resuming the move, soyou have time to consider the situation before acting.Chasing Tails
Jake used a darkened computer monitor as a mirror while he combed hishair. “I just sold a stock this morning because of a tail. Let me tell youabout it.”Figure 5.9 shows the situation. Jake saw the Eve & Eve double bottom forming but failed to place a buy order at the breakout price. Doingso would have gotten him into the stock at a much better price—about11.85. “The semiconductor stocks were weak,” he said. “They were trading near the yearly low. But the Cypress situation showed promise.”His market order to buy 1,300 shares filled at a price of 12.69 asshown in Figure 5.9. “I placed a stop at 11.05, just below the pennant inFebruary. That should support the stock in case prices turn down. I expected a climb to 15.71, according to your book.” He’s talking about myscoring system for chart patterns that I discuss in Trading Classic ChartPatterns (John Wiley & Sons, 2002).A knot of resistance in June 2004, at 14, would be a problem to additional gains, as would the 13 to 16 range (not shown).“The CCI said buy on Friday, and the stock is riding the topBollinger band upward.” The CCI is the commodity channel index, ashort-term trading indicator he uses mostly to check for divergence.That’s when the indicator trends one way but price moves the opposite.
SPECIAL SITUATIONS
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Cypress Semiconductor (Semiconductor, NYSE, CY)A
2019
2155
CP
182101
17
Tail
2047
B
1993
NASDAQComposite
1939
16
Tail
1514
1885
Dec
Jan 05
Feb
13
BoughtPennant
1831
12
17771750
1110
Eve
Eve
9
8
04 May
Jun
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Aug
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FIGURE 5.9 A tail appears on the right edge of the chart. Do you sell thestock or hang on for additional gains?
The general market, as shown by the NASDAQComposite, he expects to fall. “It trended down fromthe commoditythe first of the year but has been rising the last two orchannel index, athree weeks.” See the large inset in Figure 5.9. “Ifprice momentumoscillator thatNASDAQ continues going up, I’ll be set, but thatcompares theprobably won’t happen.” Why? “Overhead resistance.current mean pricewith the averageIt completed a measured move down, and it’s retracof its mean price. Iing to the corrective phase. It should resume theuse a 20-daydownward move soon.” I show the measured movelookback with afive-day DCCIdown chart pattern as the drop from A to B with thesignal line. I use itcorrective phase (CP) in the middle of the larger insetmost for spottingdivergences bein Figure 5.9.tween the indica“Yesterday, I pulled up the chart and saw thetor and price.tail. I decided that the risk of a drop was muchhigher than the chance for addition gains. So, Iplaced a market order to sell the stock on the open. I expect to take asmall loss.”He got lucky and the stock moved up on the open, filling his sellorder at 13.28 for a profit of nearly $750, or about 4.5% in 3 days. TheCCI
Stops
stock didn’t turn tail and run. In fact, the pricepeaked near 15 as the tail evaporated into just another bar on the chart. He should have waited aday to be sure the pattern was a tail.
Stops
65
DCCIdual CCI, a fiveday exponentiallysmoothed movingaverage of theCCI.
A stop order is an order to buy above or sell below the current price. Forexample, I use a buy stop to enter a trade in ascending triangles (see Figures 5.1, 5.3, and 5.10 for examples of ascending triangles). I place thestop a penny above the horizontal trendline and automatically get filledat a good price during the breakout. I use a sell stop (stop-loss order) toprotect my position. The stock sells when price drops far enough to hitthe stop. Here are two other types of stops that I use.Volatility Stops
Prices fluctuate like the illumination on a partlyvolatility stopcloudy day. If you place a stop-loss order too close toa method of stopthe current price, the chances increase that price willplacement suchstop you out. A volatility stop helps prevent that bethat normal pricevolatility will notcause it’s based on daily price fluctuations. (I learnedresult in the trigabout a volatility stop from Perry Kaufman’s A Shortgering of a stopCourse in Technical Trading (John Wiley & Sons,loss order. I usethe average of the2003). Refer to that book for detailed information.)high-low priceTo compute a volatility stop, I dump the pricedifference of 30days multiplieddata into a spreadsheet and take the difference beby 1.5. A stoptween the high and low price for each day. Then, Ishould not beaverage the differences over the last month. Multiplaced closer thanthe result subply the average times 1.5 and subtract the resulttracted from thefrom the current low price to get the stop price.current low price.For example, Figure 5.10 shows an ascendingtriangle. Say I place a stop order to buy a penny abovethe breakout price (point E). How far down should I place my stop loss?I found that the average daily high-low range a month before thebreakout was 21 cents. Since the breakout was at 7.25, I should place thestop no closer than 32 cents ($0.32 = $0.21 × 1.5) below the breakout—6.94. Stocks below $20 tend to be especially volatile. Instead of multiplying by 1.5, try 2.
