decline
For an established formation, when prices climbtoward the top trendline or decline toward the lowerone but fail to touch it, prices often reverse directionand break out of the formation.
Support and resistance
Follows the two trendlines into the future but issporadic.
When the stock tried to reach the top trendline but could not, the partial rise
foretold the coming decline. The stock plunged through the lower trending inlate September and continued lower.If you look at both formations, their stories are nearly the same. There isa supply of stock available at a fixed price. After exhausting the supply, priceseither rise above the top trendline or decline below the lower one. The determination on which way things will go is not clear. Sometimes the supply overwhelms buyers and the stock declines, unable to recover as it pierces the lowertrendline. At other times, the supply gives out and enthusiastic buyers jump inand push the price higher.
down-sloping trendline: It requires at least two distinct touches before drawing the trendline. There is usually ample time to recognize a broadening formation, and many times there are more than two touches of each trendline.There is no consistent volume pattern for this formation. Sometimes volume tapers off, then explodes on the breakout day, just like its triangle cousins.At other times, volume starts slowly and rises as the breakout nears. Of the two
scenarios, the first is slightly more likely than the second, at 53% versus 47%.Since the numbers are so close, I attach no significance to them.
Identification GuidelinesAre there some guidelines that can assist in identifying descending broadeningformations? Yes, and Table 3.1 outlines them. The shape of the formationlooks like a megaphone with the top held horizontal. Prices climb until theytouch the top trendline, then reverse direction. On the lower edge, pricesdecline making a series of lower lows until they touch the lower trendline.When two minor highs achieve the same, or nearly the same, price level,you can draw a horizontal trendline connecting them. The same applies to the
A partial rise, as shown in Figure 3.3, or a partial decline is often a clue to
the ultimate breakout direction. When prices curl around on a partial rise ordecline and return to the trendline, they usually break out immediately (that is,without crossing the formation again). We will see in the Statistics section thatthis behavior is more reliable for upside breakouts than downside ones.The trendlines, when projected into the future, can sometimes act asareas of support or resistance, depending on which side prices are approaching(Figures 3.1, 3.3, and 3.7 show examples). Sometimes the support or resistancelevel is active for months or even years at a time.
46
Broadening Formations, Right-Angled and Desi
Focus on Failures
jiding
Healthcare Compare (Medical Services, NASDAQ, HCCC)
Pacific Telesis Group (Telecom. Services, NYSE, PAC)
|ul 91
Aug
Sep
Oct
Nov
Dec
Jan 92
Feb
47
Mar
Apr
Figure 3.4 A descending broadening formation with prices that fail to continuemoving up. The partial decline suggests the ultimate breakout will be upward, butthe rise falters and prices move downward instead.
Figure 3.5 A downside breakout failure. Prices decline by less than 5%, turnaround, and eventually hit 42. Such failures are rare, but they do occur, so stop-lossorders are always important. A broadening top formed in early November.
Focus on FailuresSince descending broadening formations can break out in either direction, Ishow both views of failed breakouts. The first one, Figure 3.4, is characterizedby the telltale partial decline in late November. From there, the stock climbsand eventually pierces the top trendline. Once prices close above the trendline,you would expect them to throw back to the formation top then continue
Figure 3.5 shows a more harrowing tale because it involves a short sale.Investors watching the sharp 2-day decline beginning October 14, 1994, wouldbe tempted to short the stock the next day. Had they done so, or even waiteda few days, they would have bought near the low. From that point on, the stockmoved higher before it pulled back into the formation where it meanderedbefore ultimately soaring out the top. If you were a novice investor and had not
higher or simply move upward from the start. In this situation, prices stall at 45
placed a stop on your short sale, your loss would have taken you from a low of
and return to the formation proper—a classic throwback. Unfortunately,instead of rebounding and heading higher like a typical throwback, the stockcontinues down. It does some more work inside the formation before shooting
out the other side in a straight-line run.Had you purchased after the upside breakout, you would have seen thestock decline from a purchase point of about 44'/2 to a low of 367/s. Even a stop
at the lowest point of the formation would have gotten you out at 39, still ahefty decline. However, if you held onto the stock (not recommended, by the
way), it would have been rewarding. The low occurred on April 8 (not shown),and it turned out to the be the lowest price reached during the next 2 years.
