60% retraces of the prior rise or fall. At those points, prices are somewhat more likely to stage a rebound. That is what occurs in Figure 6.3. Pricesrise from a low of 13% to a high of 187/8. A 40% retrace of this range takes pricesback to 163/4. This is quite close to 17, and you can see some hesitation in thestock at that level. However, once the stock approaches the 60% retrace level(15%), the smart money knows the jig is up. They start buying heavily for the 5days surrounding the new year. Prices halt their decline and move higher. However, sellers are not sitting by idly. They sell into the rally and prices eventuallystall and drift lower, forming the partial decline highlighted in Figure 6.3.As it happens, volume dries up as prices trace a V-shaped pattern. Lowvolume before an upside breakout reminds me of the calm before an approaching storm. Formations such as ascending and descending triangles commonlyhave low volume just before a breakout. Volume spikes upward the day pricesclose above the prior minor high (where the top trendline ends in January).The momentum players take the upper hand, and prices surge higher on veryhigh volume.
Focus on FailuresI classify a failure two ways. First, when the formation acts as a reversal—thatis, a failure of the formation to continue the direction of the prior trend. Sincedescending broadening formations usually act as consolidations of the prevailing trend, a reversal is a failure. Figure 6.2 shows this type of failure.Figure 6.4 shows a second way for a failure to occur, a formation that actsas a consolidation of the trend. Before the formation begins, prices are rising.Immediately after the breakout, prices are also rising. The process starts onSeptember 3 when prices punch through the top trendline. However, they donot travel very far before returning to the trendline. I have extended the toptrendline in Figure 6.4 to make the throwback clear. You see that prices ridealong it until they gap down (a breakaway gap) on September 17.This formation is what I call a 5% failure, that is, when prices breakoutand move less than 5% before reversing course. Failures to act as a consolidation of the trend are common; failures to continue moving by more than 5%
93
, Breakout
|un92
Figure 6.4 This formation is a failure according to the 5% rule. Prices fail to moveaway from the formation by more than 5% before moving down.
are not. Only four formations, or 3%, do not pass the 5% rale. The lessonsfrom this analysis suggest that it is imperative that you wait for a breakoutbefore placing a trade. Once a breakout takes place, prices will continue moving in the direction of the breakout.
StatisticsThe descending broadening wedge is a rare formation, being found in only 101unique stocks (117 formations) over a 5-year span. Of those formations, 66%act as consolidations of the current trend. Table 6.2 shows general statistics forthis formation.As explained earlier, trend reversals count as failures of the formation to
consolidate, so the failure rate is high at 37%. Also included in the rate are four5% failures, where prices move less than 5% after a breakout before reversing.Upside breakouts have an average gain of 46%, which is very high, but itis not so surprising when you consider that this formation acts as a consolidation of the trend. In a bull market, the trend is inherently upward, and this for-
mation simply underscores that fact. Still, many bullish formations have gainsof about 40%, so this one scores well.The most likely rise from this formation is 20%, suggesting that thereis an inordinate number of large gains. The number derives from a frequencydistribution and a review confirms this suspicion. Forty percent of the chart
94
Broadening Wedges, Descending
StatisticsUnited Illuminating Company (Electric Utility (East), NYSE, UIL)
Table 6.2General Statistics for Descending Broadening WedgesDescription
Statistic
Number of formations in 500 stocks from1991 to 1996
117
Reversal or consolidation
78 consolidations, 39 reversals
Failure rate
34 or 37%
Average rise of successful formations
46%
Most likely rise
20%
Of those succeeding, number meeting orexceeding price target (measure rule)
47 or 81%
Average formation length
2.5 months (76 days)
For successful formations, days to ultimate high
6.5 months (190 days)
Volume trend
64% have a rising volume trend
Partial decline followed by upside breakout
35/46 or 76%
Note: The formation acts most often as a consolidation of the long-term bullish trend.