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Advanced Micro Devices, Inc. (Semiconductor, NYSE, AMD)2321191716151413
New High
1211
C
10
StopE
9
A
D
AscendingTriangle
8
Throwback7
B
6
F
96
Jul
Aug
Sep
Oct
Nov
Dec
Jan 97
Feb
Mar
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5
FIGURE 5.10 The stop (the horizontal lines) is raised as price makes newhighs (diagonal lines).
Trailing Stops
A trailing or progressive stop is nothing more than a stop-loss order thatrises along with prices. For example, Figure 5.10 shows an ascending triangle. If Jake places his volatility stop at 6.94, he’s protected even asprices throw back to B. The low at B is 7.07. If the stop appears to be tooclose, use a 62% Fibonacci retrace of the move from F to E (E is used because that’s all that was available on the breakout day). That would putthe stop at 6.52, just above the 6.50 round number. A lower stop meansa larger potential loss, 10% in this case, so keep that in mind.As price climbs, Jake should move up his stop. When price makes anew high at A, for example, he should raise his stop to just below theprior valley, B. When price makes a new high at C, Jake should raise hisstop to D, just below the flat support zone.The diagonal lines show where price makes a new high and the horizontal lines show were Jake should place his stop. When price peaks at24.25 in mid-March, there is no close plateau at which to place a stop.The one at 17 is 29% below the high—too far away. Where should Jakeplace his stop?
Throwbacks and Pullbacks
67
The answer is to use a volatility stop. Volatility is now 87 cents so1.5 times this is $1.31. Jake should place the stop no closer than 21.94,or 1.31 below the intraday low (23.25) the day prices peak. A stop therewould take him out the next day. The stock continued lower until finding major support at 8.50.I have found that using stops in this manner has cut my losses dramatically and allowed me to capture tasty gains instead of riding thestock back down. The method works.
Throwbacks and PullbacksThrowbacks and pullbacks are names for similar price movements. Figure5.11 shows both after breakouts from head-and-shoulders chart patterns. Apullback occurs after a downward breakout and a throwback happens afteran upward one. By definition, throwbacks and pullbacks occur within 30days of the breakout and both must have white space as price curls back tothe breakout price. The white space helps differentiate a valid throwback orpullback from prices sliding along the chart pattern’s trendlines.Advanced Micro Devices, Inc. (Semiconductor, NYSE, AMD)LS HeadRS
373431282624
Pullback
22
WhiteSpace
201816
WhiteSpace
14131211109
L
SH
Throwback
876
01
Mar
Apr
May
Jun
Jul
Aug
Sep
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5
FIGURE 5.11 Prices pull back after the head-and-shoulders top breakoutand throwback after an upward breakout from a head-and-shoulders bottom.
