asyou can see during the rise in late August.) TheGH move is near the same price as the curvingprice trend in December 2003, which suggests there might be a supportzone there.There are two more chart patterns buried in the figure. The first is ahigh, tight flag. That pattern appears when price doubles in less than twomonths, as it does from D to E. Price forms a flag or, in this case, the descending triangle. Expect the upward move after F to be at least half theprior move. That suggests a climb to just over 9, for a gain of 19%, assuming you buy in at the breakout price.The second pattern is one that appears better on the weekly scale.Since we need to check the longer-term chart anyway, look at Figure 4.7.Trying to orient myself between Figure 4.6 and Figure 4.7 reminds me ofa navigational test that I was given when applying for a scholarship as anAir Force pilot in the ROTC. I don’t think that I answered any of thequestions right, but I digress. For reference, AD is the measured move
Using SAR to Trade
47
down and E is the top of the high, tight flag, just before the descendingtriangle begins.I show a downsloping trendline from the two peaks on the far leftside of the chart and join it with a horizontal trendline from another descending triangle in 2001. Price has climbed to the level of the peak at A,stalling at the intersection of the two trendlines. From the breakout nearE, price peaked at 11.55. That is a 51% rise; but it assumes you buy in atthe breakout price and sell at the top. Still that is a juicy return and one Idecided not to take. Given the overhead resistance, I decided to pass upthe trade. Just because you think a stock might stall at a given price doesn’tmean it will. After I snapped the picture, price declined to 8 and somechange and headed down. Pull up the chart on your own computer toget a clearer picture.
Medarex Inc. (Drug, NASDAQ, MEDX)97796452433428221613
ADescendingTriangle
E
107
D
M A M J J A S O ND01FM A M J J A SON D02FMA M J J A SOND03FMAMJ J ASOND04FMAMJ J ASOND
4
1
FIGURE 4.7 Price climbed to the old peak at A before stalling. The twotrendlines indicate where overhead resistance might be a problem.
48
SUPPORT AND RESISTANCE
SAR Review and ChecklistFor further review, see also the suggested chapter section in the list entries that follow. Look for price to stall:• If a chart pattern appears in the price path. See Chart Pattern SAR.• If a Fibonacci retracement occurs. Prices retrace 38%, 50%,and 62% of the prior move before reversing. See FibonacciRetracements.• At old peaks and valleys. SAR zones appear between 19% and27% of the time at an old peak or valley. See Peaks and Valleys.• At horizontal consolidation regions. Look for flat tops, flat bottoms, or where a block of prices share the same value. See Horizontal Consolidation Regions.• At round numbers like 10, 15, and 20. Prices stop within 50cents of a round number 20% of the time and within a buck ofa round number 40% of the time. See Round Number SAR.• Along trendlines. Price follows trends, so expect it to bounce off atrendline when it touches a long one. See Trendline and Channels.• If high volume accompanies price. See SAR and Volume.“How do I find out about a company?” Jake asked. “I want to knoweverything there is to know about the jerks running my health insurancecompany.”I had no idea that my answer would be so important to him.
5Chapter
Special Situations
oday I’m going to teach you about special situations,” I toldJake. That’s what I call them because they can provide tradingopportunities or signs of things to come. Some situations areworth looking for and some are just informational. I discuss them in thischapter, sorted alphabetically.
