through his notes then read, “I bought the Eve & Evedouble bottom. The apparel market seems to be doing well. In the lastfew days, the stocks have moved higher, strongly. Many are like this one:They’ve reached a yearly high then backtracked and are struggling to recover. The bad new is that Guess has a PE (price to earnings ratio) of 50.Ouch. I have my doubts about this one working, but if the market continues to climb, this might do well, too.”On July 16, he was stopped out at 14.55, two cents below his stopprice and just a day before the stock made a bullish tail at C. The marketcontinued down into early August before staging a nice up move leadinginto October.
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“I lost $1,600 on the trade.” He slumped in the chair.I stood up and picked a piece of straw off the chair, ready to return tothe horses. “Don’t you remember that you made a bundle two weeks ago?”“Yeah. Fifteen grand. I had a good week.” He smiled and his dimplemixed with the sun’s rays sprinkled from the nearby window.“Exercise is good for you. Come help me in the barn.”His dimple disappeared and so did he. Good help is hard to findthese days.
9. Triple Bottoms (Tied with 10)• Average rise rank: 10• Breakeven failure rate rank: 4• Change after trend ends rank: 4If you know what a double bottom looks like, you can imagine what atriple bottom (TB) looks like. Triple bottoms tie with head-and-shouldersin terms of overall performance. The average rise measures 37%, rankingthe triple bottom tenth out of 23 contenders. The breakeven failure rate is4%, meaning that just 4% of the triple bottoms failed to rise at least 5%,placing triple bottoms in fourth place. Finally, once price reaches the ultimate high, it tumbles 33%, also placing the pattern fourth.Identification
Identification of triple bottoms shares many of the guidelines of doublebottoms. Look for three valleys, all bottoming at about the same price,widely spaced so that they are not part of the same valley, and with a distinct peak between them. I set no minimum price rise between the valleys as I did with double bottoms because these patterns are rare enoughwithout such qualifiers. Here are the guidelines:• Prices should trend downward to the first valley, but should notdrop below it. In other words, you don’t want to see a sinkholebefore the first valley.• The three bottoms should appear near the same price, but allowvariations.• Several weeks usually separate each valley.
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• Volume trends downward 67% of the time from the first bottomto the last, but may be high beneath the individual valleys.• Price must close above the confirmation price (above the highestpeak in the pattern) before the pattern becomes a true triplebottom.• If a double bottom forms a third bottom before the double bottom confirms, treat it as a triple bottom.Figure 6.19 shows an example of a triple bottom. Price trends downward to the bottom. The three bottoms, 1, 2, and 3, are near the sameprice level. Each bottom is a valley in its own right with a rise betweenthem. Volume trends downward but is high beneath the base of each valley in this example. When the stock closes above the price of point A, thatconfirms the chart pattern as a true triple bottom and signals a buy.Trading and Trading Tips
If the rise between the first two bottoms is higher than is the rise betweenbottoms 2 and 3, draw a downsloping trendline connecting the tops.Cypress Semiconductor (Semiconductor, NYSE, CY)Flat Base
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FIGURE 6.19 A triple bottom (valleys 1, 2, and 3) appears at the end of anextensive decline. A breakout occurs when price closes above the price ofpoint A or above the downsloping buy trendline.
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When price crosses this trendline, that’s a buy signal. Figure 6.19 showsan example of this scenario.Figure 6.20 shows another example of a triple bottom. In this example,bottom 3 is above the price level of bottom 2. When that situation happens,price after the breakout tends to move farther than when bottom 3 is at orbelow bottom 2. Every situation is different, but keep this one in mind.The dashed line extending downward from point A shows an earlybuy trendline. The horizontal trendline from point A is the traditional buysignal. In this case, prices throw back to the breakout price before resumingtheir uphill run.I also highlight a small flag. Flags often appear in strong, straightline runs like the one shown in Figure 6.20, and they sometimes markthe midpoint of the rise. Thus, they have the nickname half-staff formations. The rise from the bottom of the flag to the trend end at B is nearlyas long as the rise from point 3 to the top of the flag.Here are additional trading tips:• Triple bottoms that appear after a flat base tend to outperform.Look for a long (months) horizontal (or nearly so) price trendleading to the triple bottom. Use the weekly scale because the
FedEx (FDX Corporation) (Air Transport, NYSE, FDX)
83828180797877767574
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FIGURE 6.20 A triple bottom (1, 2, and 3) has a third bottom above theother two. This suggests a better performing triple bottom.