68
SPECIAL SITUATIONS
“Tell them what you found,” Jake said and put his hand on myshoulder then he pointed to the screen and thumped it with his indexfinger. “It’s all in the numbers, kid.”Let’s take throwbacks first. I looked at 12,256chart patterns (collected over several years) andmedianfound that price throws back to the breakout ormedian value istrendline break an average of 53% of the time.the middle one inPrices peak a median of three days after the breaka sorted list ofvalues such thatout, but it takes an average of 10 days total to makehalf the values arethe return trip to the breakout. That’s importantbelow the medianand half above. Iffor swing traders. They want to buy the breakoutno middle valueand sell a few days later as prices round over for theexists, the averreturn trip. The average distance from the breakoutage of the twoclosest values isto the top of the throwback is 10%—a quick andused. For examtasty return if you can time it right. A frequencyple, in the list 10,15, 30, 41, anddistribution of the distance shows that a rise in the52, the median isrange of 6% to 8% happens most often.30 because thereA high-volume breakout throws back 70% ofare two values oneither side of it.the time. By high volume, I mean the breakout day’svolume is above the 30-day average. So, if you havea high volume breakout, expect price to throwback. It may not but it pays to play the percentages.Once a throwback completes, price dropsswing tradingshort-term tradbelow the chart pattern 14% of the time. Look ating that takesFigure 5.11. If price continued down after the Ocadvantage oftober throwback, closing below the head (H) thenprice swings fromretrace low toit would have qualified as one of the 14%. Thatcrest high or thefailure rate doesn’t sound like much until it hapreverse.pens to you. Still, that should give you some warmfuzzies about trading a throwback. In 86% of thecases I observed, price didn’t decline below the lowest valley in the chartpattern. Thus, if you put a stop order there, it will protect you from a serious loss and usually won’t be hit.“Tell them about pullbacks,” Jake said and nudged my shoulder likea German Shepherd with a wet nose begging for attention.Pullbacks occur 56% of the time in the 10,878 chart patterns Ilooked at. Price declined a median of three days but took an average of10 days (total) to return to the breakout. The average distance from thepullback valley to the breakout price is 9% but a frequency distributionshows the range from 4% to 10% occurs about evenly.
Throwbacks and Pullbacks
69
A pullback follows a high volume breakout 66% of the time—everytwo out of three times. When prices return to the breakout, they continue climbing 13% of the time. For example, if the June pullback keptclimbing until it soared above the head in Figure 5.11, then that eventwould have qualified as one of the 13%.If you review the different types of chart patterns, you will find thatthrowbacks and pullbacks sometimes happen as frequently as 75%(island reversals) or as little as 31% (pennants).“Tell them about performance,” Jake said, reading over my shoulder.I turned around and said, “I heard that the CEO of JCB Enterprisesdied and that the stock made a big move.”Jake’s eyes widened to the size of golf balls and he raced for thedoorway. For a man approaching 60, he could still move fast when hewanted to. I smiled, knowing the rumor would get him off my back—fora few minutes, anyway.When a pullback or throwback happens, performance usually suffers.Let me give you an example. Since I’ve been using head-and-shoulders patterns, let me continue with them. I looked at 672 head-and-shoulders bottoms and found that when a throwback occurs, the stock climbed anaverage of 32% before the trend changed. Without a throwback, the risemeasured 43%. Both numbers are from a bull market and both use an average of perfect trades, so don’t think that your trade will work as well.Pullbacks show a similar trend but the numbers are closer. I lookedat 815 head-and-shoulders tops with downward breakouts in a bull market. When a pullback occurs, price declines an average of 20%. Patternswithout pullbacks decline an average of 24%.Before you trade a chart pattern, look for overhead resistance or underlying support. Those two are responsible for causing most throwbacksor pullbacks.Since throwbacks and pullbacks are so important to trading chartpatterns, let’s try a quiz. Figure 5.12 shows a downward breakout from avalid head-and-shoulders top. Will prices pull back?When I consider trading a stock, I always assume a throwback orpullback will occur. The exception to this is if a stock is making a newhigh where there is little or no overhead resistance (a prior trendline projected upward or round number might cause overhead resistance and athrowback).As I look at Figure 5.12, I see a low volume breakout. Pullbacksaccompany most high volume breakouts as I’ve already said, so a lowvolume breakout would tend to indicate no pullback would happen.
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WPS Resources Corp. (Electric Utility (Central), NYSE, WPS)
HeadLS
RS 42414039
Breakout3837363534333231
01 Aug
Sep
Oct
Nov
Dec
Jan 02
Feb
Mar
Apr
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30Jun
FIGURE 5.12 A head-and-shoulders top stages a downward breakout. Willthis chart pattern pull back?
