to the breakout price then heads lower. It
sold the stock before the breakout, you may be upset that it continues higher,
reaches a low of lO'/z in mid-June then moves sideways for 5 months (not
but eventually your tactic pays off. The stock declines 22% from the breakoutlow to die ultimate low in 1 year.
shown). By the end of this study, the stock is trading at less than $1.Breakout volume is above average and remains high for several days. Thepullback to the breakout level gives investors the opportunity to sell their positions before the downhill run resumes.
peak for the stock. From that point, it is all downhill. In early April 1994, the
Is there a reason the stock continues higher? Certainly the breakout volume is not supportive of an upward move. Although volume on the day of thebreakout is 69% above the prior day, there is no significant volume spikeshown on the chart (translation: breakout volume is not above average). This
The diamond low, at 16'/4, approximates the low in early April. These twolows, when taken together, initially appear to be a double bottom. Volume is
weak volume is unusual but not unheard of. The weak volume breakout and
higher on the left side of the double bottom than the right. The rise between
decreasing volume trend over the next week or so, even as prices climb, is awarning that the upward momentum is running out of steam.Although it is not clear from looking at Figure 11.7, the volume trend,
to rise above the confirmation point (211A, or the highest high between the two
the two troughs is sufficient to validate a double bottom. However, prices fail
measured by the slope of a linear regression line of volume, is downward. This
bottoms) so the formation is not a double bottom. This failure suggests priceswill move lower.
is typical for most diamond tops and bottoms but offers no clue to the eventualfailure of this situation. I can see no reason why this diamond fails to breakout
why did the stock fall? I could find no technical evidence to suggest why the
Double bottoms and diamond bottoms are both bullish formations, so
50-Off Stores Inc. (Retail (Special Lines), NASDAQ, FOFF)
Atlantic Richfield Co. (Petroleum (Integrated), NYSE, ARC)
Feb 92
Nov 92
Dec
|an 93
Feb
Mar
Apr
May
Figure 11.7 A failure of a diamond top to reverse direction.
Mar
Apr
Jim
jul
Figure 11.8 A diamond bottom failure. The diamond bottom fails to reverse asprices break out downward and continue moving down. The double bottom isunconfirmed; it is not a true double bottom.
174
Diamond Tops and Bottoms
Statistics
175
two formations rail to perform as expected. However, since the stock continuesdown to less than $1, this decline suggests that the fundamental situation is
decidedly weak. This alone may explain the stock's behavior.
StatisticsTable 11.2 contains general statistics for diamond tops and bottoms. Due tothe dearth of formations located in 2,500 years of daily price data, I reviewed amore recent database to augment the statistics. The numbers of formationsuncovered indicate diamond tops and bottoms arc a rare breed. Most of thetime, they act as reversals of the prevailing price trend (80% for bottoms and78% for tops).The failure rate is higher for diamond tops than bottoms (25% versus13%). Failure rates above 20% suggest an unreliable formation, so, if youdecide to trade a diamond top, be extra careful. Only diamond tops suffer from5% failures. That is when prices move less than 5% in the breakout directionbefore reversing. With just 45 diamond bottoms, the sample size is not largeenough to really determine the 5% failure rate.
The average rise after a bottom is 35%, although the most likely rise is
Figure 11.9 Frequency distribution of gains for diamond bottoms. The chart suggests the most likely rise after a breakout from a diamond bottom is 20%, but theactual value is 15% (using a finer scale than the one shown).
just 15%. Figure 11.9 shows the most likely rise and it is computed using a fre-
quency distribution of gains. The column with the highest frequency becomesthe most likely rise. Only 37 formations qualify for the chart. Still, the 20%column stands out as the one with the highest frequency. Scaling the columnsTable 11. 2General Statistics for Diamond Tops and BottomsDescription
Bottoms
Tops
Number of formations in 500
34
111
Number of formations in 299stocks from 1 996 to 1 998
11
27
Reversal or consolidation
9 consolidations, 36 reversals
31 consolidations,1 07 reversals
Failure rate
6 or 1 3%
35 or 25%
stocks from 1991 to 1996
Average rise/decline ofsuccessful formations
35% rise
21% decline
Most likely rise/decline
15% rise
20% decline
in 5% increments (instead of 10%) shows that the 15% column has the highest frequency. Even though the 20% column is highest in the chart, the mostlikely rise is really 15%.The average decline from a diamond top is 21 %, although the most likelydecline is 20%. Figure 11.10 shows a frequency distribution of the losses.There are a larger number of samples and the bell-shaped curve is smoother.Diamond tops are one of the few cases where the average decline is near themost likely decline. This suggests the declines are evenly distributed about theaverage (there are few large declines that pull the average upward).The 35% rise for diamond bottoms is below the average 40% return forother types of bullish formations. Diamond tops, on the other hand, showdeclines (21 %) similar to other bearish formation types.
