. The gaps appear at or
near die same price level but are typically not the same size. The large gapmarked as point B in Figure 25.1 (on the far right) makes this clear. That gap
has a size of almost 5 while the one on the left (point A) is only 3/g wide.
Identification Guidelines
359
because it is set off by gaps, it is not an island reversal by the traditional definition. The gaps must overlap prices or be quite close to one anodier. In thisstudy, all islands have price gaps widiin l/s of one anodier and are at least Hpoint or larger. In addition, I did not consider one-day reversals (islands composed of 1 day) as part of tiiis study. I believe that such islands are too difficulton which to base an effective trading policy.Consider Figure 25.2, which shows several island reversals. The first twoislands happen as part of a retrace in a downtrend. The small island tops last forabout a week before prices resume their downward plunge.The island bottom forms after an extensive decline that sees prices dropfrom a high of 36'/2 to 12 in less dian 5 mondis. The exhaustion gap occurs onvery high volume and prices diat day have a very large 3 '/2 point trading range.The gap remains open until prices gap upward in late January. Looking at thebottom formation overall, it looks like a complex head-and-shoulders bottom.
Marked on die figure are the dual shoulders and duplicate heads. The volumefor die head-and-shoulders pattern is what you would expect: highest on dieleft shoulder, diminished on the head, and quite low on the right shoulder.Only after prices gap upward does volume spike higher for 2 days before recovering and trending downward.
The island top on the right of die figure is somewhat difficult to spotbecause of the large gap on the left that matches the small one on die right. It
As far as identification goes, the gap in mid-December 1991 (point C)should not be paired with the gap in late October (point A) since they are notat die same price level. Even diough the price pattern looks like an island
Table 25.1Identification Characteristics of Island ReversalsCharacteristic
Discussion
Shape
Gaps set off both island tops and bottoms and share all or part ofthe same price level. Most times, prices move away from the gapsleaving the island with a clear view of the opposing gap (the leftgap usually does not close quickly).
Rising trend
Tops have prices that lead up to the left gap and fall away fromthe right gap.
Falling trend
Bottoms have prices that lead down to the left gap and rise awayfrom the right gap.
Volume
Volume is usually high on the breakout day (the day prices make asecond gap and form the island) but need not be.
Time
The island can be from one day (a one-day reversal) to severalmonths long. Some analysts have suggested that islands are quiteshort, up to a week or two, with relatively flat price zones, but Iplaced no such restrictions on them.
Figure 25.2 Several island reversals, some with short durations and some withlonger durations. The island bottom is also a complex head-and-shoulders bottomthat retests the neckline in April.
360
Island Reversals
only takes a few days for prices to reach their high before easing down. Whenprices gap lower at the end of March, volume does not budge. This may signala weak trend and it turns out that prices do not make consistent new highs forat least a year.
Focus on FailuresFailures come in all manners of depiction. Look at Figure 25.3, a chart of alarge island top. This failure is typical of many formations, especially thosewith small declines. The island is unusual as it forms after a region of consolidation. The first gap is a breakaway gap since it breaks away from the consolidation region on high volume and prices move up. The second gap is anexhaustion gap that closes quickly.The figure shows a 5% failure. Prices head lower after the second gap onthe right, but decline by no more than 5 % before recovering and moving substantially higher. Why? There is a common law, for lack of a better term, thatsays a reversal will only travel as far as the prior rise. In other words, a reversal
has to have something to reverse. In Figure 25.3, you can see that prices consolidate for 2 months. When the island top appears, what is there to reverse?The rise from December to mid-February, when prices rise from roughly 55
Focus on Failures
361
56. Beyond that, the prior year's worth of support at that level is just too extensive to allow any further decline. There has to be something to reverse. Rememberthat before you take a position in a stock, especially something such as anisland reversal that is known to be light on performance.Figure 25.4 shows another failure. The island bottom is clearly visible onthe chart. The two gaps separate the main body of the island from the mainland with plenty of clear ocean. Over the course of the formation, the first gapremains open. The second gap closes about a week after prices throw back tothe breakout point. Then prices continue lower.How could you have known that this island bottom would rise by lessthan 5% before sinking? The question is irrelevant because of throwbacks.For island bottoms, throwbacks occur 70% of the time, on average. This highrate allows an investor the luxury of waiting before investing. Once the stockthrows back to the formation, wait for prices to recover. Assuming they do,jump in and buy the stock.In the situation shown in Figure 25.4, the stock did not recover; it continued down. Had the investor been paying attention, he would not have gotten himself into this money-losing situation in the first place.Is there another reason to suspect this formation? Sure, and it is called atrendline. If you draw a down-sloping trendline along the peaks, beginningwith the tallest one, you quickly discover that the minor peak after the island
to 65, unwinds. Prices move steadily lower at first then plunge and end back at
May 93
|un
|ul
Aug
Sep
Oct
Nov
Dec
Jan 94
Feb
Oct93
Figure 25.3 Long island top that fails because prices drop by less than 5%. Areversal needs something to reverse.