“T
Bull and Bear Markets“What about this one?” Jake said and turned to me, smiling. He waslooking for chart patterns to hone his skills paper trading.I scooted my chair over and looked. “You’re going the wrong way.”If he had his glasses on, I’d take them off and clean them for him. “You’dbe going long in a bear market. That’s like driving the wrong way on theinterstate. Try again.”One of the keys to making money trading chart patterns is to tradewith the trend. If you’ve been in the markets for long, you will haveheard the phrase, trade with the trend. But what does that mean? Buy in abull market and sell short, or go into cash, in a bear market.Once you become familiar with chart patterns, you can look at theS&P 500 index and tell which way price is likely to go in the coming49
SPECIAL SITUATIONS
50
weeks. You won’t be right all of the time, but you will be able to make accurate predictions that help your trading. If you expect the index toclimb, then go long. If you expect the index to drop, then stay out of themarket or buy defensive stocks (utilities, for example, which pay dividends and are usually not as volatile as other stocks).I’m writing this in February 2005. On January 3, I was stopped outof Vertex Pharmaceuticals for a 9% loss. Ouch! But that was only thestart. The next day, another four stocks hit their stops, some for a profit,and some for a loss. By midmonth, the market had stopped me out ofevery stock. Sure, I was up nearly $10,000 on the trades, but I was hoping for more—much more.My instinct was to go shopping for new trades but the market kepttelling me the same thing: it was going down. And down it went. I foundsome footing in Exxon Mobil and Lyondell Chemical when they showedascending triangle chart patterns. Their bull run lasted about a monthand I netted $4,350 on the pair.Let’s get back to bull and bear markets. Chart patterns perform differently depending on how the market is doing. Since I mentioned ascending triangles, let’s talk about them. I found 1,092 ascending trianglesand measured their performance after the breakout. Table 5.1 shows theresults. In a bull market, triangles with upward breakouts showed pricesrising an average of 35% after the breakout. Don’t think that you willmake 35% trading triangles because (1) commissions aren’t included; (2)you can be a lousy trader; and (3) the 35% number represents 663 perfecttrades, exiting at the very top without any fees deducted.Notice that the decline in a bear market (24%) is not as large as isthe rise in a bull market (35%). You can make more money in a bull market than in a bear market.If you want the complete set of bull/bear market numbers, grab a copyof my book, Encyclopedia of Chart Patterns, 2nd ed. (John Wiley & Sons,2005). It shows the performance statistics for 63 chart and event patterns.
TABLE 5.1 Ascending Triangle Performance in Bulland Bear MarketsAscending Triangles
Bull Market
Bear Market
Upward breakout
35%
30%
Downward breakout
19%
24%
Bull and Bear Traps
51
Trade with the trend. Trade chart patterns with upward breakouts ina rising bull market and downward breakouts in a falling bear market forthe best performance. Avoid countertrend patternmoves such as buying an upward breakout in afalling market or shorting a downward breakout incountertrendpatterna rising market. That’s like swimming against thea pattern with ancurrent. You will make it to the other side of theupward breakoutriver, but if you don’t hurry, the hot shots on the jetin a bear marketor a downwardskis might run you over. Make as much money asbreakout in a bullyou can in as little time as you can in the market.market. TheBy “trade with the trend,” I mean not only thebreakout directionis against themarket trend but the industry trend as well. If theprevailing marketstock market is red hot but the machine tool industrend.try is suffering, then stay away from machine toolmakers. I follow five or more stocks in the 34 industries that I track on a daily basis. When I see a buying opportunity, Icheck other stocks in the industry. If they are showing signs of toppingout, then I stay away.“You know they’re going to go bottom fishing anyway, don’t you?”Jake shook his head, having learned the hard way to trade with the trend.His most profitable trades are those he takes when chart patterns breakout to new highs.
Bull and Bear TrapsJust when you see a promising situation and jump on it, the marketturns, filling your portfolio with blood. Figure 5.1 shows an example.This is an ascending triangle, sporting a flat top and upsloping trendlinealong the bottom. Prices cross from side to side numerous times, fillingthe pattern not with white space but with trading action. Prices toucheach trendline at least twice, and the pattern completes when price closesoutside the trendline boundary (point A). An upward breakout occurs70% of the time in an ascending triangle.In this example, prices falter at A then tumble and bounce off thebottom trendline before plunging downward through it at B, a one-daydip of almost $3 on high volume. Those that bought at A probably soldfor a loss. Those at B sell short, expecting price to continue movingdown. They are right, for a time, as prices continue lower then turn andgap upward on exceedingly high volume. Prices work their way higher.
SPECIAL SITUATIONS
52
Cognex (Precision Instrument, NASDAQ, CGNX)2726
Breakout
25
A
242322212019
B
18171615
B1413
02
Oct
Nov
Dec
Jan 03
Feb
Mar
Apr
May
Jun
Jul
12
FIGURE 5.1 A bull trap snares bullish traders at the upward breakout (A)then drags them underwater until they gush blood to the right of B.
