the celebration is short and prices tumble. They drop over20% before meeting support at 26. The new low is below the valley low, theso-called confirmation point, but prices quickly turn around. Prices move up at
a smart pace and do not stop until they touch 39. That is a 50% move from thelow. If you sold your shares once prices closed below the confirmation point,you would walk away from a chunk of money.
This type of failure is called a 5% failure. Prices break out downward butfail to descend by more than 5% before turning around. Fortunately, 5% failures are relatively rare for double tops but still represent 17% of all formationswith confirmed breakouts.
StatisticsTable 13.2 shows general statistics for double tops, but it does not tell the complete story. There are 1,280 formations identified in 500 stocks over 5 years.Out of these formations, 65% or 826 continue moving higher without firstdescending below the confirmation point. Since a double top is only valid after aconfirmed breakout, excluded from the statistics are the 826 formations. In short,
they are not double tops.The remaining 454 formations separate into reversals (75%) and consolidations (25%) of the prevailing trend. The failure rate of these formations is17%, meaning that 75 reverse course before moving down more than 5%. Iview failure rates below 20% as belonging to reliable formations. However, Imust emphasize that you have to wait for the breakout before investing.
205
The average decline for successful formations is 20%, but the most likelydecline is between 10% and 15%. Figure 13.6 shows this relationship. I createdthe graph by sorting the percentage losses into ten bins and counting theentries in each bin. The resulting frequency distribution shows an alarmingtrend. Almost half the formations (47%) descend less than 15% below the confirmation point before reaching the ultimate low.The question then becomes, is it worth taking profits on a confirmeddouble top? If prices continue down an additional 15 % and then turn around,why not just wait for prices to recover? Those are good questions. If you sellwhen the double top is confirmed, you may be selling near the ultimate low.The average decline from the highest peak to the ultimate low is 32%.Why not sell at the top? Why not take profits sooner, before the formation isconfirmed? If you do that, then you will most likely be giving up additionalprofits as prices rise after you sell (remember, two out of three twin peak formations never fall below the confirmation point). Of course, you can alwayssell and, if the stock does turn around, you can buy back in.The measure rule estimates the price to which the stock will fall, at a minimum. In the Trading Tactics section of this chapter I discuss the measure rulefurther, but suffice it to say you simply compute the formation height and subtract the value from die confirmation point. The result is the minimum pricemove expected.
Table 13.2
General Statistics for Double TopsDescription
Statistic
Number of formations in 500 stocks from1991 to 1996
454
Reversal or consolidation
11 3 consolidations, 341 reversals
Failure rate
75 or 1 7%
Average decline of successful formations
20%
Most likely decline
10% to 15%
Of those succeeding, number meetingor exceeding price target (measure rule)
1 77 or 39%
Average formation length
2 months (57 days)
Average price difference between tops
1%
Average decline between tops
15%
Percentage of left tops higher than right
56% versus 44%
Figure 13.6 Frequency distribution of losses for double tops. The figure showsthat almost half the confirmed double tops have declines less than 15%.
206
Double Tops
For double tops, only 39% of the formations decline far enough to fulfillthe prediction. Reliable values are above 80%. The poor showing of this formation further emphasizes that many double top patterns do not decline farand this formation may not be worth trading at all.
Table 13.2 presents a few statistics related to the appearance of the double top. The average formation, as measured from peak to peak, is about 2months (57 days) long. The average price difference between the two tops isjust $0.30 and the valley is 15% below the highest peak, on average. The lefttop is usually higher than the right one but it is almost a wash (at 56% of formations versus 44%).In an earlier study on a much smaller scale, I noticed a tendency of double tops to perform better with peaks closer together than with those spacedfarther apart. This study supports those findings.I measured the time difference between peaks and created a frequencydistribution of the results. Then I mapped the corresponding losses for the formations and graphed the numbers in Figure 13.7. The graph suggests thatpeaks closer together have higher losses (they perform better) than thosespaced more widely apart.As with the earlier study, the sample size is a problem. The number ofentries in the bins is quite good until the interval gets above 77 days betweenpeaks. At 91 days, there are only 16 formations in that bin (followed by 15, 8,and 8 for the next three larger intervals, respectively). Even though the 4 bins
Figure 13.7 Peak separation versus percentage loss. Peaks closer together perform better than those spaced farther apart.