Figure 25.4 An island bottom failure. Wait for prices to close above the trendlinebefore investing in this island bottom. Since prices do not close above the trendline (at point C), skip this trade.
362
Island Reversals
bottom (point C) falls well short of the trendline. Trendlines are known fortheir ability to support or resist price declines and advances, respectively. Inthis case the trendline acts as resistance to the rising trend. It repels theadvance and prices turn lower.
In odier words, die investor should have waited for prices to close abovethe trendline before buying the stock. Even if he mistakenly connects points Aand B with a trendline and extends it downward through point C, it should givehim pause. Although prices pierce the trendline, diey fail to close above it. If
they cannot close above it, how will prices rise?
StatisticsTable 25.2 shows general statistics for island reversals. I searched all 500 stocksfor island tops and bottoms and located 245 tops and 278 bottoms over 5 yearsof daily price data. The failure rates are good at 13 % and 17%, both below the20% level that I consider a maximum for reliable formations.
Figure 25.5
Frequency distribution of losses for island tops. Note that the most
likely loss is less than 10%.
The average decline (21%) and rise (34%) are about what you wouldexpect for bearish top and bullish bottom reversals. The island bottoms couldbe a bit stronger to lift them up with some of die better performing bottoms(they gain about 40%). However, the real worry is the most likely decline andrise. For tops die likely decline is 10% or less and for bottoms, the likely gainis less than 20%. Figures 25.5 and 25.6 illustrate this. Both figures show a frequency distribution of losses or gains. I use a frequency distribution to removeany unwanted skewing of large numbers that affect an average. The tallest column then becomes what I term die most likely decline (for tops) or rise (for
bottoms).
Table 25.2General Statistics for Island ReversalsDescription
Tops
Number of formations in 500 stocks from 1 991 to 1 996
245
278
Failure rate
32 or 1 3%
46 or 1 7%
Average decline/rise of successful formations
21%
34%
Most likely decline/rise
1 0% or less
20%
Of those succeeding, number meeting or exceedingprice target (measure rule)
1 66 or 78%
1 98 or 85%
Average formation length
40 days
31 days
Number of successful formations showing downwardvolume trend
1 88 or 77%
205 or 74%
Bottoms
Figure 25.6 Frequency distribution of gains for island bottoms. Island bottomshave a likely loss of 20%.
363
364
Island Reversals
Figure 25.5 shows the column with the highest frequency as having a lossof up to 10%. You can see that almost 60% of the formations have gains averaging less than 20%. That is a sobering thought. The figure warns you not to
regression on the volume data to derive t
expect too much of a decline from an island top in a bull market.
time, whereas bottoms have throwback
Figure 25.6 shows a graph of gains for island bottoms. The most likelygain is the highest column at 20% but the 10% column follows closely. In thiscase, 42% of the formations (or almost half!) have gains of less than 20%.Most measure rules use the height of the formation, so I computed thetarget price for each successful formation and tabulated whether the pattern hitits target. Both tops and bottoms do quite well, with 78% and 85%, respectively, reaching their predicted prices. I consider values over 80% to be reliable, so these are close enough for comfort. Of course, if the formation is notvery tall, then it is comparatively easy to make the grade. This is especially true
cases the numbers are quite high and suthis behavior (that is, wait for the pullb
declining volume trend is clearly visible
Table 25.3 lists additional statistics.