Point A is a classic bull trap. Prices rise after an upward breakoutthen collapse. Point B is a bear trap. Those investors expecting the stockto decline were disappointed when it gapped upward and climbed.Jake nudged me and asked, “Did you tell them how to recognize atrap before it occurs?”Don’t listen to Jake. He doesn’t know the answer either. I haven’tfound a way to predict when a breakout will reverse like that shown at Aor B. The volume pattern doesn’t vary from the actual breakout nor doesthe distance to the apex. Overhead resistance, underlying support, a market or industry reversal—all can trap a trader. When you trade chart patterns, these situations occur and you need to take prompt action to saveyour trade. That is why placing stops after you buy is so important.
Flat BaseA flat base (FB) is one of the setups that you want to look for periodically.I use a weekly scale because it makes FBs easy to spot. Figure 5.2 showsan example. I define a flat base as a long, essentially horizontal price
Gaps
movement. This one begins in March and ends atthe upward breakout in October 2003. A weeklater, an ascending, right-angled broadening formation builds. Often, when a chart pattern forms immediately after a flat base, it means that the upwardbreakout is going to be a powerful one. Jump inand buy the stock; just be sure to use a stop becauseanything can happen.Another tip that I’ve read about, but not verified, is that the longer a flat base is, the better theperformance when price takes off. Some even measure the length and project it upward, but thatsmells fishy to me. You are taking a time measure(the flat-base length) and pretending it’s a pricemove (projecting the length upward) . . . Go figure.“I may have thought that one up,” Jake saidand puffed out his chest.“Yeah, and Heisenberg may have slept here,” Ireplied.
Gaps“I hate gaps,” Jake said. “Traders put too much emphasis on them.” I think he’s right because theydon’t power stocks like most think. For example, Ifound 120 ascending triangles with breakout daygaps and 543 without gaps in a bull market andwith upward breakouts. Those with gaps showedpostbreakout rises averaging 35%. Those withoutgaps rose 35%. This is exactly the same performance. Table 5.2 lists the price performance after abreakout-day gap for some common chart patterns.The results measure from the breakout to the ultimate high and represent perfect trades.Figure 5.3 shows an example of an ascendingtriangle with a bullish gap on the breakout day. Thegap is called an “area or common gap” because pricecurls around and closes the gap a few days later. Othertypes of gaps have moves that are more extensive.
53
flat basea consolidationregion in whichprices touch ornear the sameprice multipletimes over severalweeks or months,and identificationis usually easieston the weeklyscale. The bottomof this regionappears flat andsometimes formsthe base of animpending upmove, hence thename, flat base.Some chart patterns (such asdouble and triplebottoms, or headand shoulders)form after a flatbase, the bottomof the chart pattern will usuallyreside slightlybelow the flatbase level.
gapswhen today’s highis below yesterday’s low, ortoday’s low isabove yesterday’shigh, a gap appears on the pricechart. A gapcloses when pricelater retraces andcovers the gap.
SPECIAL SITUATIONS
54
Valero Energy (Petroleum (Integrated), NYSE, VLO)48464442403836343230
Right-Angled and AscendingBroadening Formation
282624232221
Flat Base
20191817M
J
J
A
S
O
N
D
04
F
M
A
M
J
J
A
S
O
N
D
1605
FIGURE 5.2 A chart pattern occurs after the breakout from a flat base.
TABLE 5.2 Performance after Gap in Bull Marketswith Upward BreakoutsChart Pattern
Gap
No Gap
Winner
Broadening Top
26%
29%
No Gap
Cup with Handle
39%
33%
Gap
Diamond Bottoms
40%
36%
Gap
Eve & Eve Double Bottom
42%
40%
Gap
High, Tight Flag
67%
71%
No Gap
Head-and-Shoulders Bottom
43%
37%
Gap
Pipe Bottom
40%
45%
No Gap
Rectangle Top
38%
40%
No Gap
Ascending Triangles
35%
35%
Tie
Descending Triangle
44%
34%
Gap
Symmetrical Triangle
35%
31%
Gap
Triple Bottoms
34%
38%
No Gap
Falling Wedge
39%
31%
Gap
Gaps
55
Ivax Corporation (Drug, AMEX, IVX)BreakoutDay GapA
7
B6
5
BearishGap
BullishGap
4
98
Dec
Jan 99
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
3
FIGURE 5.3 A breakout-day gap occurs in an ascending triangle. The insetshows the two types of gaps.