The stock hit its peak in early November 1993 at a price of nearly 60.
243/s to 53, where it peaked near the end of the study.Figure 3.5 represents a failure type I call 5% failures. That is when pricesbreak out in a given direction and move less than 5 % before moving substantially in the direction opposite the breakout. It is the type of failure that canturn a small profit into a large loss if stops are not used.If there is a bright side to the situations shown in Figures 3.4 and 3.5, it isthat failures do not occur very often. The statistics follow, but for now let mepoint out that 8 of every 10 formations continue moving in the direction of thebreakout. The two figures should also provide a warning to make sure you usestops to limit your losses. Even if you choose to hold a mental stop in yourhead, be sure to pull the trigger once things begin to go bad.
48
Statistics
Broadening Formations, Right-Angled and Deso
StatisticsTable 3.2 shows the general statistics for the descending broadening formation. Of the broadening formations studied so far, this one is the most rare. Iused two databases and still found only 82 formations in over 3,000 years ofdaily price data. Rare indeed!
There are 6 more reversals (44) than consolidations (38) of the trend.Like most formations, I compare the trend before entry to the chart pattern tothe trend after the breakout.A formation classifies as a failure if prices do not continue in the breakoutdirection by more than 5% before reversing course. Table 3.2 provides thefailure rate for the two breakout directions. Upside breakouts show failure
49
rates of 19%, whereas downside breakouts fail 3% of the time. I consider values below 20% to be acceptable, so both directions score well.The average rise from an upside breakout is 27%, but the most likely riseis between 20% and 30%. Since I base the most likely rise on a frequency distribution of the gains for each formation, I must caution you not to place toomuch emphasis on this particular statistic. There are simply too few samples indie study on which to base any firm conclusions. The highest frequency, forexample, is seven hits in the 30% range followed by five hits in the 20% category. A frequency of 30 or higher, by comparison, is reliable. Other formationtypes typically have likely rises in the 10% to 15% range, and, if enough samples were present in this formation, that is the performance I would expect.The average decline from a downside breakout is 19%. This figure isclose to the range (20%) of most bearish formations. The most likely declineis in the 10% to 15% range, and the same warning applies to the sample size.Even though the samples may be few, the results are typical and there appearto be no surprises.
Table 3.2General Statistics for Right-Angled Descending Broadening FormationsDescription
Statistic
Number of formations in 500 stocks from1991 to 1996
69
Number of formations in 296 stocks from1996 to 1998
13
Reversal or consolidation
38 consolidations, 44 reversals
Failure rate for upside breakouts
9 or 19%
Failure rate for downside breakouts
1 or 3%
Average rise for successful upside breakoutsMost likely rise
27%20% to 30%
Average decline of successful downsidebreakouts
19%
Most likely decline
10% to 15%
Of those succeeding, number meeting orexceeding price target for upside breakouts(measure rule)
34 or 89%
Of those succeeding, number meeting orexceeding price target for downsidebreakouts (measure rule)
20 or 69%
Average formation length
3 months (88 days)
Days to ultimate high, upside breakouts
5 months (148 days)
Days to ultimate low, downside breakouts
3 months (86 days)
Success rate of partial rises
7/12 or 58%
Success rate of partial declines
18/2 3 or 78%
Note: This rare formation does better on an upside breakout, scoring an average 27% gain.
Use the measure rule to predict the target price for the formation after abreakout. The Trading Tactics section of this chapter explains the calculationmore thoroughly, but the measure rule simply computes the height of the formation and adds or subtracts the result from the breakout price. Often, the tar-
get price serves as a minimum expected price move. For this formation, upsidebreakouts hit or exceed their targets 89% of the time and downside breakoutsreach or decline below their targets 69% of the time. I like to see values above80%, so the downside target performance is low.The average formation length is about 3 months (88 days), and takesbetween 3 months (for downside breakouts) and 5 months (for upside breakouts) to reach their ultimate price values. The longer time it takes to reach theultimate high makes sense since the percentage gain (27%) is larger than thedecline resulting from downside breakouts (19%). In short, it takes longerto go further.A partial rise, where prices begin heading up from the lower trendline andapproach but do not touch the top trendline before turning down, results in adownside breakout 58% of the time. That is not much higher than guessingthe result of a coin toss. However, partial declines—which is the same curlingaction only from the top of the formation—result in an upside breakout 78%of the time. That is high enough on which to base a trading strategy: If you seea partial decline that begins heading up, buy the stock.