Tactics in the next section.The average time to a pullback or th
and bottoms, respectively. This is slight
For successful formations, the timquite widely between tops and bottoms.low, but 6 months for bottoms to clim
should not be so surprising since it often
when just 2 days' worth of prices compose an island (the days have gaps on
I separated the formations into th
either side).The average formation length is quite short, about a month or so forboth tops and bottoms. Again, the number of small duration islands influencesthe duration. Still, when you review all the data, the formations are generallyquick to reverse. About half of all islands (43% for tops and 50% for bottoms)
breakout price within the yearly range.occur in the highest third of the yearly pstrange for a bottom, it is not. That is bewhen prices decline to, then rise away frhand, have prices that lead up to, then do
last 2 weeks or less.Over the course of the formation, 77% of the tops and 74% of the bottoms show a receding volume trend. I use the slope of a line found using linear
When we substitute performance icover that island tops occurring in the
Table 25.3Additional Statistics Related to Island ReversalsDescription
Island Tops
Island Bottoms
Pullbacks/throwbacks
160 or 65%
195 or 70%
8 days
9 days
ultimate low/high
3.5 months (72 days)
6 months (178 days)
Percentage of islands occurring near12-month price low (L), center (C),or high (H)
L19%, C37%, H44%
L34%,
C28%,
H38%
Percentage change for each 12month lookback period
128%, C22%, HI 9%
L31%,
C33%,
H35%
306%, 187%, 141%,120%, 126%, 113%
201 %, 124%, 88%,
Average time to pullback/throwbackcompletion
the prior day have losses of just 16%.
For successful formations, days to
Volume for breakout day and next
5 days compared with day beforebreakoutPerformance for high volumebreakouts versus low volumebreakouts
perform best with losses averaging 28%situations (an island near the yearly low)Bottom performance is about evenly spliThe table shows volume statistics. Cday prices gap away from the formation,volume remains high through the followcalms down and remains quiet.I did a study to see if high volumisland tops, the answer is yes, as thoseprior day show losses averaging 22%, wh
84%, 86%, 86%
For bottoms, the reverse is true. Awith a 39% rise, whereas those format33%. In both cases, the 125% (high volmarks are arbitrary designations.
Trading Tactics
Table 25.4 outlines trading tactics. The f22% versus 16%
33% versus 39%
at all; it is the measure rule, which assist
is worth risking. Consider the island bo
Table 25.4
Sample Trade
367
Trading Tactics for Island ReversalsTrading Tactic
Explanation
Measure rule
Compute the formation height by subtracting thelowest low from the highest high in the formation.Add the difference to the highest high for islandbottoms, and subtract the difference from thelowest low for island tops. The result is the targetto which prices should rise (for bottoms) or fall(for tops).
Wait for pullback or throwback
Island reversals show a reluctance to continuemoving in the direction of the breakout. Pricesusually reverse direction and quickly fill the gapbefore recovering and resuming their originaltrend. Wait for the pullback (tops) or throwback(bottoms) to complete and prices to resume theiroriginal direction before investing.Trendlines, when pierced, often signal a trendchange. Should an island reversal appear near atrendline, wait for prices to close beyond thetrendline before investing.
Watch trendlines
est high in the formation is 24% (which is just below the gap in early February,not the larger gap in mid-February) while the low is 17'/2. Add the differenceof 7'/8 to the highest high to get the predicted price target. In this case, the target is 3 !3/4, a target not reached before the formation fails.Since pullbacks and throwbacks occur a majority of the time and sinceisland reversals have a low failure rate but poor performance, it is wise to waitfor the retrace. It usually occurs a week or two after the second gap. If a pullback or throwback does not occur quickly (in less than a month), then move onto the next trading situation.
When a pullback or throwback occurs, do not invest immediately. Waitfor the retrace to complete and for prices to turn around and resume their orig-
inal direction. Sometimes prices retrace to the formation, then continue moving in the adverse direction.
In die Focus on Failures section of this chapter I discuss the use of thetrendline in detail, so there is not much added here. However, both up anddown trendlines can show a trend change. Wait for prices to close above a down
trendline or below an up trendline before pulling the trigger. Many timesprices will near the trendline and be repulsed, so you want to make sure thatthe piercing does, indeed, signal a change in trend.