The measure rule, discussed in the Trading Tactics section of this chapter, involves calculating the formation height and either adding or subtracting
Of those succeeding, numbermeeting or exceeding pricetarget (measure rule)
35 or 95%
86 or 79%
Average formation length
1 .5 months (49 days)
1 .5 months (52 days)
Volume for breakout day andnext 5 days compared with daybefore breakout
1 51 %, 1 74%, 1 51 %, 1 23%,1 37%, 1 39%
152%, 200%, 177%,
1 60%, 1 60%, 1 79%
the difference from the breakout price. The result is the minimum target price.For bottoms, nearly all (95%) of the formations reach the predicted targetprices. However, tops have a success rate of 79%. I consider values above 80%to be reliable.The formation length from start to breakout is similar for both diamondtypes, at about 7 weeks (49 and 52 days). That is comparatively short.
176
Diamond Tops and Bottoms
Statistics
177
that fail to rise by more than 5%. As explained earlier, this is probably due tothe small sample size.The significance of this result is that once prices break out of the formation, they continue moving in the same direction (by at least 5% anyway), suggesting that a trader should wait for the breakout, then trade with the trend.
Breakout statistics listed in Table 11.3 show bottoms having upside breakouts 82% of the time and tops having downside breakouts 79% of the time.Bottoms have throwbacks to the price level of the breakout (where prices. pierce the diamond boundary) 43% of the time, whereas pullbacks after a diamond top reversal occur just over half the time (59%). Throwbacks allow" investors another opportunity to either place a trade or add to their position.
Pullbacks are an opportunity to exit the position before the decline resumes orto initiate a short sale. If you are on the wrong side of a trade and are givenanother opportunity to leave the trade, take it. If you do not, things only
Figure 11.10 Frequency distribution of losses for diamond tops. The most likelydecline after a diamond top is 20%.
Table 11.3 shows breakout statistics for diamond tops and bottoms. Bothtops and bottoms have breakout volume that is half again has much as theprior day, on average. It remains high throughout the next 5 trading days. Tendiamond top formations have downside breakouts that fail to continue declin-
get worse.For both throwbacks and pullbacks, the average time for prices to returnto the breakout point is 11 days. In all cases, the throwback or pullback occursin less than 30 days. Anything taking longer than a month classifies as normalprice action and is not a throwback or pullback.For successful formations, the average time to reach the ultimate low orhigh is almost twice as long for bottoms (122 days) than it is for tops (65 days).