Table 3.3 outlines the breakout statistics. Since this formation can breakout either way, the failure statistics appear in two categories: upside and downside failures. Only 19% of the formations breaking out upside fail to continuemoving up by more than 5%. For downside breakouts, only one formation failsto continue moving down. Remember, the sample size is only 47 and 30 samples for upside and downside breakouts, respectively.
50
Broadening Formations, Right-Angled and DescCfling
Statistics
Table 3.3
51
Avery Dennison Corp (Chemical (Specialty), NYSE, AVY]
Breakout Statistics for Right-Angled Descending Broadening FormationsDescription
Statistic
Upside breakout but failure
9 or 19%
Downside breakout but failure
I or 3%
Upside breakout
47 or 57%
Horizontal breakout
5 or 6%
Downside breakout
30 or 37%
Throwbacks
II or 23%
Average time to throwback completion
11 days
Fullbacks
10 or 33%
Average time to pullback completion
14 days
Percentage of upside breakouts occurring near12-month price low (L), center(C), or high (H)
L0%, C26%, H74%
Percentage gain for each 12-month lookback period
L0%, C41%, H25%
Percentage of downside breakouts occurring near12-month price low (L), center (C), or high (H)
L40%,
Percentage loss for each 12-month lookback period
L31%, C14%, 1-110%
Volume for breakout day and next 5 days comparedwith day before breakout
143%, 105%, 96%,92%, 83%, 71 %
Percentage of successful breakouts occurring onhigh (H) or low (L) volume
H76%, L24%
Percentage of failed breakouts occurring onhigh (H) or low (L) volume
H70%, L30%
92 M A M | J
C40%,
H20%
Note: For a traditionally bearish formation, there are more upside breakouts than downsideones—57% versus 37%.
A S O N D 93F
MA M J ]
A S O N D 94F MA M| j A S O ND 95 FM A M )
Figure 3.6 A horizontal breakout. Prices do not rise above or fall significantlybelow the formation for months on end, shown on a weekly scale.
Most of the upside breakouts (74%) occur near the yearly high. Thisobservation suggests descending broadening formations appear at the end ofan upward trend. Note that there are no formations appearing near the yearlylow. Since I use the top of the formation as the benchmark, this result is notunusual.
The best performance from upside breakouts occurs when the breakout isin the middle third of the yearly price range; why is unclear. In other formations, the tendency is for the upper range to perform best, possibly due to
There are three types of breakouts: up, horizontal, and down. Most of theformations (57%) break out upward. Downside breakouts are next at 37%,
momentum players taking hold of the stock and bidding it higher after anupside breakout. Since this formation broadens downward, it might scare off
with the remainder breaking out horizontally. If you are wondering what a
investors even after an upside breakout.
horizontal breakout looks like, see Figure 3.6. As shown, after the formation
Downside breakouts tell a different tale. Most breakouts split between thelower and center third of the yearly price range. The highest price range garners only 20% of the formations since I use a breakout below the lowest formation low in the computation. True to form, formations breaking outdownward in the lowest third of the yearly price range perform best, with anaverage decline of 31 %. This performance suggests that it is better to short
ends, the stock moves horizontally for about 6 months before closing above the
top of the formation. Even so, in about 4 months, prices dip below the formation top again. Not until July 1994 do prices stage a strong rally and movedecidedly higher.Throwbacks and pullbacks are rare, being found in only 2 3 % and 3 3 % ofthe formations, respectively. The duration of pullbacks, at 14 days, is slightlyabove normal (10 to 12 days) for all formation types. I ignore any throwback or
pullback beyond 30 days because I consider it normal price action and not dueto a throwback or pullback.
stocks making a new yearly low than a yearly high.
Breakout volume is surprising in that it peaks then quickly recedes. Thebreakout volume is, on average, 43% above the prior day (or 143% of totalvolume) and diminishes rapidly and steadily to 71 % a week later. I did not sep-
52
Trading Tactics
Broadening Formations, Right-Angled and Deseed,ng
arate the volume numbers into the two breakout types; the numbers apply to
all descending broadening formations.The breakout volume for successful breakouts is indistinguishable fromunsuccessful ones. Both occur on high volume about three-quarters of thetime. So, if you see weak volume on an upside breakout, do not be too concerned about an impending failure.