*
are below the minimum standard 30 entriodier bins to show the downward trend.The reason for the improved performis probably one of recognition. It is simpltwin peaks that are 2 or 3 months apart thaOnce investors recognize a double top, tprices lower.In another statistical oddity, I measurthe two peaks and compared it with the ulttops with large trough declines have largetroughs. Figure 13.8 shows the relationshtrough declines of 11% show an average lostrough declines of 18% have losses averagquite near the classic selection guideline ofTable 13.3 shows breakout statisticsoccur, it may be many days before pricesThe formations in this study take an averjourney from the right top to the confirmaAs mentioned earlier, included in thionly, which are formations in which pricessured between the two peaks. As such,
Figure 13.8 Trough decline versus loss. Dbetter than those with shallow ones.
208
Double Tops
Trading TacticsTable 13.3
Table 13.4Volume Statistics for Double Tops
Breakout Statistics for Double TopsDescription
209
Statistic
Description
Statistic
Average days after right top to breakout
39 days
Percentage of left tops having higher volume
57%
Downside breakout
454 or 100%
Number showing downward volume trend
256 or 56%
Downside breakout but failure
75 or 1 7%
191 %, 158%, 124%,
Pullbacks
314 or 69%
Volume for breakout day and next 5 days compared withday before breakout
Average time to pullback completion
10 days
Percentage of low volume breakouts subject to pullback
For successful formations, days to ultimate low
3 months (83 days)
Percentage of high volume breakouts subject to pullback
65%67%
Percentage of breakouts occurring near 12-month pricelow (L), center (C), or high (H)
L24%,
Percentage of high volume downside breakouts resultingin larger price declines compared to low volume breakouts
21% versus 15%.
Percentage loss for each 12-month lookback period
LI 7%, C20%, H20%
C50%,
H26%
breakouts. There are, however, 75 formations that break out downward butdo not continue moving down by more than 5% before turning around.
These 5% failures are somewhat rare, occurring only 17% of the time.About two-thirds (69%) of the formations have pullbacks to the breakoutprice. This is a high number and it suggests some reluctance of prices to continue moving below the breakout point. This belief is strengthened further bythe most likely decline being just 10% to 15%. Many times prices will drop by
10% or 15%, then pull back to the breakout point and continue higher. Forthis reason, it is probably wise to place a trade after a pullback and after prices
begin heading down again. The average time for prices to pull back to thebreakout point is 10 days, which is about average for many formations inthis book.Once a breakout occurs, it takes about 3 months (83 days) to reach the
ultimate low. The vast majority (70%) of formations reach the low in 3 months
11 3%, 116%, 112%
Are low volume breakouts more likely to pull back than high volumeones? No. Only 65% of low volume breakouts have pullbacks, whereas 67% ofhigh volume breakouts have pullbacks.I define high volume as 150% of the day before the breakout, whereas lowvolume is 75% of the prior day. If the low volume threshold drops from 75%to 50% of the prior day's volume, then 62% of the low volume breakouts have
pullbacks. As such, you can probably argue that high volume breakouts aremore likely to pull back than low volume ones. This makes sense. When everyone sells their shares soon after a breakout, what is left is an unbalance of buying demand (since the sellers have all sold), so the price rises and pulls back tothe confirmation point.
Do high volume breakouts send stocks lower? Yes, and the results are statistically significant. Stocks with high volume breakouts suffer larger losses(21%, on average) than do low volume breakouts (with an average 15% loss).
or less. An additional 18% complete their descent in under 6 months. Thus, Iclassify double tops as having short-term investment implications.
Where in the yearly price range does the breakout occur? Most of the formations have breakouts in the center third of the price range. Substitutingperformance figures in the frequency distribution, we find there is really noclear-cut winner. The percentage loss is about the same regardless of where inthe yearly price range the breakout occurs.Table 13.4 shows statistics related to double top volume. One of the identification guidelines is that the left top has higher volume than the right top.This occurs 57% of the time, whereas just over half (56%) show a decliningvolume trend over the life of the formation (from peak to peak).Table 13.4 also shows breakout volume when compared with the daybefore the breakout. It starts out high (191% of the prior day's value) andgradually diminishes.