Sample TradeConsider the situation faced by Clarence as illustrated in Figure 25.7. Hewatched the semiconductor company's stock plummet. During November and
December, the stock formed a type of island consolidation. He knew it was nota reversal because the two gaps did not line up across from each other. Thenanother island formed in January to early February.
Since prices gapped down to the second formation then gapped up awayfrom it, he knew he was dealing with an island bottom, a better investmentchoice for performance than an island top. He used the measure rule to gaugethe likely price to which the stock would climb. The target represented nearlya 30% rise in price, large enough to risk a trade.Before he bought the stock, he made a few checks. He saw that the trend
was down, as the stock had fallen from a high of 6ll/s to the island low of 17!/2.Clarence drew the trendline from the highest high downward and saw it goSep 95
Oct
Nov
Dec
Jan 96
Feb
Mar
Apr
May
]un
Jul
Figure 25.7 A failed island bottom. Sometimes the best trade you can make isnone at all.
through the right island gap. This was a good sign as prices had moved abovethe line and closed there. It signaled a trend change.Still, something did not feel right about the stock. It had made a new lowand the semiconductor industry as a whole was soft. Did the island bottomreally mark a turning point or would the stock simply rise up, spin around, and
retest the low? He was unsure, so he decided to wait and see if prices threw
366
368
Island Reversals
back to the formation. If they threw back then continued higher, he would buythe stock. Three days after the upside breakout, the stock threw back andclosed the gap. Now, Clarence knew, all the stock had to do was move higher.It did not. The stock continued moving down and in less than a week hadslipped below the trendline again. He decided to look elsewhere for a morepromising situation.Looking back at the stock well over a year later, he saw that it reached alow of 8 and never rose above 27I/4, the high just after it pierced the trendline.He realized that sometimes the best trade you can make is none at all.
26Measured Move Down
R E S U L T S SNAPSHOTAppearance
Prices move down, retrace, then move down again.The two down legs are nearly equal in both price andtime.
Reversal or consolidation
Intermediate-term (up to 6 months) bearish reversal
Failure rate
22%
Average decline
36%, with most likely decline between 25% and 40%
First leg decline
25% in 54 days
Corrective phase rise
16% in 39 days (40% to 60% retrace of prior decline)
Last leg decline
27% in 60 days
Measure rule
43% of second legs are longer than first leg pricedecline.
Surprising finding
The corrective phase should be in proportion to thefirst leg decline.
Synonym
Swing measurement
See also
Flags and Pennants
The measured move down, or swing measurement as it is sometimes called, isan exciting formation because it vividly tells you how far down it is going.Unfortunately, with a failure rate of 22%, it is also more risky. I consider
369
370
Identification Guidelines
Measured Move Down
formations with failure rates less than 20% to be reliable. That is not to saythat this one is unreliable, especially since it has a 36% average decline, whichis well above the usual 20% decline for bearish reversals. For this formationeven the most likely decline is high but wide at 25% to 40%.When we examine the two down legs of this formation, we find that theyare nearly the same length, 60 days versus 54 days, with declines of 25% versus 27%. On a percentage basis, the second leg seems longer, but on a pricebasis, the second leg is 8% shorter. Remember that as prices fall, they have totravel less far to make the same percentage decline. This helps explain whyonly 43% of the second legs exceed the first leg price decline (in other words,the measure rule).
A surprising finding that helps with gauging the veracity of the formationand its performance is the size of the corrective phase. A large first leg pricedecline should also show a large corrective phase retrace. If the correctivephase falls short of the usual 40% to 60% retrace, then beware. Be prepared toexit the trade well before reaching the target price.
TourFigure 26.1 shows what a typical measured move down looks like. The declinefrom the high (point A) to the start of the retrace (point C) is called the first kg.
371
decline to the low is called the second leg. The first and second legs are nearly
the same size, but their behavior is described in more detail later in the Statistics section.The corrective phase is simply an upward retrace of the downtrend. It isa place for the stock to catch its breath and for novice investors to buy into thesituation. They purchase the stock and push it up, believing the decline is at anend. Do not be fooled; the decline is only half over. That is die beauty of thisformation. Before you buy a stock after a long decline, consider that it mightbe making a measured move down and that the decline is not over. Payingattention might save you some big bucks.Returning to Figure 26.1, you can see the two legs following a trendlinethat has nearly the same slope. This is not always the case, but a surprisingnumber of formations obey this dictum. Further, a channel—two parallel linesthat follow prices down—can encompass the two legs. Although the examplein Figure 26.1 is weak on die first leg, you can see how the second leg followsa top trendline, connecting points D and E and extending down.Lastly, the three points marked A, B, and C mark another measured movedown. This one is more compact and it is not uncommon to find nested formations like this. Sometimes, you get one measured move right after another.