Trading TacticsTable 3.4 outlines trading tactics for descending broadening formations. Figure 3.7 illustrates the computation of the measure rule. Compute the formation height by first taking the difference between the highest high (49'/>) and
the lowest low (43'/2). Add the result (6) to the value of the horizontal trendlineto get a target price of 55l/2. Prices reach this target during mid-March 1996 asthe stock climbs on its way to 60.
53
If the stock breaks out downward, the measure rule computation is nearlythe same. Subtract the formation height from the lowest low giving a targetprice of 37'/2. Be aware that upside breakouts are more likely to reach their targets (89%) than downside ones (69%).Once you know the target price, you can make a profit and loss assessment for the trade. What is the likely downside move compared with the target price? Does the potential profit justify the risk of the trade? For Figure 3.7,there is support in the 46 to 47 area. Examining the peaks and valleys of theprior price action determines support and resistance levels. In March 1995(not shown in Figure 3.7), there is an area of congestion bounded by a symmetrical triangle with an apex at about 46. Additional resistance appears in Julyand October, as shown in Figure 3.7. Together, the 46 to 47 area makes a goodlocation for a stop-loss order.
Let us say the stop is 453/4, just below the bottom of the support area. Ifthe trade happens at 50'/2, which is the close the day after the upside breakout,that gives a potential loss of less than 10%. With a target price of 55'/2, or 10%upside, the win/loss ratio is an unexciting one to one. In such a situation, you
Table 3.4Trading Tactics for Right-Angled Descending Broadening FormationsTrading Tactic
Explanation
Measure rule
Compute the formation height by taking the differencebetween the horizontal top and the lowest low in theformation. For upside breakouts, add the result to the valueof the horizontal trendline. For downside breakouts,subtract the value from the lowest low. The result is theexpected target price.
Wait for confirmation
It is unclear which way prices will break out, so it is best towait for prices to close outside the trendlines. Once they do,expect prices to continue moving in the direction of thebreakout. Place your trades accordingly.
Stops
Once a breakout occurs, consider the opposite side of theformation as the stop-loss point. However, in many casesyou will want something closer to your purchase price solook for nearer support or resistance zones. Once the stockmoves substantially, advance the stop to the break-evenpoint.
Intraformation trading
Once you recognize a broadening formation, considerplacing a trade as prices reverse course at the trendline. Colong at the bottom and short at the top but be sure to usestops to protect against an adverse breakout.
Partial decline
Buy a stock if you see a partial decline once prices curlaround and begin heading back up.
Note: Always wait for the breakout, then trade with the trend.
Figure 3.7 An upside breakout from descending broadening formations. To compute the measure rule for upside breakouts from descending broadening formations, find the difference between the high and low in the formation, denoted bypoints A and B. Add the result to point A to get the target price. It took almost 7months for prices to exceed the target. A small symmetrical triangle appears atpoint C.
54
Broadening Formations, Right-Angled and Descenv...ignv...ic
4
could either tighten your stop by moving it higher (and risk getting taken outby normal price action) or look elsewhere for a more profitable trade. Remem-
ber there is no rule that says you have to place a trade.The Statistics section of this entry introduces you to partial declines—78% of the time an upside breakout follows. That is high enough to risk atrade. If you see a partial decline occur (and it really does not matter how fardown it dips, so long as it is not touching or coming too close to the lower
Broadening Tops
trendline) and it begins heading back up, buy the stock. With any luck, it willshoot out the top of the formation and continue higher. As always, be sure toplace a stop-loss order and raise it as prices climb.
Sample TradeRalph is a formation trader with a measure of experience milking chart patternsfor all they are worth. When he noticed what he thought was either a descending broadening wedge or a right-angled descending broadening formation, he
bought the stock. His order, placed at point C in Figure 3.7 (463/8); was justafter the stock bounced off the lower trendline.He monitored it closely, and watched the stock move up the very next
day, then ease lower. After a few days, Ralph saw a symmetrical triangle formand he became worried. Those formations, he reasoned, usually follow thetrend and the trend was downward. When the stock moved below the lowertriangle trendline, Ralph sold the stock and received a fill at 461/2.When he erased the lines from his computer screen and looked at thefresh price chart, he knew he had made the right decision because a partial rise,such as where the triangle formed, usually portends an immediate, downsidebreakout.Sure enough, the following day prices dropped even further, tagging thebroadening formation trendline again. Then they rebounded. In the comingdays, he watched as prices surprisingly zipped across the formation and
touched the top trendline. Ralph took a small loss after factoring in commissions. Did he sell too soon or was he just being cautious, and what lessons didhe learn? Spend some time searching for the answers in your own trades andyou will rapidly become a better investor.