This makes sense when coupled with the average price rise and fall. Bottomsrise almost twice as far (35%) as tops fall (21 %), so it is not unusual for bottoms
ing by more than 5%. Since this represents only 9% of the formations, the
to take almost twice as long to cover almost twice the distance.Where do breakouts occur in the yearly price range? For bottoms, 56%
result is quite good. There are no diamond bottoms that have upside breakouts
of breakouts occur in the center third of the yearly price range. For tops, 69%
Table 11.3Breakout Statistics for Diamond Tops and Bottoms
numbers, you may wonder how a diamond bottom can occur in the top of theprice range or a diamond top can occur in the bottom of the price range.I base my definition of a bottom or top on the price trend leading to theformation, not the price itself. Diamond bottoms have price trends that decline
of breakouts happen in the top third of the price range. Considering these
Description
Bottoms
Tops
Upside/downside breakout but failure
0
10 or 9%
Upside breakout
37 or 82%
29 or 21 %
Downside breakout
7 or 16%
109 or 79%
Horizontal breakout
1 or 2%
0
Throwbacks/pullbacks
16 or 43%
64 or 59%
Average time to throwback/pullbackcompletion
11 days
11 days
For successful formations, days toultimate high/low
4 months (122 days)
2 months (65 days)
Percentage of breakouts occurring near12-month low (L), center (C), or high (H)
L16%, C56%, H28%
L7%, C24%, H69%
Percentage gain/loss for each 12-monthlookback period
L30%, C37%, H35%
L26%, C15%, H20%
to the start of the formation; diamond tops have price trends that lead up to theformation at its start. If this is still confusing, review Figures 11.1 and 11.2.The formations are grouped according to the price trend because theyshare the same characteristics. When prices rise up to a formation (as in thecase of a diamond top), expect a reversal to send prices declining once the formation completes. If you classify a formation based on price, then tops will
form at the top of the yearly price range and bottoms will form at the bottom.How do you classify a formation that appears in the middle of the range? It canbe either a top or a bottom. See the dilemma?Substituting the percentage gains or losses in the yearly price range, wefind most successful bottom reversals rise by 37% (and they have breakouts thatoccur in the center third of the yearly price range). Since all three of the gains(30%, 37%, and 35%) are relatively close, and since the frequency distribution
178
Trading Tactics
Diamond Tops and Bottoms
Dow Chemical Co. (Chemical (Basic), NYSE, DOW)
used to gather these statistics rests on a few samples (5, 18, and 9, respectively),do not read too much into the numbers.Tops tell a similar story. The statistics suggest tops occurring in the lowerthird of the price range decline further. This may or may not be true since it isbased on only five samples (the other two categories have 17 and 50 samples,respectively).
Trading Tactics
DiamondBottom
Table 11.4 shows trading tactics for diamond tops and bottoms. Use the measure rule to predict the minimum price move. Consider Figure 11.11, a chartof a diamond top and diamond bottom. Compute the measure rule by firstfinding the formation height. Locate the lowest low in die formation (shownas point B) and subtract it from the highest high (point A). Subtract the difference (in the case of diamond tops) or add it (for bottoms) to point C—thebreakout price. The result is the minimum target price.For the diamond top, the formation height is 75/s (that is, 79'A - 715/s).Subtract the difference from point C to get the target price of 657/s (or 731/? 75/s). Point C, incidentally, is where prices pierce the diamond trendline. Pricesmeet the target just 1 week after the breakout.Calculation of the measure rule for diamond bottoms proceeds in a similar manner. The height turns out to be 33/4 (that is, 713/4 - 68). Add the difference to point C, the location where prices pierce the diamond boundary. Thetarget price is 74'/2 (or 703/4 + 33/4). Prices meet the target in just 3 days.As noted in the Statistics section of this chapter, prices fulfill the measurerule 95% of the time for diamond bottoms and 79% for tops. Both these numTable11.4Trading Tactics for Diamond Tops and BottomsTrading Tactic
Explanation
Measure rule
Compute the formation height by subtracting the lowest lowfrom the highest high in the formation. For tops, subtract thedifference from the location where prices pierce the diamondboundary. For bottoms, add the difference to the breakoutprice. The result is the minimum price move to expect.Alternatively, formations often return to price levels from whichthey begin. The base serves as a minimum price move.
Wait for breakout
For best results, wait for prices to close outside the diamondtrendline before placing a trade.
Risk/reward
Look for support (risk) and resistance (reward) zones beforeplacing a trade. These zones are where the trend is likely to stop.From the current closing price (before the breakout), computethe difference between the zones and the current price. Theratio of the two must be compelling enough to risk a trade.
179
Aug 94
Sep
Figure 11.11
Oct
Nov
Dec
|an 95
Feb
Mar
Apr
May
Triangle
)un
Jul
- 66
Aug
Adiamond top and a diamond bottom. Compute the measure rule
using the formation height by subtracting point B from point A. For diamond tops,
subtract the difference from point C and for bottoms, add the difference. Theresult is the expected minimum price move. Diamonds often return to their base.The Expected Decline and Expected Rise lines are another way to gauge the minimum price move. A symmetrical triangle appears in late May.
bers are high enough that you should consider the measure rule a reliable priceprediction mechanism.However, there is an alternative method that sometimes yields moreaccurate results. The method involves looking at the price chart and seeing ifthere is something to reverse. By this I mean diamonds sometimes form aftera quick run-up in prices. The reversal will usually erase these gains and returnprices to where they were before the run-up.Figure 11.1 is a good example of this. Prices make a 1-day jump from the20 area. After the reversal completes, prices quickly return to the same level.Figure 11.11 also shows the two jump-off points. The diamond top startsclimbing from the 68 level. Prices quickly return to this level after the reversal(see the Expected Decline line shown in Figure 11.11).The diamond bottom has a start from the 74 level (see the Expected Riseline in the figure) to which prices quickly return after the reversal. After reaching that level, prices do not exceed it for almost 2 months.When trading technical formations like diamond tops and bottoms, itis always safest to wait for the breakout. Although failures from bottomsoccur only 13 % of the time, tops are more error prone (with a failure rate of25%).