patterns with upside breakouts have gains over 50%. Since large gains tend topull the overall average up, I ignore the category and choose the bin with thenext highest total. That turns out to be the 20% category.I computed the price target using several different rules and discoveredthat the traditional way works best for upside breakouts. The Trading Tacticssection explains this more thoroughly, but it involves computing the formationheight and adding the result to the breakout price. This results in 81% of theformations meeting their target prices (for successful, upside breakouts only).I consider formations with values above 80% to be reliable.The average formation length is about 2 '/2 months and results in a longterm move (6 months or longer). This formation is one of the few that havelong-term, bullish implications. The long-term category is a reinforcement ofthe tenet that large rises take longer than shorter ones.The upward volume trend is stronger in this formation than its brother,the ascending broadening wedge. Almost two out of three formations (64%)experience heavier volume over time. The slope of a line found using linearregression on volume determines whether volume is trending up or down overthe length of the formation.Partial declines and rises are important clues to the performance of thisformation. An upside breakout follows a partial decline 76% of the time (Figure 6.5 shows a good example of this).A partial decline must always begin after touching the top trendline. Pricesthen head down toward the lower trendline but do not touch it (or come thatclose). The stock curls around and moves back up and pierces the top trendline, usually immediately. The piercing results in an upside breakout.
95
Partial Decline Followed by Upside Breakout
|an 92
Figure 6.5 A descending broadening wedge with an upside breakout follows apartial decline 76% of the time. The stock must always touch the top trendlinebefore beginning the partial decline and must not come too close to the lowertrendline before reversing.
Downside breakouts also follow a partial rise. However, due to the scarcityof downside breakouts and even fewer partial rises (there are only 5 out of 22),only two partial rises have downside breakouts. The sample size is just toosmall on which to base any conclusions.Table 6.3 shows breakout-related statistics. Premature breakouts arewhen prices close outside the formation boundary (that is, a close above orbelow the trendline) and return to the formation before the genuine breakout.Due to the broadening nature of these formations, you would expect few premature breakouts. That is exactly what happens. There are only seven premature breakouts, six of them occurring as premature upside breakouts.Thirty-four formations with upside breakouts fail. Most of these failuresare due to the formation acting as a reversal instead of a consolidation of theprice trend. If the price trend is downward and the breakout is upward, for example, then the chart pattern is a failure because it does not act as expected. Thereare nine formations with downside breakouts that fail in a similar manner.Most of the formations (79%) have upside breakouts, 19% have downsideones, and the remainder are horizontal (no breakout for months).Throwbacks, when compared to pullbacks, are much more numerous at37 versus 8 simply because there are more upside breakouts. On a percentagebasis, throwbacks and pullbacks are about even at 40% and 36%, respectively,for upside and downside breakouts. The average time to complete a throwback
96
Trading Tactics
Broadening Wedges, DescendingTable 6.3
Breakout Statistics for Descending Broadening WedgesDescription
Statistic
Premature upside breakouts
6 or 5%
Premature downside breakouts
I or 1 %
Upside breakout but failure
34 or 37%
Downside breakout but failure
9 or 41 %
Upside breakout
92 or 79%
Horizontal breakout
3 or 3%
Downside breakout
22 or 19%
Throwbacks
37 or 40%
97
Volume on the day of the breakout averages just 36% above the prior day(136% of the volume figure). However, a day later, the volume rises to 52%above the day before the breakout. We have seen this pattern before. Presumably, once investors recognize a breakout, they jump on the bandwagon. Thatis why the day after a breakout sometimes has a higher average volume.
Trading Tactics
Average time to throwback completion
II days
Table 6.4 outlines trading tactics for descending broadening wedges. Use themeasure rule to predict the minimum price to which the stock will move. First,subtract the lowest price in the formation from the highest. This gives theheight of the formation. Once prices break out upward, add the result to the
Fullbacks
8 or 36%
breakout price to arrive at the target price.
Average time to pullback completion
14 days
Percentage of breakouts occurringnear the 12-month price low (L), center (C),or high (H)
L16%, C45%, H39%
Percentage gain for each 12-monthlookback period
L51%, C53%, H44%
Volume for breakout day and next 5 dayscompared with day before breakout
Figure 6.6 makes die computation of the measure rule clear. The highestprice in the formation is at the start: 471A. The lowest low is near die formation end at 42 ] /s. Add the difference, 5l/a, to the low of the breakout price(441/2) to get the target of 495/g. Consider the target a minimum price move.The daily highs and lows used in die height calculation represent the widestpoints. I use the daily low at the breakout as a conservative measure.
