 A close above the confirmation line represents the traditionalbuy signal. The inset shows a buy signal when the pattern follows a trendline.
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is in a straight-line run. The inset in Figure 6.6 shows an example. Thisalso shows another buying technique. When price follows a trendline,buy after the scallop touches the trendline on the right side of the scallopand bounces off, moving up.If price drops below the valley on the right side of the scallop (pointB in Figure 6.6), then the pattern is a failure and you should exit thetrade. Never take a position in a scallop in which the valley on the right isbelow the valley on the left. A lower valley signals a trend change.Measuring Success
Price prediction uses the height of the scallop projected upward from thetop of the scallop. Using Figure 6.5 as an example, height is point 1(13.10) subtracted from point 3 (22.75), or 9.65. Add the height to thehighest peak in the pattern to get a target of 32.40 (22.75 + 9.65). Thismethod works just 61% of the time, so be conservative in your targetsand look for nearby resistance zones where price might reverse.
4. Three Rising Valleys• Average rise rank: 6• Breakeven failure rate rank: 5• Change after trend ends rank: 4The three rising valleys (3RV) pattern is one I heard of only recently.When I tested it, I was surprised at how well it performed. In a bull market, the overall performance rank is four, with an average rise of 41% after the breakout (if traded perfectly), 5% fail to rise at least 5%, and pricesdecline 33% once they reach the ultimate high and then reverse.Identification
I show the 3RV pattern as bottoms 1, 2, and 3 in Figure 6.7. Most often, the pattern acts as a reversal of the downward price trend, and reversals also give the best performance. As the pattern’s name implies, lookfor three valleys, each one higher than the last, so that the pattern beginsor continues an upward price trend. Each valley should appear similar,but they need not follow a trendline. You wouldn’t, for example, pair
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bottoms 1 and 2 with 4, the little nubbin pokingdownward. If you select wide bottoms, stick withreversala price reversalwide bottoms on all three valleys. If you start withoccurs when priceone-day spikes, then choose narrow valleys—thoseenters and exitsjust a few days wide.the chart patternfrom the sameThe pattern confirms as a valid 3RV whendirection.price closes above the confirmation line—thehighest peak in the pattern. When the peak between valleys 1 and 2 is higher than the one between peaks 2 and 3,draw a downsloping trendline connecting those peaks. When pricecloses above the trendline, that signals a buy and it might get you in earlier than waiting for the standard breakout (a close above the confirmation line).Try looking for 3RVs on the weekly chart, as they look like iciclesand are almost as plentiful.What selections should you avoid? Look at valleys A, B, and C inFigure 6.7. The valleys do not represent a valid 3RV pattern because
Brooks Automation (Machinery, NASDAQ, BRKS)2221201918
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FIGURE 6.7 The three rising valleys pattern, shown here as 1-2-3, suggests a reversal of the downward price trend.
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valley C is not above valley B. Instead, the pattern is a right-angled andascending broadening formation. (Draw a horizontal line from A to C tocomplete the pattern.)Here are the steps to identifying a 3RV pattern:• Look for three valleys; each valley must be higher than the lastwith no ties allowed. The weekly chart might help with selection.• Select similar shaped valleys. Pair wide ones with wide ones, narrow ones with slim valleys in both width and height.• A buy signal occurs when price closes above the highest peak inthe pattern or pierces a downsloping trendline drawn joining thepeaks between the three valleys.• Volume trends downward in two out of three cases.Trading and Trading Tips
The 3RV pattern is a plentiful one, so you can be selective. Before tradingany 3RV, switch to a higher time scale and see what the price landscapelooks like. Many times, you will see overhead resistance that you will wantto avoid. That usually causes me to toss a pattern and look for another one.Figure 6.8 shows one such example, although it is on the daily scale.The 3RV appears as narrow price spikes, but each valley is above theprior one, as expected. When price closes above the confirmation line abuy signals, or does it?If you draw a downsloping trendline joining the peaks on the chart,notice how prices rise to the trendline and then reverse. This is common behavior for 3RVs. Since 3RV reversals give the best performance, be sure thepattern passes the 1-2-3 trend change method discussed earlier in the book.Look for (1) price to close above a downsloping trendline; (2) price to retestthe valley (attempt to reach a low but make a higher valley); and (3) wait forprice to close above the peak between the lowest valley and the retest.The 3RV in Figure 6.8 fails the trendline test because price does notclose above it. Thus, a trend change is not indicated so you would avoidtrading this pattern.Here are some additional trading tips for this pattern. Performancenumbers are averages and represent perfect trades, so your results will vary.• Patterns with below average breakout volume tend to performbetter than those with above average volume, with rises averaging53% versus 38%, but 76% break out on high (above the 30-dayaverage) volume.