The inset shows a bullish and bearish gap. A bullish gap occurswhen the intraday low price is above the prior day’s high. A bearish gaphappens when the intraday high is below the prior day’s low. Both leave agap of white space on the price chart.The dashed line in the figure is an internal trendline outlining thetop of the ascending triangle pattern. The trendline above the dashedone does not touch prices enough to outline a valid triangle, so I drew inthe dashed one.“I was going to complain about that,” Jake said.I smiled. Jake was an enthusiastic learner with good intentions evenif Murphy’s Law interfered sometimes. I guess he was serious about making enough money to afford his escalating health insurance premiums. Inthe months since I started helping him, he changed his initial stake intosome serious money. Of course, almost anyone can make money in a bullmarket. The real test would come when things went wrong. Would he beable to cut his losses?
SPECIAL SITUATIONS
56
Lower Highs and Higher LowsWant to know when the trend changes? Pay attention to peaks and valleys. A rising price trend shows higher peaks and higher valleys. A fallingprice trend has lower peaks and lower valleys.Consider peaks A and B in Figure 5.4. The top of B is slightly below the top of A. Traders buying the stock lost their enthusiasm and letselling pressure halt the advance at B. With momentum swinging fromup to down, additional selling pressure gathered like a snowball rollingdownhill. The failure of B to rise above A and continue higher suggested atrend change.B need not stop rising below A to signal a bearish turn. This is notan exact science, so sometimes B rises slightly above A before runninginto resistance. Figure 5.3 shows an example of this situation at peaks Aand B. Notice that B is just above A before the trend reverses.To the right of peak E in Figure 5.4 shows another example of a declining top. The peaks seem to slide lower over time, suggesting a bearishtrend developing.HNI (HON Industries) (Furn/Home Furnishings, NYSE, HNI)
4544
EA
43
B42
F
G
414039
CD
38
37
36
04
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Jan 05
35
FIGURE 5.4 When a lower peak occurs (A, B), it warns of a bearish trendchange. Valleys that fail to continue moving lower (C, D), also warn of abullish trend change.
Partial Rises and Declines
57
The bad news with trying to call turns like A and B is that it onlyworks 35% of the time. That’s how often a twin-peak pattern confirms asa double top. A confirmed double top means that price closes below thevalley between the two peaks. Sixty-four percent of the time in a bullmarket, prices don’t decline that far before going on to make a new high.Do valleys also signal trend changes? Yes—see points C and D inFigure 5.4 for an example. Valley D is below C before the decline tiresand prices rebound. Prices rise and stall at F, matching the old Septemberpeak at G. Prices then decline less than a point but meet support at theround number 40 before continuing up.This scenario is an example of two peaks, F and G, not signaling atrend change. Valleys C and D, however, do show momentum changingfrom down to up. Like their peak counterparts, price can fall just short ofor decline just beyond a prior valley low before recovering. A second valley correctly predicts a trend change 36% of the time. That’s how often atwin valley pattern confirms as a valid double bottom in a bull market.When your trade begins an uphill run like the straight-line rise from37 in May to point A, your skin will begin to tingle as prices rise. Eachday professionals will ask if the trend is about to change, while amateurswill count their paper profits. When a second peak occurs and stalls nearthe first one, you’ll break out in a sweat and feel that the time has come tosell. Have patience—and if price closes below the valley between the twopeaks, then sell. Remember, two out of three times price will resume itsuphill run in a bull market, so don’t be too quick on the trigger.