136%, 152%, 101 %, 103%, 89%, 109%
Table 6.4Trading Tactics for Descending Broadening Wedges
Note: Upside breakouts are the most plentiful, occurring 79% of the time.
to the formation top is just 11 days. Fullbacks take 2 weeks, on average, toreturn to the lower trendline axis.Most formations (45%) have breakouts in the center third of the yearlyprice range. To determine this, remove any formation with a breakout less
than a year from the start of the study. Then sort the breakout price (using the
Trading Tactic
Explanation
Measure rule
Compute the formation height by taking the differencebetween the highest high and the lowest low in theformation. For upside breakouts, add the result to thebreakout price to achieve the target price.
Wait for confirmation
This formation has too many failures (trend reversals) torisk taking a position before a breakout. Wait for prices todose beyond the trendiines before placing a trade.
Partial decline
If a stock shows a partial decline from the top trendlineand begins to head back up, consider going long. Anupside breakout most often follows a partial decline.
Trade the trendiines
If the formation is especially broad, buy at the lowertrendline and sell at the top. If the stock executes a partialrise and begins falling, close out the position as it maybreakout downward. Alternatively, sell short at the toptrendline once prices are heading down and close theposition after it rebounds off the lower trendline.
Stops
For intraformation trading, place a stop on the other sideof the trendiines, just to catch an adverse breakout. Movethe stop as prices cross the formation. Pick areas showingsupport or resistance.
daily low) into three categories, low, center, and high, according to where it
appears in the yearly price range. The results indicate where in the yearly pricerange the breakout is most likely to occur.
Since descending broadening wedges trend downward over time, itshould come as no surprise that relatively few breakouts occur in the highestthird of the price range. A formation probably has its start in the highest rangebut trends down and moves into the center third of die range before the breakout. Mapping performance over the yearly price range shows where the bestperforming breakouts occur. The gains are highest in the center third of dierange with scores averaging 53%. This compares with a 46% gain for alldescending broadening wedges with upside breakouts. So if you have a choicebetween two chart patterns, one with a breakout near the yearly high and onewith a breakout in the center of the yearly price range, go with the center one.Chances are, it will perform better.
Note: Unless trading the trendiines, always wait for the breakout then trade with the trend.
98
Sample Trade
Broadening Wedges, Descending
Sample Trade
Cat* Corp. (Diversified Co, NYSE, CMT)
Feb95
Mar
Aug
99
Sep
Figure 6.6 Calculated minimum price move using the measure rule. Take the difference between the high and low in the formation and add the result to thebreakout price. The target price is the minimum you can expect, and prices reachthe target over 80% of the time.
If you are considering buying this stock, it is not obvious at first that abroadening wedge is forming. Over time, once enough minor highs and lowsappear, draw the two trendlines. Then, it becomes a matter of waiting for abreakout. Since most descending broadening wedges break out upward, that isthe way to trade it. However, with a failure rate of 3 7 %, you really need to waitfor prices to close above the top trendline before buying.An exception to this rule is the partial decline. As prices move down fromthe top trendline, watch them closely. If prices reach a support zone and beginmoving up, buy because that is a partial decline, and it usually signals animpending upside breakout. Place a stop '/8 below the curl low, just in case.If the formation is especially wide, try an intraformation trade. Buy at thelower trendline and sell at the top one, or sell short at the top and cover nearthe bottom. With the trendlines sloping downward, a short sale will be moreprofitable. Use a stop Vfc beyond the appropriate trendline hi case of an adversebreakout. Adjust your stop as prices move in your favor. Place them H below asupport zone (long trades) or above a resistance area (short trades).