Trading TacticsTable 13.5 contains suggested trading tactics. The first tactic is the measurerule. The rule helps predict the price to which the stock will decline, at a minimum. An example of the measure rule as it applies to double tops is shown inFigure 13.9. The double top forms after a climb from 9!/4 to 15'/s beforedescending and climbing again to the top area. In this regard, the double topis unusual as prices are higher 2 months before the formation tops out. Still, aninvestor willing to trade this formation would first consider whether it is profitable to do so. That is where the measure rule comes into play.First, compute the formation height by subtracting the highest high fromthe lowest low in the formation. The highest high is the left top, at 143/s, and
210
Double Tops
Trading Tactics
Table 13.5Trading Tactics for Double TopsTrading Tactic
Explanation
Measure rule
Compute the formation height by subtracting the lowest lowfrom the highest high in the formation. Subtract the differencefrom the lowest low between the two tops (the confirmationpoint). The minimum price move results. Better performance(70% versus 39% reach the target) occurs by dividing theheight in two before subtracting from the confirmation point.
211
With such poor performance of double tops, one has to ask, why risk thetrade? Should you decide not to trade, prices will probably continue movinghigher after the second peak—especially in a bull market. About a third of therime, prices continue down. Sometimes stocks suffer agonizing declines, butFigure 13.6 shows that only 4% (17 out of 379) of the formations with confirmed downside breakouts have declines over 50%. Of course, a 30% declineis nothing to sneeze at either.
A way to improve the performance of double tops is to sell just after thesecond top forms. Most of the time, prices will rebound and move higher. If so,
Do not trade
With a likely decline of just 10% to 15%, is it really worthselling your shares? If the answer is yes, then sell near thesecond peak and buy back should prices close above the higherpeak (or begin a sustained uptrend).
Tops close together
For better performance, select tops that are closer together,say, 60 days apart or less.
Deep troughs
For better performance, the valley between the two topsshould be deep, 15% or more.
Wait for breakout
Since 65% of the formations break out upward, you must waitfor a downside breakout before placing a trade. On a confirmeddownside breakout, prices continue down 83% of the time.
points or 19% below the confirmation point, large enough to risk a trade.When should you place the trade? Prices must close below the confirmation point before the double top is confirmed. In Figure 13.9, the little down-
Wait for pullback
Two-thirds of the formations pull back to the breakout price.Therefore, consider waiting for the pullback and for prices tohead downward again.
side spike to the left of the breakout point is not a breakout because prices donot close below the confirmation line. Prices close below the line on February2, a day of very high volume.
you can always repurchase your shares and ride the stock up. Should pricesmove down then you got out at the best time.
As mentioned earlier, the better performing double tops are those thathave peaks closer together with deep troughs. Figure 13.9 is an example. Thepeaks are just 35 days apart and the valley descends 16% from the highestpeak. For this situation, the measure rule implies a minimum decline of 2'/4
the lowest low is 12^8 (in the valley between the two peaks). Subtract the difference, 2'/4, from the confirmation point (12 Vs) to arrive at the target price of
97/s. Prices reach the target in late March.Since the measure rule has a success rate of just 39%, meaning that onlyabout a third of the formations decline to the predicted price, it is worth considering using half the formation height in the calculation. Doing so boosts the
success rate to 70%. For Figure 13.9, a new target price using half the formation height is 11. Prices meet the new target the same day as the breakout.It is always wise to check the fundamentals before placing a trade. Mostformations making a double top on weak fundamentals are ripe to fall. Unfortunately, the news from a company and from brokerage firms following the
company may be glowing just as the situation is about to change. You may findbrokerage firms upgrading the company or boosting earnings estimates nearthe top. That is not their fault; it is just that earnings are notoriously difficult
to predict and brokerage firms get caught up in die enthusiasm.For any trade, it is critical that you understand why the stock is performing as it is. This understanding is even more important for double tops because
of the poor most likely decline (just 10% to 15%). If you discover in yourresearch that the fundamental factors are changing for the worse, then it givesyou added confidence to risk a trade.
Figure 13.9 Measure rule as it applies to double tops. Sell short after the pullbackonce prices begin declining again.