Partial Rises and DeclinesA partial rise or decline occurs in broadening chart patterns and rectangles. Partial rises and declines are brief price moves that signal a breakout,usually an immediate one. They are early trading signals.Let’s take the partial rise first, an example of which appears in Figure 5.5. Look for a valid chart pattern. By that, I mean a pattern that hasprices touching each trendline at least twice, and it meets any other identification guidelines appropriate for the individual chart pattern. Then,look for price to touch the bottom trendline, rise up, curl around, andhead back down before coming close to or touching the top trendline.An immediate breakout usually follows.Figure 5.5 shows an example of a partial rise in a broadening bottom chart pattern. The partial rise begins at A when price touches the
SPECIAL SITUATIONS
58
Hughes Supply Inc. (Retail Building Supply, NYSE, HUG)15
14
13
CPartialRise
12
Breakout
11
Breakout
B
10
A9
PartialDecline
99
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Jan 00
Feb
Mar
8
FIGURE 5.5 A partial rise correctly predicts a downward breakout and apartial decline predicts an upward breakout.
lower trendline and then price moves up, retraces the rise, and breaks outdownward. A partial rise correctly predicts a downward breakout from abroadening bottom 67% of the time.Statistical analysis of 649 chart patterns with partial rises shows thatthe height of the partial rise as a percentage of the formation height averages 60% with peaks at 36% and 62%, close or equal to the Fibonaccinumbers of 38% and 62%. That means the average partial rise climbs60% of the way up the chart pattern before curling down.“That’s good to know,” Jake said. “If price climbs above a 62% retrace, then chances are price will continue moving higher.”A partial decline is nearly the same as a partial rise except it appliesto upward breakouts. Price touches the top trendline, drops down butdoes not come close to or touch the bottom trendline before curling upward and staging an upward breakout. A partial decline applies to established patterns and it occurs before the breakout.Figure 5.5 shows an example. Price touches the top trendline at B,drops down then reverses and stages an upward breakout. A partial declineworks 72% of the time in a broadening top. Analysis of 543 partial declinesshows that prices retrace an average of 59% with peaks at 36% and 75%.
Partial Rises and Declines
59
The bad news is that partial rises and declines are difficult to trade.As price crosses from side to side, it often pauses midway across beforecontinuing in the original direction. It looks as if price is going to reversebut it doesn’t.One way to combat this is to use a 62% Fibonacci retrace of theprior move. For example, in Figure 5.5 if prices retrace 62% of the dropfrom C to A and then appear to reverse, short the stock or sell any longholdings. This also works for 38% and 50% retrace values, so you canexperiment.Jake walked into the office sporting a new suit, silk tie, and fancyshoes. He read the page I was working on then said, “Did you tell themabout that $3,000 disaster in Cisco?”I bought a partial decline from a right-angled and descendingbroadening formation. The stock touched the top trendline then zippedto the wrong side and I sold as soon as it broke out downward. I lost15%, about double the usual loss size.“Let me tell them about my Varco trade,” Jake said. “Can I, huh?Can I?” He reminded me of a kid until he grabbed his lapel as if he wasWinston Churchill making a speech before parliament. Figure 5.6 showsthe trade. He bought 600 shares at 9.38 in late May “as a three-year playto give oil a chance to stabilize and for them to get a good return on theiroil rig investments.” He predicted a target of 13 and a downside of 8.75,the low just a few days before he bought. He also saw resistance at about11, the site of the symmetrical triangle apex. A portion of the triangle appears in April and it may look strange because price pokes out the top ofthe upper trendline. Additional trendline touches are off the chart.“With summer approaching and OPEC holding firm on quotas, Iexpected the price of oil would hold, but I also expected the stock tounderperform. I figured I would pick up more shares if the pricedropped 10%.”“Averaging down.” I made tsk-tsk noises. “For traders, not investors, that’s a good way to lose more money.”In late July, he bought 500 more shares at 10.38. “Bollinger bandsshowed low volatility for the past two months,” meaning that thebands were narrow, “and prior low volatility lasted three months beforeprice shot from 8 to 13. I expected the same thing to happen this time.”Downside was 8.63, the site of the May low, and upside was 13 with amove expected in the next 1.5 months.Instead, the up move came a week later. Price shot to 14.25, forming a broadening top.
SPECIAL SITUATIONS
60
Varco International, Inc. (Oilfield Svcs/Equipment, NYSE, VRC)14
SymmetricalTriangle
B
13
Sold
12
Bought11
A
10
Bought
9
99
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Jan 00
Feb
8
FIGURE 5.6 Jake bought the stock twice and sold it as the stock made apartial rise.