"Do you feel lucky, punk?" Mary growls as she looks at her computer screen(Figure 6.6). She just finished watching a Dirty Harry movie and is feelingornery.She decides to buy the stock as an intraformation trade once it reboundsoff the lower trendline. When it is clear the stock is climbing again, she pullsthe trigger and receives a fill at 43. Immediately, she places a stop-loss order Vgbelow the lower trendline, at a price of 42. If things go wrong, she only willlose 3%. Then she waits.The stock cooperates by moving higher each day. Soon it is at the toptrendline, and she waits for it to ricochet off the line and begin heading down.It does not. Prices close above the top trendline, signaling an upside breakout.She calculates the price target using the measure rule, 495/s and that is whereshe places her sell order. She raises her stop-loss point to 44, '/s below theminor low in mid-April.As the stock advances each day, she keeps wondering why it has notpaused. She shrugs her shoulders and does not worry about it. When the stockmakes a new high at 473/8, she raises her stop to 45%, slightly below the twominor highs in late April and mid-May.In a burst of energy, the stock zooms up over a 2-day period and reachesher sell point. The stock sells at the high for the day, 495/8. She has cleared over$6 a share on her trade. Even better, the stock moves lower for several days,reinforcing her sell decision.It turns out that she sold too soon, but she does not care. She spotsanother promising formation in a stock she has been following for quite sometime. She leans back in her chair, smiles and mumbles something about luck,then runs to the VCR and plugs in another Dirty Harry movie
Tour
7Bump-and-RunReversal Bottoms
101
all have bottom versions. Why not the bump-and-run reversal? It never
dawned on me to look for the formation before then. As I searched through the2,500 years of stock data looking for candidates, I was skeptical that the formation added real value. Some looked like cup-with-handle formations withthe handle coming first, whereas others looked like rounding bottoms. Onlyafter I compiled the statistics did my thoughts change.If you wait for a breakout, the failure rate drops from 19% to 9%. I consider anything less than 20% to indicate a reliable formation. The average gainis 37%. This is a bit shy of the usual 40% for bullish formations, but the most
likely rise, at 20%, is quite good.The percentage of BARR bottoms meeting the price target is exceedinglyhigh, at 92%. I consider anything over 80% to be reliable. Of course, the measure rule sets the price target. We see how to do that in the Trading Tacticssection of this chapter.
TourWhat is a bump-and-run reversal, anyway? If I had to name this formation
R E S U L T S SNAPSHOTAppearance
Looks like a frying pan with the handle on the leftfollowing a trendline down until a large declineensues.
Reversal or consolidationFailure rate
Short-term (up to 3 months) bullish reversal19%
Failure rate if waitedfor upside breakout
9%
Average rise
37%, with most likely rise being 20%
Volume trend
High volume at formation start, bump start, andbreakout
Throwbacks
38%
Percentage meetingpredicted price target
92%
See also
Cup with Handle; Rounding Bottoms
More than a year after I discovered the bump-and-run reversal (BARR) top, Idecided to look for its complement: the BARR bottom. The reasoning is simple. Many formations, such as double tops, ascending triangles, and triple tops
100
independent of all others, I would probably call it the frying pan or spoon formation because that is what it looks like. However, the formation is just aBARR top flipped upside down, so I call it a BARR bottom. I guess a moreaccurate description is an inverted BARR. Even the word bottom is a misnomer since the best performing BARRs appear in the middle of the yearlyprice range.Why do BARR bottoms occur? Like the top version, the BARR bottomis a study in momentum. Consider the chart shown in Figure 7.1 on a weeklyscale. Since late 1991, the stock was moving sideways—a trading rangebetween 6'/2 and 11. However, that changed during the last week of October1993, when the stock moved up and closed higher than the prior week. At first,this did not seem unusual since many weeks close higher than the prior week,but this one was different. It initiated a long climb to the highs of early January. On the highest volume that the stock had seen in years, the stock hit a newhigh of 143/8 during the week of January 14, 1994. Volume began tapering off,although it was still high, and prices tagged a much smaller peak during theweek of March 25, at 14. The two minor highs, one in mid-January andanother in late March, formed the basis of a down-sloping trendline.As the weekly volume trended lower, so did enthusiasm for the stock.Eventually, bullish sentiment could not sustain the high price and the stockcollapsed. As it headed down, volume continued to taper off. The upwardmomentum experienced during the rise to the highs in January was now working against the stock. Over the course of a year, the stock gave back all its gainsand, by mid-February 1995, it started sinking to new lows.