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trend becomes clearer there. The pattern does well because pricepushes its way through overhead resistance to find clear skiesabove, and ample room to rise. The flat base–triple bottom combination is the best setup for triple bottoms. The inset of Figure6.19 shows the flat base, triple bottom setup.• Triple bottoms often appear as the corrective phase of a measuredmove up (picture a flat step in a rising staircase). The rise after thebreakout may not be as high as you expect. Avoid trading triplebottoms that occur after an extensive (months) price uptrend.The trend may be ending.• When a triple bottom appears after a decline, draw a downslopingtrendline along the peaks before the triple bottom. Expect price tostall once it reaches the trendline. It may push through the overhead resistance, but play it safe. The left inset in Figure 6.19 showsthis situation on the weekly scale. Price reaches the trendline thencollapses.• Triple bottoms with short-term declines leading to the patternhave postbreakout rises averaging 39%. Intermediate-term declines yield rises of 35% and long-term declines, 37%. Tradetriple bottoms with short-term declines.• Here’s another variation on the small decline scenario: Triplebottoms with a price decline less than the 21% median declineleading to the chart pattern have postbreakout rises averaging44% versus 29% for those with a larger decline. A triple bottomthat forms after an extensive decline suggests serious problemsthat will take time to fix. The rise after the breakout is often just aretrace in a downtrend, not a trend change.• If a triple bottom appears after a decline from a peak, assume thatprices will stall when they return to the peak. The triple bottom becomes the valley between two mountain ranges. This is a variationof a big W chart pattern (ends D and E) (see Figure 6.17 and accompanying text).• If the third bottom has a flat top, then swing traders should buywhen price closes above the flat threshold and sell at the confirmation price if price stalls there. Place a stop just below the bottom. This is similar to the shelf shown in Figure 6.17.• For position traders and investors, buy when price closes above theconfirmation price—the highest peak between the three bottoms
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(or above a downsloping trendline connecting the peaks betweenthe bottoms. See the earlier discussion).• Throwbacks happen 64% of the time and when they do occur,performance suffers: 41% rise postbreakout without throwbacksversus 34% with throwbacks.• If the last valley bottom is above the price of the second valley bottom, then expect better performance: 43% average rise versus 32%.Measuring Success
The measure rule for triple bottoms is the pattern’s height added to thebreakout price. This works 64% of the time, so be conservative whenpicking a price target (that means select a closer target). If the target isnear overhead resistance, then expect price to stall there.For example, point A in Figure 6.20 shows the highest peak in thepattern and the lowest valley at point 1. The height is the difference between those two, 70.40 – 64.84, or 5.56. Add the height to the highestpeak to get a target of 75.96.Case Study
Jake looked over my shoulder and groaned. “Not another one. Whydon’t you show them one of my winning trades?”“Because the reader learns from your mistakes. Like this one.” Ipointed at the screen and Figure 6.21 shows the image. “You should haveknown the trade wouldn’t work out.”“Your hindsight works perfectly.”I swung my chair around and faced him. That’s when I noticed hisgold cuff links. Exquisite. “Tell me about the trade.” He went to the keyboard 8 feet away and started typing, pulling up his notes.“First, let me say that it was a long time ago,when I didn’t know what I was doing. Anyway, Ilimit orderput a limit order to buy 400 at 28 on the triple botan order to buy fortom confirmation of 27.88. The limit order shouldno more or to sellhave been a stop order to buy. So, I picked up thefor no less than aspecified price.400 at 27.64 instead of 28.”He predicted overhead resistance would hit at30 and then again at 32, corresponding to knots ofprice action at those levels in June.