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Dell Inc. (Computers & Peripherals, NASDAQ, DELL)
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FIGURE 6.8 This 3RV fails to pierce trendline resistance, and pricesreverse. To avoid similar situations, use the 1-2-3 trend change method.Notice the receding volume trend.
• When volume trends upward throughoutcontinuationthe pattern, postbreakout performance imfor chart patterns,proves: rises average 45% versus 38%, butI use this term as67% have downward sloping volume trends.a synonym forconsolidation. For• Sixty-seven percent act as reversals, and rea continuation,versals perform better than continuations,prices must breakout in the samewith rises of 46% versus 33%.direction as they• Two out of three patterns break out withinentered the pattern. For example,a third of the yearly high and they performif price enters thebest.pattern from thebottom and exits• Tall patterns perform better than short ones,out the top, theby 45% to 37%. Use the median height ofpattern acts as acontinuation.23.80% (the height divided by the breakoutContrast withprice) as the divider between short and tall.reversal.• Narrow patterns perform better than wideones, 44% versus 39%. A narrow pattern isone narrower than the median 43 days, measured from the firstvalley to the last.
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• Patterns both tall and narrow show postbreakout gains of 53%.• Throwbacks occur 60% of the time and when they occur, performance suffers (50% average rise without throwbacks versus 36%with them).• The farther up the price trend a 3RV appears, the smaller thepotential gain.Measuring Success
The measure rule for 3RVs is the same as for most other chart patterns.Subtract the price of the lowest valley from the highest peak in the pattern to get the height. Add the height to the highest peak and the result isthe target price. This method works just 58% of the time, so you mightconsider cutting the height in half before applying it to the highest peak.That boosts the success rate to 79% in a bull market.Let’s take the 3RV shown in Figure 6.8 as an example. Subtract thelowest valley (valley 1 at 22.06) from the highest peak in the pattern (30,at the confirmation line) to get a height of 7.94. Add the difference tothe highest peak to get a target of 37.94. If you cut the height in half,3.97, you get a closer target of 33.97.Take the height (3.97) and divide it by the breakout price (30) toget 13%. If you traded this stock perfectly, 13% is how much you couldexpect to make—assuming price climbs to the target (if not higher). Ofcourse, you won’t trade it perfectly, and you need to factor in commissions, so your results might be lower. Before trading, balance the possiblegain with the size of the potential loss. Is the reward substantially higher(by 2 or 3 times) than the loss?Jake walked into my office and said, “Did you know that the government has a Department of Redundancy Department? They monitor synchronized swimming teams to make sure that the first swimmer doesn’tdrown because, well, you know.” Then he walked back out. I’m starting toworry about him.