102
Identification Guidelines
Bump-and-Run Reversal BottomsCKE Restaurants, Inc. (Restaurant, NYSE, CKR)
103
Identification GuidelinesTable 7.1 shows a host of characteristics that correctly identify a BARR bottom. Figure 7.2 illustrates the various characteristics outlined in Table 7.1.Overall, the formation appears as a frying pan. The handle, or lead-in phase,forms a trendline that slopes downward at an angle of about 30 degrees to 45degrees, sometimes more and sometimes less. Draw the trendline along thedaily high prices as the line signals a buying opportunity once it is pierced.Unlike BARR tops, sometimes horizontal trendlines in the lead-in phase
contain valid BARR bottoms. Such situations are rare, though, and shouldprobably be avoided. The trendlines in this study are higher on the left andslope downward—these give the best performance.
93FMAM|
ASO
Table 7.1
N D 94 F M A M J J A S O N D 95 F M AM
Figure 7.1 Bump-and-run reversal bottom. Upward momentum propels priceshigher during late 1993 then stalls at the start of the new year. Volume tapers offand prices follow. A cup-with-handle formation or rounding bottom takes shapeand prices climb 350% from the 1995 lows. A channel appears in late 1993 and afalling wedge in late 1995.
Identification Characteristics of Bump-and-Run Reversal BottomsCharacteristic
Discussion
Frying pan shape
The formation looks like a frying pan with the handle onthe left sloping downward to the pan. After a deepeningdecline that takes prices into the pan base, prices level outand eventually soar out the right side.
Down-sloping top trendline,lead-in height
The handle forms a down-sloping trendline thatapproximates 30-45 degrees (but this varies withscaling). The handle portion of the formation is called thelead-in as it leads in to the bump phase. The lead-inheight measures from the trendline drawn across thehighs to the low (not necessarily the lowest low) of theformation. Select the widest distance from the trendlineto the low, measured vertically, in the first quarter of theformation. The duration of the lead-in should be at least amonth, but varies depending on the situation.
Bump phase
The bump is analogous to the frying pan base. The downsloping trendline deepens to 60 degrees or more. Pricesdrop rapidly then level out and turn around, usuallyforming a rounded turn. After the turn, prices move upand sometimes pause at the 30 degree trendline beforemoving higher. The bump height, as measured from thetrendline to the lowest low, should be at least twice thelead-in height. Strict adherence to this rule is notrequired, but it serves as a good, general guideline.
from the low.Many would recognize this formation as a cup-with-handle, and indeed it
Uphill run
Once prices lift out of the bump phase, they begin anuphill run that carries prices higher.
is. But it is also a BARR bottom, as a cup does not depend on a down-slopingtrendline and a larger handle on the left such as that shown in Figure 7.1.Whatever you call the formation, the result is still the same: Prices move
Volume
Volume is typically high during the three critical parts ofthe formation: formation start, bump start, and upsidebreakout. However, high volume is not a prerequisite.
higher.
Note: The frying pan shape and descending trendline is a study in bearish momentum.
High volume a month later was a key as it signaled a turning point. Aweek later, again on high volume, the stock closed higher by over 10%. Theupward move had begun but soon stalled out. The stock moved sideways foranother 2 months, gathering strength for the uphill run. Then it took off, notjumping up, but slowly moving higher, almost week after week. When thestock reached the trendline in mid-August, it was clear that it had executed amassive rounding bottom—a turn in the trend that signaled higher prices.
The stock pushed through the trendline on relatively high volume, thenpaused for a month, and formed a falling wedge or pennant. Following that, onvery high volume, prices jumped up to new highs, but this did not last verylong as the stock entered a consolidation phase just below 18. There it stayedfor many months before the stock jumped up and ran still higher. By late June,the stock had touched 283/4) a rise of about 140% from the breakout, and 350%
104
*,
Bump-and-Run Reversal Bottoms
Focus on Failures
105
the formations will have hit their ultimate high and started moving downagain.
Bethlehem Steel Corp. (Steel (Integrated), NYSE, BS)
Focus on FailuresFigure 7.3 shows what a BARR bottom failure looks like. The stock starts itsascent in June 1994 when it hits a low of 24'/2 (not shown). Although the riseis not a straight-line path, prices reach a new high a year later (the highest peakon the left). Then it is downhill from there. The decline is quite orderly withpeaks that follow the trendline down. During early September, however, pricesdrop rapidly on high volume as the bump forms. Prices quickly reach a low of335/8 before rebounding. Having sliced through the trendline and moving just
a bit higher, prices throw back and follow the trendline lower. Prices following a trendline lower are not unusual, but what is unusual is that prices do not'-12
Figure 7.2 Various components of a bump-and-run reversal bottom. A pricedrop-off follows the lead-in phase where prices move in a narrow range. The bumpforms, then rounds upward as prices leave the bowl and move higher on the uphillrun to new highs.