RESULTS SNAPSHOT
Upside BreakoutsAppearance
Price trend is upward, leading to the formation.Megaphone appearance with higher highs and lowerlows that widen over time. Breakout is upward.
Reversal or consolidation
Short-term (less than 3 months) bullish consolidation
Failure rate
4%
Average rise
34%, with most likely gain between 10% and 15%
Volume trend
Ragged, but usually follows price: rises as prices rise,falls when prices fall.
Percentage meetingpredicted price target
75%
Surprising finding
Partial rise at the end of the formation predicts adownside breakout 65% of the time and a partialdecline predicts an upside breakout 86% of the time.
Synonyms
Expanding triangle, orthodox broadening top, andfive-point reversal
See also
Broadening Bottoms; Broadening Formations, RightAngled and Ascending; Broadening Formations,Right-Angled and Descending; Broadening Wedges,Ascending; Broadening Wedges, Descending
55
56
Tour
Broadening Tops
Downside BreakoutsAppearance
Price trend is upward, leading to the formation.Megaphone appearance with higher highs and lowerlows that widen over time. Breakout is downward.
Reversal or consolidation
Short-term (less than 3 months) bearish reversal
Failure rate
4%
Average decline
23%, with most likely decline between 10% and 20%
Volume trend
Ragged, but usually follows price: rises as prices rise,falls when prices fall.
Percentage meetingpredicted price target
See also
64%
Broadening Bottoms; Broadening Formations, RightAngled and Ascending; Broadening Formations,Right-Angled and Descending; Broadening Wedges,Ascending; Broadening Wedges, Descending
Broadening tops, not surprisingly, act a lot like broadening bottoms. Whatseparates a top from a bottom is the price trend leading to the chart pattern.For tops, the intermediate-term price trend is upward; for broadening bottoms, it is downward. This is an arbitrary distinction I made just to see if thetwo formations act differently. In answer to the question you have probablyposed right now: The two formations act similarly, but their performance differs slightly.Broadening tops divide into two types: those with upside breakouts andthose with downside ones. You can see in the Results Snapshot that the failurerates are the same for both: 4%. That is a very good number. I consider failurerates below 20% to be acceptable.The average gain for upside breakouts is subpar at 34%. Well-behavedbullish formations usually score about a 40% rise. Downside breakouts frombroadening tops perform better than normal with a 23% loss. The usual lossfor all bearish chart patterns is about 20%.The broadening top formation performs better than some chart patternsregarding the measure rule. The rule estimates a target price for the stock.Three out of every four broadening tops (75%) with upside breakouts meet orexceed their price targets, whereas 64% of those formations with downsidebreakouts meet or exceed theirs. Still, I consider values above 80% to be reliable, so the formation comes up a bit short.This formation does excel in predicting the breakout direction. When apartial rise or decline occurs—that is, when prices move toward the oppositeside, then reverse before touching the trendline—it is a breakout signal. Forpartial rises, the breakout direction is downward. A downside breakout follows
57
those formations showing a partial rise 65% of the time. Partial declines scoreeven better when they break out upward. Almost all the formations (86%)showing a partial decline correctly predict an upside breakout.
TourBroadening formations come in a variety of styles and names. There are thebroadening tops and bottoms, right-angled ascending and descending, expanding triangle, orthodox broadening top, and five-point reversal. The last three,expanding triangle, orthodox broadening top, and five-point reversal, are synonyms of the broadening top formation, with the last two being based on fiveturning points.For a quick tour of the formation, look at Figure 4.1. The stock began anuphill run in December 1994 and paused for about 2 months in May and June.Then it continued its climb and reached a high in mid-September at a price of533/4. Holders of the stock, witnessing the long run, decided to sell their sharesand the stock headed lower. On September 25, 1995, volume spiked upwardand halted the decline. Investors, seeing a 40% retrace of their gains from the
Beneficial Corp. (Financial Services, NYSE, BNL)
Double Top
Jun 95
|ul
Aug
Sep
Oct
Nov
Dec
|an96
Mar
Figure 4.1 A double top changed into a broadening formation. The one-dayreversal appeared as the third peak after an unsustainably quick price rise. Thebroadening top formation marked a struggle between eager buyers and reluctantsellers at the lows and the quick-to-take-profit momentum players at the peaks.