“On October 1, I sold 1,100 shares at 12 as the stock started moving back to the lower trendline in a classic partial rise.” You can see thestock leave the bottom trendline at A and climb to B before heading backdown. On the two trades, he netted over $2,300 or 21%. “You can seewhat happened to the stock after that. Sometimes you have to sell a longterm holding.” The stock hit 9.19 before recovering, a decline of 23%from where he sold.
Quick Rises and DeclinesFigure 5.7 shows what happens after a quick price rise from A to B. Thestock rolled over and dropped, ending at C, 64% below the May high. Isthis typical or unusual? The answer doesn’t matter if you happen to beholding the stock. If you want to make money in the stock market, whena stock declines, sell it.I will say that I find diamond tops an interesting play on the quickrise, quick decline scenario. The inset in Figure 5.7 shows an example
Quick Rises and Declines
61
Fastenal Company (Retail Building Supply, NASDAQ, FAST)B
2826252423222120
QuickRise
A
1918171615141312
E
11
DCJan 98
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
10
FIGURE 5.7 A slow decline from B to C follows a quick price rise fromA to B.
taken from the stock charts. Prices zip up from D to the diamond topand then retrace almost all of their gains (E) after the breakout. I thinkthis behavior is common for diamonds; but as I searched for examples, Idiscovered that it’s less common than I thought.As for the Fastenal example, I named an event pattern after this behavior. It’s called an “inverted dead-cat bounce.” Prices shoot up thendrift lower. You can read about the pattern later in this book.Does a quick rise follow a quick decline? Yes, but it happens less often than the reverse. You see this after the breakout from a diamond bottom. Imagine the inset in Figure 5.7 flipped upside down. That’s what itlooks like.Let me issue this warning too: Just because you see a quick rise is noreason to expect a decline. With flags and pennants, a quick rise is whatyou are looking for. After the chart pattern the rise resumes, nearly equaling the rise before the chart pattern. The difference is that price breaksout upward after the chart pattern instead of downward. If you own thestock and it breaks out downward, then sell immediately. Otherwise, youmight hold onto a stock that looks like the disaster in Figure 5.7.
SPECIAL SITUATIONS
62
Spikes and TailsSome call them spikes and some call them tails. I prefer tails, but it doesnot matter what they’re called, just so you don’t panic when your stock iswhipped by one. Figure 5.8 shows several examples of tails on the dailychart. Tails are long price spikes that occur in a stock and usually markshort-term turning points after a sharp price run-up or violent decline.The inset shows a close-up of a bullish tail. The opening and closingprice need not be at the same price as I show here (the left half of thehorizontal bar is the opening price and the right half is the closing price).A bullish tail appears after a strong downdraft and the closing price isnear the intraday high. A bearish tail is a slim antenna sticking up on ahilltop. The price rise leading to the hilltop is a sharp, robust advanceand price closes near the intraday low. All of the tails shown here obeythose guidelines except for the one in late September at about 41. There,the close is near the intraday high, not the low.I remember holding a position in a declining stock that showed adownward spike. I became upset because of the paper loss. Then I smiledbecause I betted that the stock was forming a bullish tail. Sure enough,
Ameren (Electric Utility (Central), NYSE, AEE)Tail
4544
Tail
43
42
41
40
Tail
39
38
37
Tail
01
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Jan 02
Feb
FIGURE 5.8 Several tails mark the turning point in this stock.
Mar
36
Spikes and Tails
63
the stock rebounded the next day and soon posted new highs. The tailturned into a major turning point.Tails are panic buying or selling that sends prices spiking upward ordownward, respectively. They may even trigger stop running, where theexecution of one stop triggers the next, forcing price to move rapidly intraday. After the run exhausts, price collapses, retracing the move as buying demand hands off to selling pressure. The close is near the low for theday, leaving a tall spike on the chart. The next day, the sellers still havethe upper hand because those wanting to buy did so yesterday. The pricedrops and continues declining in the coming days, leaving the tail reversal as a tree standing alone on the hilltop.One important lesson I learned about tail chasing is not to act tooquickly. Let a day lapse after you think a tail appears. Why? Because thenext day may also have a large trading range, covering the tail in a parallel spike, and eliminating the trading signal. In many cases, prices congest at the base of the tail for several days before