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Forest Oil Corp. (Petroleum (Producing), NYSE, FST)383736353433
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FIGURE 6.21 Resistance highlighted by a downsloping trendline warnedof this failed triple bottom trade.
“Upside was 36, near the old high where I thought I’d sell.”On the downside, he was looking at a 14% loss to 24.50, the priceat valley 2.“This trade might have worked out except for one thing,” he said.“I bought two days before 9/11, when the terrorists struck.”Trading resumed on 9/17 and the price touched the downslopingtrendline on that day then drilled down.“I used a mental stop at 24.50, but price shot through that and Isold at 23.64, a day before price bottomed. I expected the price to continue moving down.”“This is an example of market risk,” I said. “Something comesalong and just pulls the rug out from under you. That’s why you want tobe out of the market as much as possible. Unlike you, I was lucky. I soldAlaska Air three trading days before 9/11 for a loss of less than $250.Had I waited until 9/27, I would have lost over $4,000. The stock wasdown 44% from where I sold.”
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10. Head-and-Shoulders Bottoms(Tied with 9)• Average rise rank: 9• Breakeven failure rate rank: 3• Change after trend ends rank: 6The head-and-shoulders formation is arguably the most famous of thechart patterns, but that distinction is reserved for tops, not bottoms.Still, the head-and-shoulders bottom (HSB) ranks tenth for overall performance. The average rise is 38% in a bull market, placing it ninth. Thebreakeven failure rate is quite low, 3%, ranking third. Finally, once thetrend changes after price reaches the ultimate high, prices tumble an average of 31% for sixth place.Identification
Figure 6.22 shows a near perfect example of a HSB. The head protrudeswell below the bottoms of the shoulders. The two shoulders looksimilar—needles in this case—and are nearly an equal distance from thehead. They look symmetrical, which I consider important. The volumepattern, however, is backward. Most often, you’ll find volume heaviestbeneath the left shoulder or head, and diminished below the right shoulder. A neckline joins the armpits and slopes downward in this case and inmost HSBs. When price closes above the neckline, that’s the buy signaland it confirms the pattern as a valid HSB. Without confirmation, youdon’t have an HSB.To identify HSBs, look for the following:• Find three valleys with the center valley below the other two.• The shoulders should appear similar in shape.• The shoulders should be almost equidistant from the head.• The shoulders should have valleys that stop near the same price.• Volume is highest on the head 48% of the time, the left shoulder37% of the time and the right shoulder 15% of the time.• Volume trends downward 66% of the time (between the left andright shoulder valleys).
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Russell Corp. (Apparel, NYSE, RML)
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FIGURE 6.22 Shown is a head-and-shoulders bottom with pronouncedshoulder symmetry and a downsloping neckline. Only the volume pattern isbackward in this otherwise perfect example.
Trading and Trading Tips
Figure 6.23 shows another example of an HSB. In this example, the bottom of the right shoulder is above the price of the left, but they are closeenough. The shoulders look similar and are almost the same distancefrom the head. Volume is highest on the head.A neckline joins the armpits and signals a buy when price closesabove it. This works well when the neckline slopes downward as in Figure 6.22, but you can see what a disaster it is in Figure 6.23. You give upprofit by waiting (price closes above the neckline at point A). In fact,sometimes the neckline slopes so steeply that price never closes above it.That’s like walking to school uphill, both ways.A solution to the steep neckline problem is to use the highest peakin the pattern as the buy signal. When price closes above the value of thehighest peak, buy. I show this scenario in Figure 6.23 as the dashed line.Here are additional trading tips. Many are the same as for triplebottoms.• For downsloping necklines, a close above the trendline signals abuy.