212
Double Tops
With pullbacks occurring 69% of the time, it may pay to wait for a pullback before investing. You can see hi Figure 13.9 that the stock pulls back tothe confirmation point and continues moving upward for several days. Onceprices begin dropping again, place the trade.
14Flags and Pennants
Sample TradeRachel is an executive secretary for a mutual fund company, one that is prospering. She has the intelligence and good fortune to date a few of the managersrunning the funds. Along the way, she has picked up several investment
tips and speaks the lingo. Best of all, her buddies are still friends and willing tohelp her.When she spotted the situation shown in Figure 13.9, she asked herfriends if shorting the stock was a good idea. With their encouragement andfurther research on her own, she decided to sell the stock short on March 8 andreceived a fill at 12. In short order the stock drifted downward, easily fulfilling
the target price. Since prices were moving down, she felt no rush to cover herposition.That changed on March 31 when prices closed higher. Since she usually
RESULTS SNAPSHOT
reviews her stocks at the end of the day, there was nothing to do but wait until
the stock opened in the morning. The following day, prices moved back down
Flags
again and she decided to wait another day.
Appearance
When prices again moved up, she covered her short and received a fill at9. She made almpst $3 of profit for each share (after commissions) or 25% in3 weeks. Had she held on, her profits would have been even better. The stockmoved sideways for about 3 months before reaching an ultimate low of 6'/s.
A short sloping rectangle bounded by two paralleltrendlines
Reversal or consolidation
Short-term (up to 3 months) consolidation
Failure rate in uptrend
13%
Failure rate in downtrend
12%
Average rise in uptrend
19%, with most likely rise being 20%
Average decline indowntrend
17%, with most likely decline being 15%
Volume trend
Downward
Fullbacks
20%
Throwbacks
10%
Percentage meetingpredicted price targetin an uptrend
63%
Percentage meetingpredicted pricetarget in a downtrend
61%
See also
Rectangle Bottoms; Rectangle Tops
213
214
Flags and Pennants
PennantsAppearance
TourA short sloping triangle bounded by two convergingtrendlines
Reversal or consolidation
Short-term (up to 3 months) consolidation
Failure rate in uptrend
19%
Failure rate in downtrend
34%
Average rise in uptrend
21%, with most likely rise between 15% and 20%
Average decline indowntrend
17%, with most likely decline being 25%
Volume trend
Downward
Fullbacks
17%
Throwbacks
16%
Percentage meetingpredicted price targetin an uptrend
58%
Percentage meetingpredicted price targetin a downtrendSee also
52%Triangles, Symmetrical Bottoms; Triangles,Symmetrical Tops; Wedges, Falling; Wedges,Rising
Flags and pennants look alike and in many ways their performance is similar,too. The formations are usually very short in duration, from a few days to 3weeks, and mark the halfway point in a quick price move. These formations canbe profitable short-term investments, but you must be nimble and attentive totake full advantage of them. Pennants, with a failure rate of 34% in downtrends, are above the 20% rate I consider acceptable. Flags at 12% to 13 % andpennants in a uptrend (19%) perform better.The percentage of formations that meet or exceed their predicted pricetargets is disappointing for both flags and pennants. I view values above 80%to be reliable, but the results show values that range from 52% to 63%, suggesting that you should trade these formations with caution as your profits maynot be as large as you expect.The most likely rise or decline is deceptive for these formations. Whenthe likely rise or decline value is above the average, it simply means that a frequency distribution shows more hits at a particular value, but the bin totals ofthe prior columns are high, pulling the average downward.
Figure 14.1 shows a good example of a fltrendlines and usually is less than 3 weeksdays). You see these formations appearing(such as that shown in Figure 14.1), usually nThis particular flag goes against the graindowntrend. This is the most common behabut it is not unusual for flags to appear horizdownward (following the trend). Since flagsusually slope downward, but can be horizonThe volume trend is downward. As wechapter, a receding volume trend usually accFigure 14.2 shows what a pennant lookbetween a flag and a pennant is the shape oflines that eventually meet outline a pennawedge. Sometimes the trendlines slope upwtimes they do not. Usually, they slope upwain an uptrend.Like the flag formation, the volume preceding volume trend is more prevalent, occin this study.