However, I don’t put much faith in volume. Instead, I look at the generalmarket, industry, and especially prior support zones.I use the S&P 500 as the proxy for the general market, and on theday of the breakout, the S&P was trending downward. A pullback happening would be like the stock swimming against the current.Using the Dow Utility index as the proxy for the utility industry,the index was also trending downward. A spot check of the 11 centralU.S. electric utility stocks I follow showed them all heading downward.That also made it unlikely a pullback would occur.Finally, I check for underlying support. Do you see any in Figure5.12? I do, starting in February and running through March. If I wereshorting this stock—betting on a continued decline—that horizontal consolidation region at 38shortto 39+ would cause me to change my underwear. Iwhen a stock iswould expect price to enter that area and be resold with thepulsed. With the industry and market also trendingexpectation that atrader can buy itdown, I would not expect an immediate pullbackback at a loweron the approach to the area, and because strongprice.breakouts often push through nearby support
Throwbacks and Pullbacks
71
zones. Thus, I would expect it to bounce off the bottom of the range, hitting, say, 38.50 or so.What happened? Figure 7.12 of this book gives the answer. Withthe market and industry tide pushing the stock lower, the price shotthrough the horizontal consolidation region (an ascending triangle) andbounced off a second support zone shown in January 2002 at 36 to 37.Prices bounced there and pulled back to the chart pattern, as expected.“You lied!” Jake shouted from the office doorway. He was talkingabout the rumored death of the CEO of JCB Enterprises and the ensuing stock move. Fists clenched, face the color of a cherry, he was breathing heavily, and I knew he had run from his office. He shouted, “I’mdeleting your manuscript” and stomped to the server to which my computer was networked.I have to go now.
6Chapter
The Top 10Performing Bottoms
he good news is that I found my manuscript files intact in the recycling bin on the server. Jake knew that’s where they’d go, so he wasjust playing with me—I think.“I made $2,500 yesterday,” he said and plopped into the guest chairbeside my desk. His smile was as wide as the Grand Canyon.“Mowing lawns? Delivering newspapers? Yesterday was Sunday.”“Trading on Friday.” He slid a box of chocolates from behind hisback and handed it to me as a thank you gift. I didn’t have the heart totell him that I prefer cash or checks, especially seven-figure ones. Even10% of the profits would suffice.The discussion reminded me of when I first started trading. About25 years ago, I researched stocks and opened a brokerage account. Then Ibought my first stock, 100 shares of Essex Chemical for $2,250, and heldon. I sold it less than three years later for a profit of almost $2,000, a gainof 88% including dividends. Two months after I bought Essex, I grabbedNuclear Pharmacy with its way-cool name. I found it in the prospectusof my mutual fund and researched the fundamentals. Everything lookedgood, so I bought 200 shares for $1,800. Two weeks after I bought, thestock did a dead-cat bounce. On paper, I lost a bundle. Another company swooped in and swallowed the stock on the cheap. I held it for lessthan three years before giving up and selling for a 25% loss.
T
73
THE TOP 10 PERFORMING BOTTOMS
74
Lesson 1: If your mutual fund owns the stock, there is no need foryou to buy it—you already own it. Lesson 2: Don’t fall in love with astock just because it has a way-cool name.Since those trades I have learned much about stocks and stock market behavior. In this chapter, I share some of that knowledge. Here arethe top 10 buy signals—chart patterns—ranked according to their overall performance.
1. High, Tight Flag• Average rise rank: 1 (best)• Breakeven failure rate rank: 1 (best)• Change after trend ends rank: 1 (best)I received an e-mail from a woman asking meabout a symmetrical triangle after I had told herabout a high, tight flag (HTF) I saw forming on herI measure the risechart. She bought at 80 and sold at 135 for a 69%from the breakoutprice to the ultigain. Her e-mail almost shouted, “Somebody stopmate high, or theme before I make too much money!”decline from theThe brokerage firm she deals with protectsbreakout price tothe ultimate low,customer accounts up to $25 million. Can youfor each stock,imagine her telling them, “It’s not enough. Canand then computethe average.you cover me for $50 million?” Trading the HTFjust might get you there one buck at a time.HTFs are the best performing chart pattern;they have the highest average rise (69%, based on perfect trading with nocommissions), lowest breakeven failure rate (0%), and best decline afterthe uptrend ends (36%). None of the 253 HTFs I looked at failed to riseat least 5% (since writing this, I have found HTFs that moved less than5%). Just five failed to rise at least 10%. However, you have to know howto hunt this animal and how to ride it, or it could be as risky as runningwith the bulls in Pamplona.average riseor decline (ARD)
Identification
Here’s what to look for:• Prices should climb at least 90% in two months or less.