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Cabot Oil and Gas A (Natural Gas (Diversified), NYSE, COG)
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FIGURE 6.23 A head-and-shoulders bottom appears with an upslopingneckline. Buying using the traditional method of price closing abovethe neckline can lead to reduced profits. Instead, when the necklineslopes upward, draw a horizontal line from the highest peak in thepattern and buy when price closes above it.
• For upsloping necklines, use a close above the highest peak in theHSB as the buy signal.• HSBs that appear after a flat base tend to outperform. Look foran extended horizontal price move of several months durationbefore the HSB forms.• When price declines in a straight line run leading to the HSB, expect price to recover to the top of the pattern. Figure 6.17 showsa big W pattern (ends D and E). The HSB replaces the doublebottom. Expect price to stall or reverse at E.• HSBs with short-term declines leading to the pattern have postbreakout rises averaging 42%. Intermediate-term declines yieldrises of 37%, and long-term declines give rises of 32%.• Throwbacks happen 45% of the time and when they do occur,performance suffers: 43% rise postbreakout without throwbacksversus 32% with throwbacks. Avoid selecting patterns with overhead resistance that may cause a throwback.
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• When volume is higher on the right shoulder, the HSB tends tooutperform: 40% average rise versus 37%.• Postbreakout performance improves for those HSBs with downsloping necklines: 42% average rise versus 34% rise for thosewith upsloping necklines.• HSBs with a falling volume trend from shoulder to shoulder outperform: 39% average rise versus 36% for those with a rising volume trend.• Patterns taller than the 18.81% median height divided by thebreakout price rise an average of 41% postbreakout versus 36%for short HSBs.• Breakout day gaps occur 18% of the time. HSBs with a breakoutday gap rise 43%. Those without a gap rise 37%.• HSBs with breakouts near the yearly high perform best, 42% average rise versus 37% for those in the middle and lower thirds ofthe yearly price range.• Ninety percent acted as reversals of the prior price trend.• From the right shoulder valley, it takes an average of 16 days forthe stock to climb to the breakout price.Measuring Success
The measure rule for HSBs is slightly different than for other chart patterns.First, compute the pattern height from the head vertically to the neckline.In Figure 6.23, the black dot at B shows the neckline intersection at about23.25. Directly below, the head low is at 17.75 for a height of 5.50. Add theheight to the breakout price to get a target. Using the highest peak inthe pattern as the breakout point (23.83) would mean a target of 29.33. Using a trendline pierce as the breakout (25.59) would give a target of 31.09.For the statistics, I used the average price of the neckline start andend points (the two armpits) instead of projecting it upward from thehead to the neckline. Prices meet this measure rule 74% of the time.“What’s next?” Jake asked.“I’m thinking of buying American Power Conversion Corp. It’sshowing a rectangle top, and it just completed a throwback.”He smiled. “I meant, what’s next in the book?”“Common chart patterns. They act as wrenches when your teethwon’t do. Let me show you.”
7Chapter
Common Patternsfor the Toolbox
ake held up a pile of papers an inch thick. He slammed it down onmy desk as if to make a point. “They have a fleet of private jets, allmanned with flight crews. They own three choppers. Their executivesuite has 35 vice presidents, each earning over $300,000. Plus, they allget stock options worth seven figures, cars, massive expense accounts—”“What are you talking about?”“My health insurance company! I finished researching them. Theyown real estate, a co-op in Manhattan, box suites at the track, sportsarena, and opera, bodyguards for the big boys. . . . No wonder my premiums go up each quarter by double digits!”“Why don’t you just change companies and be done with it?”“I can’t. If the health insurance company denies your application,your name goes on a computerized black list that other companies checkbefore issuing coverage. I can’t take the chance. I have to wait five yearsfor my medical history to clear before I apply to a new company. Whatgood is universal coverage if you can’t afford it?”“Take a deep breath, Jake. Every problem has a solution. Your trading has improved enough that you’re making money on a consistentbasis. That income is high enough to pay those premiums with plentyleft over. If you make your stock selections carefully, use stops on each
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trade, and have some luck, you’ll be able to self-insure. Imagine tellingthe insurance company to get lost because you have ten million bucks inthe bank protecting you.”He unclenched his fists, sat back in the chair, and smiled. “Whatare your favorite patterns to trade?”I will trade almost any chart pattern provided the setup looks good.This chapter looks at more chart patterns. Some will help you get outnear the top. Others tell you how far price is likely to move. They helpyou avoid buying too soon or they suggest staying longer in a trade. Theyare specialized tools you will need to diversify your toolbox and helpmake money easier.I’m going to mention a lot of boring performance numbers in thetrading tips section of each chart pattern. For a pattern you’re interestedin trading, piece together the tips you find valuable. If tall patterns outperform short ones by a huge margin, then put that on your selectionchecklist. If a decreasing volume trend is important, put it on your list.Consider the tips as menu items from which to choose and then applythem to your chart pattern selections. The results can help you select better performing patterns.