Advanced Micro Devices, Inc. (Semico
|un93
Sen
Figure 14.1 Aflag bounded by two, parallel trume pattern.
216
Flags and PennantsCircuit City Stores (Retail (Special Lines), NYSE, CC)
Georgia Gulf (Chemical (Basi
|an 94
Nov 93
Figure 14.2 A pennant bounded by two converging trendlines looks like a shortrising wedge.
Identification Guidelines
Figure 14.3 This flag appears abo
other chart patterns in this book. In die casetrading days long, whereas the pennant in
long. Many times when a formation is very s
Table 14.1 outlines the identification characteristics for flags and pennants.
as a horizontal rectangle—a dark blob in di
Two parallel trendlines bound die price action for flags as shown in Figure14.3. Two converging trendlines outline the boundaries for pennants as shown
in Figure 14.4. In both figures die formations are short compared with manyTable 14.1
Identification Characteristics of Flags and PennantsCharacteristic
Discussion
Prices bounded bytwo trendlines
Flags: price action bounded by two parallel trendlines.Pennants: the two trendlines converge. For both patterns,prices usually go against the prevailing trend: They rise ina downtrend and fall in an uptrend, but exceptions arecommon.
Three-week maximum
Flags and pennants are short, from a few days to 3 weeks.Formations longer than 3 weeks may fail more often or arebetter classified as symmetrical triangles, rectangles, orwedges (rising or falling).
Steep, quick price trend
These formations usually form near the midpoint of asteep, quick price trend. If you do not have a strongadvance or decline leading to the chart pattern, ignore theformation.
Downward volume trend
Volume usually trends downward throughout the formation.
Figure 14.4 A short pennant forms after a qdownward and prices move upward after lea
218
Flags and Pennants
..alog Device! Inc. (Semiconductor, NYSE, ADI)
formations usually are shorter than 3 weeks but this is an arbitrary limit. Sixteen formations in this study (6%) have durations greater than 3 weeks (the
longest flag is 32 days and the longest pennant is 28 days).Reliable flags and pennants appear during steep, quick price trends. Thetrends might be up or down, but prices rise or fall quickly, moving severalpoints in just a few days to a few weeks. In Figure 14.3, for example, the downtrend begins on January 18 and the flag begins on February 1. In that short
time, prices tumble from a high of 403/4 to a low of 301/g.Although one might argue the uptrend in Figure 14.4 begins in earlyApril, I suggest the rise leading to the pennant begins later, on April 26, froma low price of 223/8. Six trading days later, the price climbs to the top of the
pennant at 313/4. The later starting point is after the two minor highs and itserves as a reference point for the measure rule.
Figure 14.3, the price trend in die flag slopes upward, whereas in Figure14.4 the pennant slopes downward. This behavior is typical for the prevailingprice trend (that is, flags or pennants typically move against the trend). Thechart patterns usually appear near the midpoint of the move. As such, they are
often termed half-mast formations.
Jan 96
May
Figure 14.5 A flag failure. The failure of prices to continue rising is probably dueto two factors: The price rise leading to the formation is short and the flag is longerthan normal.
The volume trend nearly always recedes over the course of the formation.However, this is not an inviolate rule but usually is the case. I should point outthat rising volume is no cause for alarm. Of the 45 formation failures, only 4have rising volume trends.When selecting a flag or pennant to trade, the most important guidelineis the rapid, steep price trend. If prices are meandering up or down and form a
flag or pennant, then look elsewhere. The flag or pennant must be a placewhere the stock can take a breather from its rapid pace. Prices move against theshort-term trend for several days before continuing on.
Focus on FailuresLike all formations, flags and pennants are not immune to failure. Figure 14.5
shows a flag failure. The flag, while obeying the confines of the two downsloping trendlines, has a good volume trend. Prices should continue higher
after the flag completes but do not. Why? One explanation is that the formation is just too long at 26 days. Sometimes an excessively long formationsuggests an impending failure or a weak price move (after the breakout).Trade flags or pennants more than 3 weeks long carefully or pass them upentirely.Figure 14.6, another flag formation, is also a failure. Prices should continue rising after the flag completes. The duration is good, at 10 days (about
Figure 14.6 Another flag formation failure. Prices rise for just 1 day before thisflag develops, much too short a rise to support a good formation.
average for flags), and the volume trend is downward. However, the formation
has an inadequate price rise leading to it. The difference between the take-off
719
220
Flags and Pennants
point and the formation high is just over a dollar, well short of the 19% aver-
Statistics
age rise. There is probably little danger that you would select this formation to
trade. Since flags and pennants signal the halfway point, the predicted rise inthis example is just too small to take advantage of. An investor viewing this formation for trading would likely pass it by.