1. High, Tight Flag
75
• After the rise, find a place where prices pause—a congestion orconsolidation area.• Volume should trend downward in the flag.Figure 6.1 shows three examples that appear as pennants. The firstone occurs in mid-August 1999 and is a tight pennant, meaning pricestouch the trendlines in a small, well-shaped pattern of price crossings.Prices climb 66% until reaching the September peak and dropping atleast 20%, signaling a trend change.The middle HTF occurs in December and tops out at High 2, thetop of the loose pennant, for a rise of 74%. It also is a tight pattern withprices crossing from trendline to trendline in a narrow cluster of action.The final HTF happens less than a month later and price soars 54% afterthe breakout (to High 3). Notice how the logarithmic scale makes thelarge price move appear small. On the arithmetic scale, the August HTFis a speed bump in the foothills of the Himalayas.To find these three HTFs, I looked for a rising price trend that doubled in two months or less. The August pattern, for example, reaches itshighest peak at the start of the pattern on August 16, at 7.63. On JuneAbgenix (Drug, NASDAQ, ABGX)90786657
High 3
484236
High 2
30
LoosePennantHigh 1
242118
TightPennant
15129
TrendStart 1
Trend Start 2 and 3TightPennant
Jul
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FIGURE 6.1 High, tight flags appear as flags, pennants, or random shapesafter price doubles in less than two months.
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THE TOP 10 PERFORMING BOTTOMS
16, two months before the HTF, prices reached a low of 3.78. That represents a rise of 102% in two months.Prices pause and form a pennant shape, moving sideways then resting, gathering strength for the climb to higher ground. Volume in thisexample trends upward and that is unusual because it happens just 10%of the time, and performance often suffers when it does occur. The upward breakout confirms the pattern as a valid one. I found the other twoHTFs using the same method—a price doubling in less than two monthsattended by price moving sideways.The HTF need not appear as pretty as the ones shown in Figure 6.1.Sometimes the congestion area is irregular, looking like the loose pennantin late December. With some HTFs, you can’t draw a trendline along thetops because it is as ragged as discarded clothing. Still, if HTFs breakoutupward and obey the identification guidelines, then they are valid patterns. For irregularly shaped HTFs, use a close above the highest peak inthe pattern as the breakout price instead of a close above the trendline.Trading and Trading Tips
Once you have correctly identified a HTF, how do you trade it? Here arethe rules for buying:• Wait for price to close above the upper trendline or above thepattern high if the pattern has no top trendline.• Buy the stock.• Place a stop below the prior valley, below the pattern itself, or usea volatility stop.With this pattern, the most important rule is to wait for an upwardbreakout. In a test of 78 HTFs, I found 13 patterns that broke outdownward. That might not sound like much until a failure happens toyou. Save your bucks and wait for the upward breakout.The hardest thing to do when trading HTFs is to buy the stock.Chances are the stock is near the yearly high after doubling in price.How much higher can it possibly go? Buy in and find out! Remember,HTFs have the lowest failure rate and highest average gain of any chartpattern. Your selection may prove the exception and fail, so place a stoploss order below the valley nearest the breakout. This may be below the
1. High, Tight Flag
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HTF itself. Check to make sure the stop is not too close. You don’t wantvolatility to stop you out. Later in the book, I review two HTF trades,one where I stole two grand from someone and another in which theystole it back . . . with interest.When identifying or trading HTFs, what should you look for oravoid? Here is a list:• Avoid overhead resistance that may cause a throwback. HTFswith throwbacks rise just 49%, but the rise averages 100% forpatterns without throwbacks.• Avoid loose patterns. Figure 6.1 shows one loose HTF and twotight ones. Loose patterns underperform (50% average rise versus85%). Your chance of having a losing trade increases with looseHTFs.• Patterns with breakout volume equal to or below the 30-day average perform better than do those with heavy breakout volume,79% average rise versus 63%.• Keep the HTF retrace (the flag portion of the HTF) to less than36% (the median) of the prior up move leading to the pattern.HTFs with smaller retraces show post breakout gains of 74% versus 63% for patterns with larger retraces.• Avoid HTFs with nearly vertical rises leading to the pattern. Figure 6.2 shows an example of this. Much of the vertical move lastsjust a few days. Patterns with moderate rises (typically 45 degrees)climb an average of 70% after the breakout versus 64% for thevertical moon shots.• Wide patterns perform less well than narrow ones—65% averagerise versus 71%—so keep the flag portion of the HTF width toless than the median 15 days.• Select patterns with a top trendline that slopes downward. HTFswith downsloping top trendlines perform better (70% versus65% average rise).You may decide to trade a stock with an HTF that has all of the elements suggesting underperformance. Good! Just be sure to watch thestock closely and raise your stop as price makes a new high.