5. Rounding Bottoms (Tied with 6)• Average rise rank: 5• Breakeven failure rate rank: 5• Change after trend ends rank: 6
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I prefer to think of rounding bottoms as rounding turns because theyneed not be bottoms at all. Rather, many of them have prices that enterthe rounding pattern from below, so they act as consolidations (pauses)of the upward price trend.Rounding bottoms have an overall performance rank of five. The average rise, if you were to trade perfectly the bull market patterns I lookedat, is 43%. The breakeven failure rate is 5%, meaning that 5% of the patterns failed to rise at least 5% after the breakout. Once the trend changesafter reaching the ultimate high, prices tumbled 31%, on average, so itpays to sell as close to the top as possible. No surprise there, right?Identification
Figure 6.9 shows a rounding turn on the daily scale. In this example,prices climb into the pattern, curve downward, and soar out the rightside without pausing. A rising approach happens 62% of the time andwhen it does, it predicts better performance after the breakout—an average rise of 57% versus 36% for rounding bottoms with downtrends leading to the chart pattern. Thus, select patterns in a rising price trend.Diamond Offshore (Oilfield Svcs/Equipment, NYSE, DO)
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I show the same rounding bottom on the weekly scale in the inseton the far left. You still have to use your imagination; the turn doesn’tappear as smooth as it could, but few chart patterns are perfect. That’spart of the identification challenge.Insets B and C have prices trending down into the pattern. Inset Bis on the weekly scale and the rounding turn looks smooth. The exit doesnot pause at the price level of the left cup rim. Inset C is on the dailyscale, and I picked this rounding bottom to show you what a handlelooks like. The handle is on the right (H).Here are the identification tips for rounding bottoms:• Use the weekly scale. Rounding bottoms are large enough toappear there and the graceful turn becomes apparent easily.• Price enters the pattern trending upward 62% of the time (best)or downward (38%).• Look for a peak that occurs before the rounding turn. This formsthe left cup lip.• Price should round downward in a bowl shape, usually smoothbut allow variations.• Midway through the turn, prices may shoot up and then easedown to just above where they started.• Volume trends upward 51% of the time.• Volume shape splits between dome (51%), U (43%), and everything else (6%).Trading and Trading Tips
Unless I am making a trade, I rarely look at the weekly scale, but I makethe effort monthly. Each month, price adds four or five additional bars tothe chart, and sometimes that’s enough. I found a rounding turn abouthalfway through its development in Lam Research and decided to tradeit. Because I knew (hoped, really) that prices would rise to the height ofthe left cup lip, I decided that the trade would be a long-term one. Nevertheless, I used a trailing stop that I raised as prices climbed. The generalmarket downturn at the start of the new year cashed me out, but not before I made some money. (I detail the trade later in the book.)The point of mentioning it now is to convince you to look at theweekly scale (or a higher period than the one you usually use) to find this
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pattern. If you can spot a gentle turn in development, then buy the stockand ride it upward. However, be aware of the midway bump that sometimes happens. Figure 6.10 shows an example.Prices start the rounding turn at B and slide downward to the September low in an almost straight-line decline. Then prices retrace a goodportion of the decline. When the retrace completes, prices drop to pointA, slightly above where they started the rise. Then, the rise resumes, ending at C before forming a handle and moving higher.If you buy a rounding turn and prices shoot up midway throughthe bottom, you can exit at the top of the retrace if you are a swingtrader. Those traders with a longer-term perspective might do well holding onto the stock. You can add to your position or buy back in onceprice returns to just above the launch point. Don’t expect it to meet thelaunch point low because it usually makes a higher valley like that shownin Figure 6.10.Most times a handle forms when price reaches the high of the leftcup lip (resistance at a prior peak). I measured the time from the right cuplip to the breakout and found that 90% of the patterns took longer thanAmazon.com Inc. (Internet, NASDAQ, AMZN)Throwback
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seven days to climb to the breakout. That gives plenty of time for a handleto form.Here are some additional trading tips:• Use the weekly scale to find a rounding turn that is at the midway part of its development. Buy if you expect the industry andgeneral market to trend upward.• Swing traders can sell if prices bump up after the midwaypoint—retracing a portion of the downward move that forms theleft side of the cup. For all others, don’t get too disappointedwhen prices return to just above the launch point. When pricesresume the uptrend, consider adding to your position.• Count on price pausing near the level of the left cup lip. If thegeneral market or industry is weak, then sell. You can always buyback in when price bounces off the handle low.• If the rounding bottom has a handle, try drawing a downslopingtrendline connecting the two cup