Table 14.2 shows the general statistics for b144 flags and 106 pennants over 5 yearsexpected.
Figure 14.7 shows a failure of a pennant in a downtrend. The formation
All formations except 23 act as con
probably reminds you of a short symmetrical triangle—one that acts as a rever-
Those acting as reversals are also formatioare quite reasonable. For flags, they are 12Pennants have a wider spread, 34% anddowntrend fail more often than the 20% b
sal (which is unusual for a symmetrical triangle). The volume trend is receding,as you would expect. The formation price trend, bounded by the two sloping
trendlines, looks good too. The price trend leading down to the formation represents an 18% decline, exactly the average for a pennant in a downtrend.Prices should continue moving lower after this formation completes but they
do not. Why?You can see in Figure 14.7 that prices loop around the formation endthen head lower (a throwback). If you held onto your short position, you wouldeventually make money. However, I still classify this formation as a failure.Prices should continue down immediately after piercing the trendline boundary. The reason prices ascend immediately is not clear. A scan of the databasereveals 66% of the formation failures (30 out of 45) fail in this manner. That isto say, they move briefly in the wrong direction (a breakout failure) but soonturn around (by throwback or pullback) and complete properly.
Alza (Drug, NYSE, AZA)
you might consider avoiding trading them
Nearly all the flags (87%) and manyexpected, that is, prices continue in thecompletes as they were moving before theTable 14.2 lists throwbacks and pullbthe possibility of a throwback or pullbackboth happen so infrequently.The average length, at 11 and 10 days
is quite short. As described in the Identificusually range from just a few days to about
Seventy-eight percent of the flags andtrends that recede over the course of the foining the slope of the line formed using linfrom the formation start to its end. As I mmation shows rising volume is no reason to(or 9%) and 41 successful formations have
Table 14.3 shows the statistics for flagprice trend is upward, which means the tren
Table 14.
General Statistics for FlagDescription
Flags
Number of formations in 500
stocks from 1991 to 1996
144
Reversal or consolidation
1 30 con
14 rever
|an92
Feb
Figure 14.7 This pennant looks like a small symmetrical triangle. Prices break outupward, throw back to the formation, and head lower.
Failure rate in uptrend
1 0 or 1 3
Failure rate in downtrend
8 or 1 2%
Throwbacks
7 or 1 0%
Pullbacks
12 or 20
Average formation length
1 1 days
Downward volume trend
112 or 7
222
Flags and Pennants
Statistics
Pennants
flags and 58% for pennants. I consider values above 80% to be reliable. Whileboth values are over 50%, meaning that these chart patterns do act as half-mastformations most of the time, the values suggest that you should be conservativewhen gauging the eventual price move.Table 14.4 shows behavior statistics for flags and pennants in downtrends.
Table 14.3
Statistics for Flags and Pennants When Price Trend Is RisingDescription
Flags
223
Percentage beginning near 12-monthprice low (L), center (C), or high (H)
17%, C18%, H76%
L7%, C9%, H84%
Price trend duration
62 days
S3 days
Average rise leading to formation
19%
22%
Average rise after formation
19%
21%
Most likely rise after formation
20%
15% to 20%
Of those succeeding, numbermeeting or exceeding price target(measure rule)
63%
58%
even though the chart pattern may have a falling price trend within the confines of its boundary.Where in the yearly price range do flags and pennants usually form? Mostflags begin life near the yearly high, with 76% of the formations falling intothis category (I divided tie yearly price range into thirds). For pennants, 84%are within one-third of the yearly high.The trend duration, from the prior minor low before the formationbegins to the minor high after the formation ends, is 62 days for flags and 53days for pennants. Since flags and pennants are half-mast formations, andshould you enter a trade after a flag or pennant completes, you should be outof the trade in about a month, on average. This quick investment turn meansyou can make a decent profit in a short