THE TOP 10 PERFORMING BOTTOMS
78
Measuring Successtrend startwhere the trendbegins. To findthe trend start,begin at the formation start andmove backward intime. If pricesclimb leadingaway from theformation, findthe highest peakbefore pricecloses 20% ormore below andbefore the highestpeak. When thisoccurs, the highest peak marksthe trend start.If prices dropleading awayfrom the chartpattern (workingbackward intime), find thelowest valleybefore pricecloses 20% ormore above andbefore the lowestvalley. When thatoccurs, the lowestvalley marks thetrend start. Inmany cases, Iignored briefprice overshoot orundershoot justbefore the chartpattern begins.For flags andpennants, thepeak (swing high)or valley (swinglow) closest to thestart of the trendleading to the flagor pennant isused (not a 20%trend change).
How far will price rise? Find the lowest valley inthe two months before the pattern and measure therise during that time to the top of the HTF. For thestock shown in Figure 6.1, let’s use the JanuaryHTF, the highest one on the chart. The lowest valley within the last two months begins at the trendstart in November at 9.88. The top of the pattern isat 37.25. Take the difference and divide by two,leaving 13.69. Add this to the lowest valley in theflag portion of the HTF (26.19 in this example),projecting upward for a target of 39.88. The stockshown in Figure 6.1 hits the target just a few daysafter the breakout. This measure rule works 90% ofthe time.Case Study
“Didn’t you make a trade in a high, tight flag,Jake?”“Me? No. Never.”I punched a few keys and pulled up his trading stats. “Just as I thought. Frontier Airlines.Ouch! Looks like you lost some money.”“How do you know that?”“Lucky guess. Tell me about the trade.”Figure 6.2 shows his situation. He bought1,300 shares at the market open two days beforeChristmas, filled at 11.69. After placing the trade,he put a stop at 10.33, which is slightly below thetop of the November congestion region.“I was expecting price to rise to 15, matchingthe left side of a failed Big W pattern in January2004. Oil prices were dropping and that was goodfor airline stocks. The industry was working withme as the other airlines started moving up in October or earlier, just as this one did.”Unfortunately, the S&P 500 would changetrend in six trading sessions. The airline stock
1. High, Tight Flag
79
Frontier Airlines, Inc. (Air Transport, NASDAQ, FRNT)Bought12
High, TightFlag
11
10
Sold
9
8
7
6
Apr
May
Jun
Jul
Aug
Sep
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FIGURE 6.2 This high, tight flag ended in failure when price moved marginally higher before plummeting.
crashed a day later, and he was stopped out at 10.334. He lost $1,800 oralmost 12%.“The good news, Jake, is that you sold. You could have ridden itdown for a loss of,” I punched some keys, “$5,000 or 32%. What do youthink you did wrong?”“The stop was too far away. Volatility was 56 cents so that wouldcall for a stop at 10.54 (that is, 1.5 times .56 subtracted from the intraday low at 11.38 on the buy date). That would have saved me $260.Other than that, it was a good trade.”Sometimes good trades go bad. That’s why stops are so important.Remember this: Half of my trades go bad—half. But my winners arefour figures or larger when my losers are three figures. So far this year(2005), for every dollar I lost I’ve made five.Jake chortled and sat back in his chair. “Four figures. Ha! You’re including the two digits to