180
Diamond Tops and Bottoms
If you do not wait for the breakout, you may face a situation similar tothat discussed in the Focus on Failures section of this chapter. Instead ofreversing, prices resume their original trend and the investor misses out on
additional gains or suffers larger losses.Before placing a trade, consider the risk/reward ratio. In essence, youfirst identify the support and resistance levels and calculate the differencebetween those levels and the current price. Trades that result in risk/rewardratios of one to four or higher are worth making. When the ratio drops below
one to four, the risk may be too high to warrant a trade. An example makes thecalculation clearer. For the diamond bottom shown in Figure 1 1.6, assume thefigure is all that is known about the stock. On the left side of the figure, the
stock descends to 6'/2 before rebounding. The stock bounces from this level,suggesting that the price level is a support zone.The measure rule suggests prices will rise to 145/s, about where pricestopped out recently (the resistance level shown in Figure 1 1 .6). The close the
day before the breakout, is 1 1 /i6. Calculating the differences between the support and resistance zones to the closing price gives a ratio of (1 1 13/i6 - 6l/i) to(145/g - H13/i6) or 5.31 to 2.82. The ratio is slightly less than two to one and itwarns that the risk of failure is higher than the potential reward. The 2:1 ratiois well outside the 1 :4 minimum. You would be taking on twice as much risk aspotential reward. You could always tighten up the risk by placing a stop-lossorder at die base of the diamond or even closer to the purchase point. Thecloser the stop is to the buy point, the more likely normal price fluctuationswill take you out.
Sample TradeScott recently graduated from engineering college and took his first professional job at a growing software company. The job pays well, but he has many
school loans and a mountain of debt. He thought of using his paycheck to keepahead of the bills while depending on the bull market to furnish the luxuries.He had his eye on a new stereo system and wanted it for a party he washosting during the Fourth of July festivities. That did not leave him much
time, so he searched for a chart pattern he could trade profitably. He chose thediamond bottom shown in Figure 11.11. Scott first noticed the diamond inMay, a few days before the breakout. He believed that the price would notdecline below 697/s, l/z below the round number of 70 and at the same level asa couple of price peaks in January.
Risking just $0.75 with a possible reward of $3.75 gave him a risk toreward ratio of 1:5, he calculated. If everything worked as planned, he wouldmake a tidy sum, enough to buy the stereo.The day after the stock broke out upward, he bought and received a fill at71/4 (near point C in Figure 11.11). That was higher than he liked, but with
the strength shown, he was sure the tradplaced his stop-loss order at 697/s with hisclosed at 75, above the target price. He drodle the knobs and flip the switches of his dThen things began going wrong. Th72'/s. It dropped to 713/8 the next day and mdenly, Scott was losing money and his steplugging. Should he sell the stock and putLuck was on his side and prices began74, but the honeymoon did not last long. Pangle but Scott did not see it. They broke otrendline (extend the lower right diamondstock even gave him another chance to getpullback to the triangle boundary. Scott wmissed the signal. When he received a call fing that the stop took him out at 697/8, Scotwhat went wrong. Do you know the answer
'
12
The average rise is 40% but is tempeing gains less than 15%. These small risesmations showing gains over 45%. The m30%, relatively high for bullish formationsThrowbacks occur 68% of the time,
Double Bottoms
throwback and invest once prices turn up
throwback can save you from making an uA surprising finding is that bottomspaced farther apart. The Statistics sectiomore detail.
Tour
Appearance
A downward price trend bottoms out, rises, thenbottoms again before climbing.