Broadening PatternsBroadening patterns come in six varieties and we’ve seen one already, theascending broadening wedge. I cover the others here. The first two arebroadening tops and bottoms. The difference between the two is howprice enters the pattern. Tops have price entering from the bottom. Bottoms have price dropping into the pattern.My study of this pattern confirms the breakout direction is random,so wait for the breakout instead of guessing. Just because price is trending downward doesn’t mean the breakout will be downward. Rememberthat.
Broadening Tops and BottomsFigure 7.1 shows an example of a broadening bottom. Price enters thepattern from the top and eases out the bottom before reversing in lateFebruary and embarking on a sustained up move.
Broadening Tops and Bottoms
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ENSCO International (Oilfield Svcs/Equipment, NYSE, ESV)
20191817
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FIGURE 7.1 A broadening bottom led to two profitable trades.
Identification
When trying to identify broadening tops (BT) or bottoms (BB), look forthe following:• Bottoms have prices trending downward into the chart pattern;tops have prices trending upward.• Find a megaphone price trend—higher peaks and lower valleys.Price broadens out over time, giving the pattern its name.• Prices follow two trendlines. The top trendline slopes upwardand the bottom one slopes downward.• Price should touch each trendline at least twice.• Price should cross the pattern from side to side and not leavemuch white space. Too much white space and you risk trading apattern that does not exist. The trendline touches need not alternate but usually do.• Volume trends upward between 57% and 60% of the time. Thatis not much above a random 50%, so don’t depend on it.
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Trading and Trading Tips
Here are some general trading tips for broadening tops and bottoms:• For skilled swing traders, buy when price bounces off the lowertrendline and sell when it reverses at the top one.• For all traders, buy after price touches the lower trendline for thethird time. Watch for a partial rise to occur, but hope for an upward breakout. A partial rise occurs 25% of the time in broadening bottoms and 49% of the time in broadening tops.• If price drops below the lower trendline, then sell a long holdingbecause the breakout is downward.• Trade in the direction of the breakout. That means buying after anupward breakout. But where is the breakout? If price punchesthrough one of the trendlines and closes outside it, that’s a breakout.For broadening tops (price trends upward into the pattern):• The best postbreakout gains (38% average rise) come after anintermediate-term rise leading to the pattern, followed by shortterm (32% rise) and long term (21% rise). Downward breakoutsfollow the same trend with intermediate, short, and long termsdoing well, in that order.• Those with breakouts near the yearly low perform best, regardlessof the breakout direction.• Upward breakouts on light volume have better performance.• BTs with downward volume trends perform better after thebreakout, regardless of the breakout direction.• A partial decline correctly predicts an upward breakout 72% ofthe time.• A partial rise works 61% of the time.• The breakout is upward 50% of the time.• Prices throw back (upward breakouts) 54% of the time and pullback (downward breakouts) 48% of the time. Throwbacks hurtpostbreakout performance (24% average rise postbreakout versus34% without throwbacks), but pullbacks have no influence onperformance.• The median height divided by the breakout price is 14.66% forupward breakouts and 15.95% for downward breakouts. Tall BTs