Identification Guidelines
The retrace is commonly referred to as the corrective phase and the remainingFleetwood Enterprises (Manuf. Housing/Rec. Veh., NYSE, FLE)
Table 26.1 highlights identification characteristics for the measured movedown chart pattern. The first leg occurs as prices reach a new high and a trendchange begins. Prices decline leaving a price peak on the chart. From diere,Table 26.1Identification Characteristics of the Measured Move Down
Mar 92
Figure 26.1 A typical measured move down. The slope of the trendline is similarfor both legs. Points A, B, and C mark a nested measured move.
Characteristic
Discussion
First leg
Usually begins from a new high. Prices decline rapidly in astraight-line fashion. Avoid declines that curve (they are foundingturns, scallops, or saucers).
Corrective phase
Prices can move horizontally but usually rise and recover from40% to 60% of the prior decline before resuming the downtrend.If the corrective phase nears or rises above the first leg high, lookelsewhere.
Second leg
The dope of the first leg down trendline often carries onto thisleg. Both legs usually fit inside their own trend channels.
Avoid
For cascading measured moves, use the first retrace and not laterones as they get progressively closer to the end of the trend.Avoid horizontal, saw-tooth consolidation regions and measuredmoves that rise from a flat base. Make sure the measure rule doesnot predict prices will fall below zero.
372
Measured Move Down
Air Products and Chemicals Inc. (Che
prices continue moving lower, usually in a straight-line run. Most times youcan draw two parallel lines, one connecting the minor highs and one joiningthe minor lows, forming a down-sloping trend channel. The corrective phasestops the decline. Prices can move horizontally but usually retrace a significantportion of their losses, say, between 40% and 60%.When the second leg begins, the downturn resumes. Prices usually followthe slope set by the first leg but this varies from formation to formation. Of
course, the two legs will not share the same trendline since the corrective phaseoffsets them. Even so, the second leg usually fits inside its own trend channelas prices decline in a straight-line fashion. The second leg decline approximates the price decline set by the first leg and the time it took to accomplish it.There are several guidelines that you should follow when searching forthe measured move down. Avoid formations that show a rounded first leg,where prices move lower but curve around in a sort of rounding turn, scallop,
or saucer. The trend should be a straight-line decline.During the corrective phase, prices should not rebound (or come close) tothe high set by the first leg. If prices near or rise above the first leg high, thenavoid the formation.
|un95
Watch for consecutive measured moves in a declining price trend. Thedowntrend eventually will end, so it is best to trade on the first or second measured move and avoid the rest.
decline from A to B.
Figure 26.2 Two measured moves. Nochannel. With measured moves, the price
Occasionally, the prevailing price trend will be horizontal. Prices rise upand reach a high then begin down in the first leg. When prices return to thebase, they bounce. This bounce, wrongly interpreted as the corrective phase ofa measured move down, is really a minor high in a consolidation trend. Prices
The second leg is steeper than the fihalf the time (36 days versus 19 days).
return to the base and may bounce several more times before beginning a sus-
one falls 71A).Another measured move occurs insame level as the first formation in late Jyou look closely at Figure 26.2, you can sin the first leg from point E to point F.
tained move upward. The overall picture looks like a horizontal saw-tooth for-
mation. Avoid measured moves that spring from a horizontal trend.The last caveat is to consider the measure rule. I discuss the measure rulein the Trading Tactics section of this chapter, but the measure rule says thesecond leg will approximate the price move of the first leg. If the first leg has alarge decline, you may find that the predicted price is very close to zero or per-
shorter than the first one (the first leg
phase.
haps even negative. Obviously, the stock is not going to go negative and probably will remain far above zero, so you might look elsewhere for a more
promising trade. Examples of these idiosyncrasies follow in the Focus on Failures section.Figure 26.2 shows two examples of the measured move down formation.The first one, marked by points A, B, C, and D, begins after a long price rise. Thestock moves up from 43'/s in late November 1994, to 595/s in early July. Then,prices decline following a down trendline and stay within die trend channeluntil mid-August, when they reach a low of 51 '/z. The corrective phase beginson volume that is high but not unusually so. Prices move up and retrace 68%of the decline before tumbling again. In the second leg, prices move below thelow (point B) and continue lower to point D. Then it is over.