What does a double bottom look like? Figdouble bottom. Prices reach a high in mnext 3 months, prices continue down in a sVolume picks up as prices near themillion shares on June 18, the day prices rehigh, the stock declines 47% in 3 months.point and the stock moves upward. Howevprices round over and head down again. I
Reversal or consolidation
Short-term (up to 3 months) bullish reversal
low when the stock drops to 13.06, also on
Failure rate
64%
Failure rate if waitedfor breakoutAverage rise
3%40%, with most likely rise between 20 and 30%
Volume trend
Downward until breakout
Throwbacks
68%
Percentage meetingpredicted price target
68%
RESULTS SNAPSHOT
Fleetwood Enterprises (Manuf. Hou
Surprising finding
Bottoms closer together show larger gains
See also
Head-and-Shoulders Bottoms, Complex; Horn
Bottoms
Perhaps the biggest surprise with double bottoms is the high failure rate at64%. Only a third of the formations classify as true double bottoms. They arethe ones that have prices rising above the confirmation point, which is thehighest high between the two lows. The failure rate tumbles to just 3 % if onewaits for confirmation. Only those formations with confirmed breakouts are evaluated in this study.182
Mar 92
Apr
May
Jun
|ul
Au
Figure 12.1 A double bottom occurs after acommonly occurs on the first bottom.
184
Double Bottoms
Identification Guidelines
W
185
General Mills Inc. (Food Processing, NYSE, CIS)
The day after the low, on a burst of buying enthusiasm, the stock jumpsup and reaches the confirmation point in just 2 days. Instead of continuing
upward, however, the stock throws back to the breakout point and moves horizontally for just over a week before resuming its move upward. By late January, the stock reaches a high of 267/8, again of75% from the breakout price.Figure 12.1 shows a double bottom and the gains achieved by such a formation. Are there key elements that make up a double bottom? Yes, and a discussion of the key elements follows in the next section.
Identification GuidelinesNot any two bottoms at the same price level will suffice for a double bottom.
Listed in Table 12.1 are a number of guidelines that make correct selection easier. While considering the guidelines, look at Figure 12.2. The stock beginsdeclining in mid-October 1993 from a price of about 56l/2. It bottoms out atApr 94
Table 12.1Identification Characteristics of Double BottomsCharacteristic
Discussion
Downward price trend
Prices trend down (short term) and should not driftbelow the left bottom.
Rise between bottoms
There should be a 10% to 20% rise (or more) betweenthe two bottoms, measured from low to high. Peaks closetogether tend to be at the lower end of the range. Therise usually looks rounded but can be irregular.
Dual bottoms
Bottom to bottom price variation is 4% or less. This is notcrucial except that the two bottoms should appear nearthe same price level.
Bottom distance
Bottoms should be at least a few weeks apart (manyconsider a month to be the minimum), formed by twoseparate minor lows (not part of the same consolidationarea). Minimum bottom separation is not critical as thebest gains come from formations with bottoms about 3months apart, on average.
Prices rise after right bottom
After the second bottom, prices must rise above theconfirmation point without first falling below the rightbottom low.
Bottom volume
Usually higher on the left bottom than the right.
Breakout volume
Volume usually rises substantially.
Confirmation point
The confirmation point is the highest high between thetwo bottoms. It confirms that a twin bottom formation isa true double bottom. A breakout occurs when prices riseabove the confirmation point.
May
|un
]ul
Aug
Sep
Oct
Nov
Dec
|an 95
Feb
Mar
Figure 12.2 Invalid double bottom. Points A and B do not depict a double bottom because there are lower lows to the immediate left of point A.