continue their climb. Instead, they drop off the end of the trendline and plummet. By late June, they slip to under $20 a share, less than half what they wereat the high.Why did the BARR fail? This formation is not a perfect example of aBARR bottom, but few formations are. In this case, the bump height is less
Apple Computer Inc. (Computers & Peripherals, NASDAQ, AAPL)
Calculate the lead-in height once a trendline forms. Do this by finding
the widest distance from the trendline to the daily low, measured vertically, inthe first quarter of the formation. In Figure 7.2, the lead-in height calculation
uses prices on June 16 (point A). On that day, the low is 175/s and the trendlinehas a value of about 203/s. Thus, the lead-in height is the difference betweenthese two, or 2 /4. Both the minimum bump height and the target price use thelead-in height, so the calculation is important.After the lead-in phase comes the bump phase. Prices decline rapidly,although usually not quite as rapidly as that shown in Figure 7.2, and form anew trendline that slopes down at about 45 degrees to 60 degrees or more.Volume is noticeably higher at the start of the bump, but selling pressure overtakes buying demand and the truth finally comes out: There are problems withthe company. The stock continues down as the smart money and the momentum players leave the stock in droves.Eventually, downward pressure abates allowing the stock to recover. It
rounds over and touches the original 30 degree trendline. Here, it may movelower for a while or it may sail right through the trendline. About a third of the
time, prices start moving higher, then throw back to the trendline before continuing up.Volume picks up as prices break out of the formation and move higher.Rising prices characterize the uphill run phase. Within 3 months, about half
)un95
Figure 7.3 A bump-and-run reversal bottom failure (less than 20% fail). Thebump height is less than twice the lead-in height, a clue that the pattern probablyis not worth investing in. A trendline drawn from point A to B (not shown) satisfiesthe bump to lead-in height guideline. Using the new line, an investor waiting forprices to move above the trendline would not buy this stock.
106
Statistics
Bump-and-Run Reversal Bottoms
than twice the lead-in height. However, this depends on how the trendline isdrawn. Drawing a trendline beginning from the peak at point A, the bump tolead-in height is about 2 to 1 . The new trendline also touches the peak at B. So,if you wait for prices to move above the new trendline before investing, youwould not purchase this stock. Sometimes it is wise to draw alternative viewsjust to see how the chart pattern behaves (do not forget to draw the pattern onlogarithm-based scales).
Statistics
_
107
ultimate high. This is a very good number but is even higher if you happento catch the rise sooner. From the low during the bump phase, the rise isan astounding 57%. Of course, trying to predict the bottom is exceedinglydifficult and I would not use the 57% figure as anything but a statistical
observation.Undo influence by a number of large gains can affect the average, so I
created a frequency distribution of gains to check the result (Figure 7.4). Thegraph shows that the most likely rise is 20%. The graph also shows the relatively high number of large gains (41 formations or 14% with gains over 90%).The many outsized gains apparently pull up the overall average.If you trade this formation, you might be lucky to have a large gain, but
To determine how the average BARR bottom performs, I searched the hundreds of stocks in the database and tabulated their performance statistics. Table7.2 shows the results. Compared with other formations, the BARR bottom is
you probably will not. Instead, expect a more reasonable rise and use the likelygain of 20% as the benchmark. That is the tallest column in Figure 7.4—the
plentiful, appearing 360 times in 2,500 years of daily price data. When the
one with the highest frequency—and it represents the most likely gain.The measure rule, which predicts the target price, works 92% of the time
BARR bottom appears, it acts like a reversal of the prevailing trend 55% of the
when using the lead-in height as the benchmark. Simply add the largest height
time and a consolidation the remainder of the time.
found during the first quarter of the formation to the breakout price. Theresult is the target price to which prices rise, at a minimum. Later (see Trad-
The BARR bottom performs well with 81 % of the formations movingupward at least 5 % after the breakout. If an investor waits for an upside breakout, the performance is even better, with 91% of the formations movinghigher