Focus on Failures
What constitutes a failure of a measuredchart pattern, I decided that if prices dothe formation classifies as a failure. Admto a large extent on the size of the correweaker situations.
There are a number of identificatiFigure 26.3 shows the first one. The se
high, along with a host of other chip mak
1995. The stock forms a head-and-sho
374
Measured Move Down
Focus on Failures
Integrated Device Technology (Semiconductor, NASDAQ, IDT1)
Anadarko Petroleum Corp. (Petroleum (Producing), NYSE, APC)
Apr 95
Figure 26.3 A head-and-shoulders top leading to a measured move down. Thehead-and-shoulders top forms the basis for the large decline. The corrective phaseis small in comparison to the large first leg decline. The measure rule for the measured move formation predicts prices will go negative. Think the stock will make it?
before burning out. In a near straight-line run, the stock tumbles from a highof33 I /2toalowof9 1 /s.If this decline marks the first leg of a measured move down, how far willprices fall in the second leg? That depends on how far up the corrective phasebrings prices. The corrective phase rises to a high of 15!/4.1 discuss the measurerule later, but it says the second leg approximates the price decline of the firstleg. If we run through the computations, we discover that the predicted declineis minus 91/s. Even if the company were to declare bankruptcy, its stock pricewould never go negative, there is no way that prices are going to decline that far.Another key to this failure is the size of the corrective phase. Usually,prices recover 40% to 60% of the first leg decline, but this one does not comeclose (about a 25% retrace). With larger price declines, the corrective phase isproportionally larger too. However, the formation in Figure 26.3 does notshow such behavior.Figure 26.4 shows another situation: the flat base problem. Prices areessentially flat from the start of February. By that I mean the minor lows allshare the same value—about 40. When prices move up in August and reach aminor high in September, it is nothing unusual. Although the prior minorhighs do not ascend to this height, there is no reason to suspect that a measuredmove will follow.
375
May
Oct
Dec
Figure 26.4 A measured move from a horizontal base. These formations rarelywork out as anticipated.
When prices decline to the base at 40 and bounce, a naive investor mightthink a measured move down is forming. The corrective phase in late Octoberand early November sees prices rebound quite a ways up the first leg beforecurling over and heading down. If the investor sells short at this point, it willbe a costly mistake. Prices quickly skyrocket to 60 by May from the second leglow of 447/s. Why does this formation fail? The strong support level at 40 curtails any meaningful decline below that point. In other words, there is nothingto reverse.Figure 26.5 shows the last failure, a case of mistaken identity. After along, extended rise, a retrace can be expected, maybe even a trend change thattakes prices drastically lower. When prices turn down in early January, adecline is long overdue. If you connect the minor lows in the uptrend, you discover that prices pierce the up trendline in mid-December. This piercing supports the theory that the trend is changing. It is not conclusive, but it does tiltthe scales in that direction. Throughout the month of December prices essentially move horizontally before perking up and making a new high just beforeprices plummet. The failure to continue moving higher is another clue to atrend change. The final clue is when prices descend and drop below the priorminor high reached in late October. It even tumbles below the support level at125/8 before recovering.The corrective phase of the measured move down sees prices recoverquite far, representing a retrace of 85%. That is well above normal and should
376
Measured Move Down
Statistics
Champion Enterprises (Manuf. Houslng/Rec. Veh., NYSE, CHB)
377
Table 26.2General Statistics for the Measured Move DownDescription
Statistic
Number of formations in 500 stocksfrom 1991 to 1996
622
Reversal or consolidation
77 consolidations, 545 reversals
Failure rateAverage decline of successful formations
134 or 22%
Most likely decline
36%25% to 40%
Average formation length
5 months (153 days)
First leg price decline
25% in 54 days
Corrective phase price rise