about 411/? in mid-May. Prices never drop below the left low on the way to thebottom. The reason for this guideline is that you should use the two lowestminor lows on die price chart. Do not try to select one low then a nearby lowjust to satisfy the guidelines. The two points marked A and B in Figure 12.2 represent an incorrectly selected double bottom because point A has lower lows todie left of it.The rise between the two bottoms should climb at least 10%, as measuredfrom the low at the bottom to the rise high. The confirmation point is diehighest high between the two bottoms, and it is used to calculate the measurerule and to gauge the breakout price (more about diat later). Figure 12.2 showsa rise from the right bottom, at 415/32, to a high of Mlh. That is a rise of 15%,well above the 10% threshold.The bottom to bottom price variation should be 4% or less. The basicrule is that the two bottoms should appear to be near one another on the pricescale. Figure 12.2 shows a price variation of about 1%.The two bottoms should be at least a few weeks apart but are often separated by many months, as shown in Figure 12.2.1 set a 10-day minimum as diestandard for selections in this study (15 days between turns out to be the measured minimum for all double bottoms hi this study). A month is the minimumseparation that many professionals view as leading to powerful rallies. I set alower standard to help verify diat this is true. It turns out that peaks close
186
Focus on Failures
Double Bottoms
together perform better than those spaced farther apart. I limited the maximum separation to about a year (the widest had a separation of 374 days).Many of the identification guidelines are arbitrary and the classic definition of a double bottom has different ones. The classic definition says that thetwo bottoms should be at least 1 month apart, separated by less than a 3 % pricevariation, and have a confirmation point that rises 20% above the low (bottomscloser together have somewhat lower confirmation points). The rise betweenthe two troughs should look rounded.I examined the performance difference between my definition and theclassic one and optimized the parameters to achieve the best performance.What I discovered is that there is no meaningful performance differencebetween the various settings, so I used the less stringent guidelines in the statistical evaluation (10-day minimum separation, 4% price variation, 10% minimum rise to the confirmation point).A double bottom is not a true double bottom until prices rise above theconfirmation point. In tabulating the statistics, / only count those double bottomsin which prices rise above the confirmation point. Why? Because of the high failurerate: 64%. There were 980 formations that looked like double bottoms, buttheir price trends eventually moved below the second bottom. An additional525 formations performed as expected by rising to the confirmation point andcontinuing higher. If you buy a stock just after it touches the second bottom,your chances of having a successful trade are one in three. In other words, waitfor prices to rise above the confirmation point.
The volume chart for double bottoms usually shows the highest volumeoccurring on the left bottom. Diminished volume appears on the right bottom,and the volume trend of the overall formation is downward. None of these areabsolute rules. Sometimes volume is highest on the right bottom instead of die
left. However, on average, most of the formations obey the guidelines.The breakout volume is high, usually well above the prior day's volumeand above the average volume as well. Again, this is not an inviolate rule soexpect exceptions.Why do double bottoms form? To answer that question, consider thedouble bottom shown in Figure 12.3. Prices reach a high in mid-April 1993and move horizontally until nervousness sets in during September. Then pricesstart moving down, sliding from a high of 337/g to 20'/4 by late June 1994, a40% decline in 9 months.
After reaching a multiyear low in June, prices recover some of their lossesby moving upward. After reaching a new low, a rebound is quite common witha retest of the low typically following. A retest is just like it sounds; pricesreturn to the low and test to see if the stock can support itself at that price level.If it cannot, prices continue moving down. Otherwise, the low usually becomesthe end of the decline and rising prices result.Such is the case depicted in Figure 12.3. It seems clear from the volumepattern that many investors believe the low, shown as point B, is a retest of
187
Central and South West (Electric Utility (Central), NYSE, CSR)
May 94
|un
Figure 12.3 Prices confirm the breakout once they close above the confirmationpoint, shown here as the horizontal line. The confirmation point is the highest highreached between the two bottoms. Prices often throw back to this level after thebreakout.
point A. Volume surges on two occasions in the vain hope that the decline hasended. Investors are wrong.Prices hold at 21 for about a week before continuing down. As prices headtoward the level of the June low, volume surges again. This essentially marksthe end of the downward plunge. Prices hesitate at that level for slightly lessthan 2 weeks before turning around and heading upward.A double bottom is nothing more than a retest of the low. Investors buy
the stock in the hope that the decline has finally ended. Sometimes they areright and sometimes they are not, which leads us into the next section: failures.
Focus on FailuresIt is obvious that the formation pictured in Figure 12.4 is a double bottom. Thefirst bottom occurs after a downward price trend, as you would expect. Thetwo bottoms are far enough apart, the rise between them is sufficient to delineate two minor lows, and the price variation between the two bottoms is small.The volume pattern is unusual in that the second bottom has a higher, denservolume pattern than the first. However, this is not significant. After the secondbottom, prices rise at a steady rate until the confirmation point. Then pricesjump up and pierce the prior minor high at about 40s/s. When prices close abovethe confirmation line, it signals a valid breakout and confirms the double bottom formation.
188
Double Bottoms
Statistics
In this case, as is common for most double bottoms