58
Identification Guidelines
Broadening Tops
June level, apparendy thought the decline overdone and purchased the stock,sending prices higher.Prices peaked at a higher level, 54V:, on October 19. Many diligent investors probably suspected that a double top was forming and promptly soldtheir holdings to maximize their gains, sending the price tumbling. Prices confirmed the double top when they fell below the confirmation point, or thelowest low between the two peaks, at 483/4.Volume picked up and the struggle between supply and demand
59
Table 4.1
Identification Characteristics of Broadening TopsCharacteristic
Discussion
Price trend
The intermediate-term price trend leading to the formationshould be up.
Shape
Megaphone shape with higher highs and lower lows. Fivepoint reversals have three peaks and two troughs.
Trendlines
reasserted itself. The decline stalled as traders willing to buy the stock overwhelmed the reluctance to sell. The stock turned around and headed higher.By this time, chart followers could draw the two trendlines—one across the
Prices are bounded by two trendlines: The top one slopes upand the bottom slopes down.
Touches
Should have at least two minor highs and two minor lows,but not necessarily alternating touches.
twin peaks and another below the two valleys. The broadening top formation
Volume
was born. Astute traders probably jumped on the bandwagon at this point andpurchased the stock. They wanted to play the anticipated rise as the formation
Irregular but usually rises as prices rise and recedes as pricesfall.
Breakout
The breakout can occur in either direction and, in severalcases, prices move horizontally for several months beforestaging a definitive breakout.
broadened out. The stock cooperated and moved higher, reaching the toptrendline once again at a new high of 55l/2.The steepness of the ascent in the latter stages was unsustainable. Thepeak looked like a one-day reversal, with a close near the low of the day and awide daily price swing. However, volume was unconvincing. It was higher that
day than during the prior week, but it certainly was not of the caliber of the late
Identification Guidelines
November spike. In any case, the stock tumbled downward and soon reacheda new low of 43'/2, stopping right at the down-sloping trendline. Once thestock began moving higher, the momentum players jumped on board and volume increased along with the price. Buying enthusiasm and rising momentumpushed the stock higher, climbing through the top trendline. An upside break-
Table 4.1 shows the identification guidelines for the broadening top formation. The first criterion is the price trend leading to the formation. This pricetrend is what differentiates a broadening top from a broadening bottom. For a
out occurred.
broadening top, the price trend should be leading up to the formation, not
Throughout the various peaks and troughs of this formation, there was astruggle between buyers and sellers. Near the lows, the buyers believed thestock was oversold and they eagerly bought it. At the top, they quickly soldtheir shares and pocketed their handsome profits. This selling, of course, sentthe stock back down.Some investors, seeing the stock decline below their purchase price andstill believing that the stock had value, bought more. The behavior also helpedturn the stock around at the lows and probably explained their heightenednervousness at the tops. They wanted to keep their gains this time, instead ofwatching them evaporate should the stock decline again. Once a higher highwas evident and the stock turned lower, they sold, forcing down the stock morequickly this time and on higher volume. You can see this on the declines afterthe second and third peaks.The formation in Figure 4.1 also makes evident that identifying the ultimate breakout is exceedingly difficult. It appears that each new high or newlow may be the final breakout. Only when prices move in the opposite direction is it clear that prices will not break out. We explore ways to profit fromthis behavior in the Trading Tactics section.
down as in its bottom counterparts. This is just an arbitrary designation I havechosen to distinguish the two formations.
Trendlines drawn across the peaks and valleys resemble a megaphone.Higher highs and lower lows make the formation obvious to those versed inspotting chart patterns. The slope of the trendlines is what distinguishes thisformation from some others. The top trendline must slope up and the bottom
one must slope down. When one of die two trendlines is horizontal or nearlyso,