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perform substantially better than short ones for both breakoutdirections.For broadening bottoms (price trends downward into the pattern):• The best postbreakout gains (30% average rise) come after ashort-term decline leading to the pattern, followed by the longterm (24%) and intermediate-term (23%) rises. Downwardbreakouts show the intermediate-term trend doing best but samples are few.• Those with upward breakouts near the yearly high perform best(30% average rise, postbreakout), the lowest third comes in second at 28%, and the middle third is last at 24%. Downwardbreakouts have too few samples to be meaningful.• Upward breakouts with downward volume trends throughout thepattern show the largest rise postbreakout. Downward breakoutswith rising volume trends perform best (prices decline farthest).• A partial decline correctly predicts an upward breakout 80% ofthe time.• A partial rise works 67% of the time.• The breakout is upward 53% of the time.• Prices throw back (upward breakouts) 41% of the time andpull back (downward breakouts) 42% of the time. Throwbackshurt postbreakout performance (25% versus 28% withoutthrowbacks). Pullbacks are similar with postbreakout declinesaveraging 12% for those with pullbacks versus 17% for thosewithout.• The median height divided by the breakout price is 15.13% forupward breakouts and 17.50% for downward breakouts. Tall BBsperform marginally better than short ones for both breakout directions.Measuring Success
Use the measure rule to help predict a price target. Find the height of thepattern from the highest peak to the lowest valley in the pattern. For upward breakouts, add the height to the breakout price (where price crossesthe trendline boundary). Price reaches the measure rule target between59% and 62% of the time.
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For downward breakouts, subtract the height from the breakoutprice. The result is the target but this works only 37% to 44% of thetime. For both breakout directions, it might be best to use half the formation height, instead of the full height, to find a price target.Case Study
Here is my notebook entry for the first trade (point A in Figure 7.1):12/8/98. I bought 500 shares at market and received a fill at9.75. RSI says it’s oversold and the stock has hit the bottom ofa broadening formation. Oil service stocks were strong yesterday on a small rebound in oil price. MACD just turned greenyesterday, but is in negative territory. CCI said buy 3 days ago.Looks like resistance at 14 and again at 17. Stop should be atthe bottom of the formation, about 8, call it 7 7⁄8. The way themarkets are acting, I would say this will traverse to the otherside of the formation, but you never know. Somehow, thatsounds just too optimistic especially with oil predicting to gointo single digits. Pessimism abounds. I trimmed my 1,000share buy to 500 on the uncertainty.For those versed in technical indicators, the relative strength index(RSI) was oversold, meaning price was unusually low and represented a bargain. But the stock could go on sale tomorrow at aneven lower price. The moving average convergence/divergence histogram (MACD) suggested that moRSImentum was turning upward (green). As a swingthe Welles Wilderrelative strengthtrading indicator, the commodity channel indexindex, a price(CCI) issued a buy three days before I bought, sugmomentumindicator.gesting a short-term trade. (Please note: I use indicators like CCI, RSI, MACD, and Bollinger bands on asporadic basis with default settings. Since this is abook about chart patterns and not indicators, I don’t detail how the indicators work in this text.)Unfortunately, I did not log the entry for the second buy; but Igrabbed 1,000 shares at 9.56 on February 8. Together, the two tradesrepresented an investment of about $14,500.Bottoms A and B are an Eve & Eve double bottom, with a confirmation point at C. If I had seen the EEDB at the time, I am sure I
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would have stayed in the trade instead of selling on April 1. Price threwback to the double bottom breakout price and then rebounded, as isusually the case.A measured move up, with the stair step-rise from D, a pause at F,and completing the pattern at E, pointed the way higher. Price often fallsback to the corrective phase (F) as it did in this case, before rebounding.I may have been worried about the quick rise leading to E. Quick