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chart pattern breakout when price closes outside of a trendline chart pattern boundary, it is said to break out... Look for trendlines that slope upward or downward when searching for

Chart Patterns

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Bulkowski, Thomas N.,

Getting started in chart patterns / Thomas N Bulkowski — Second edition.

pages cm.—(Getting started in series)

Includes index.

ISBN 978-1-118-85920-9 (paper)—ISBN 978-1-118-85923-0 (ebk)—ISBN 978-1-118-85911-7 (ebk)

1 Stocks—Charts, diagrams, etc 2 Commodity futures—Charts, diagrams, etc 3 Investment analysis I Title

HG4638.B853 2014

332.63’2042—dc23

2013047227 Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

The Most Important Chart Patterns

I read that a chartist becomes world class after viewing a million chart patterns

If you analyze one pattern per chart on 250 stocks each trading day, it’ll take

15 years to reach a million Fifteen years! We don’t have that much time I’m asking for only a few hours

Before we go any further, look at the cover of this book See where it lists the price? If you buy this book and make one profitable trade because of it, that money will be well spent That’s cheap education, but I’m going to give you so much more.Chart patterns are the footprints of the smart money, but the dumb money is mixed in as well Together their footprints leave a trail I’ll help you follow that trail so that your dream of earning a million can become reality.One investor did it She read this book, made a million It took her a year But she’s the outlier You won’t be that lucky

So let’s begin by discussing chart patterns, starting with the basics: lines, support, and resistance Then let’s discuss the buy and sell signals, the spe-cial situations, and the busted patterns I’ll sprinkle the text with actual trades that still teach valuable lessons Near the end of the book, I’ll include a trading checklist and a list of things we’ve learned along the way Don’t overlook the visual index of chart patterns It’ll make identification easy

trend-Throughout the book, I gear the presentation to the beginning investor or trader, but it comes with tips and techniques that will delight and inform the professionals, too

What differentiates my books from others is that I prove what I say The statistics mentioned throughout this book are not guesses nor are they copied from others, but are the results of studies I conducted using tens of thousands of chart patterns that I found

This edition updates most of the statistics Each statistic represents the performance of hundreds of patterns traded perfectly, without commissions or fees You won’t be able to achieve those returns, but these numbers provide a basis for comparison, they provide a foundation for dreams

Let those dreams carry you away And when you return to earth, let’s get

to work on that million

Begin with this book

For the first edition, I would like to thank the talented efforts of Pamela van

Giessen, Mary Daniello, and Jennifer MacDonald from John Wiley & Sons These three make publishing a book easy and fun Almost Thanks

to Bernice Pettinato at Beehive Production Services for proofreading the book

I am indebted to Colonel James Bulkowski for acting as my support group Thanks, brother

Other Books by Thomas Bulkowski

Encyclopedia of Candlestick Charts

Encyclopedia of Chart Patterns, Second Edition

Fundamental Analysis and Position Trading: Evolution of a Trader

Swing and Day Trading: Evolution of a Trader

Trading Basics: Evolution of a Trader

Trading Classic Chart Patterns

Visual Guide to Chart Patterns

Regarding Serious Inquiries

Visit my website at www.thepatternsite.com The site contains over 650 articles

I have written on price patterns and trading; it’s free, and there is no registration

If you would like to contact me, e-mail me at tbul@hotmail.com

T B

1

Introduction to Chart Patterns

Chapter

An investor I’ll call Gina e-mailed me her story She had saved $100,000

in her IRA Then she bought this book and used its teachings to grow her account She bought exchange-traded funds that tracked the metals

A year later, her account was worth $1.1 million She made a million in one year Wow

I had a hard time believing her story so I talked to my brother “She’s an outlier.” She’s the exception to the rule, the one person in the world that makes

it to the very top She was in the right place at the right time and did everything right to make a bundle

If Gina can do it, why not you?

What Are Chart Patterns?

Have you ever strolled into the woods and found footprints in the soil? If it’s muddy, you may see bird tracks You may also find larger tracks from cats, dogs, and even deer You don’t see the actual animal, just their tracks If you follow the tracks, perhaps you can discover a beautiful creature

When people trade a stock, they leave behind a footprint Volume increases The price bar printed on the chart may also change String enough of those price bars together and they form patterns, which we call chart patterns

I used to think that chart patterns were the

foot-prints of the smart money I think the dumb money steers the feet, too What does that mean?

Imagine that you sell office supplies to a retailer called BOSS (Best Office SupplieS, a fictional company), which, in turn, sells them to the public Your business

is prospering because BOSS is buying lots of your ucts With that knowledge, you purchase their stock.Six months later, you notice that the rate of their purchases has slowed Uh-oh It could be a seasonal fluc-tuation Fewer people need office supplies when they are

prod-on vacatiprod-on during the summer But the slowdown sists You decide to sell the stock

per-Imagine another scenario when you meet your good friend Barry, the CEO of BOSS He is looking glum, as if someone spit into his cereal He shakes his head and remarks, “We’re being sued If they win, we’re sunk If we win, we still take a big hit from legal fees.”

“Your stock is going to take a pounding.”

“No kidding,” he says

The next day you dump your holdings in BOSS

Enter the Retail Investor

It’s not only the smart money leaving footprints on the stock charts What about people without inside information, the so-called retail investors?

Anyone can drive by BOSS and see vacant parking lots If people inside the store are pushing around empty carts with no one waiting in line at the cashier, then that can’t be good for business

That scenario happens with apparel retailers all the time Last year’s fad has faded, and the chain is left with too many lemon-yellow polka dot sweaters

In summer!

Facebook is a good example of the public’s excitement (fear and greed) for a stock Facebook is an Internet company that went public in mid-2012

(Figure 1.1) It seemed as if the entire world was in love with the company

Two days before the initial public offering (IPO), the company said it would increase the number of shares offered by 25% due to demand

One analyst said the stock could reach as high as $60 on the first day.The underwriters priced the IPO at $38, and the stock opened at just over

$42 It reached a high of 45 but closed just pennies above the offering price.Then look what happened The stock didn’t hit 60; rather, it went the other way It plummeted like a climber slipping off the Balcony on Mount

Everest, bouncing down until it reached base camp at 17.55 in early September, less than half the offering price.

Could retail investors have predicted such a move by looking at the charts

of other IPOs? LinkedIn Corporation’s stock opened at 83 but within six months, the stock hit a low of 60.14

Of course, Facebook could have been the exception Google, for example, opened at 100, and six months later, it was trading at almost 200

These are just examples of the footprints left by the smart and dumb money Our job as investors and traders is to recognize those footprints, decide which are valuable, and profit from them

● Use prior price action to help determine future price movement

Advantages of Chart Patterns

What advantages do chart patterns offer when trading a stock? The first two that come to mind are that chart patterns give buy and sell signals

FIguRE 1.1 Facebook has an initial offering price of $38, shown at the

horizontal line on the daily scale.

Facebook (E-Commerce, FB)

44 42 40 38 36 34 32 30 28 27 26 25 24 23 22 21 20 19 18 17

12 Jun Jul Aug Sep Oct Nov Dec

B A C

1 Chart patterns issue clear buy signals.

2 Chart patterns issue clear sell signals

When price closes above the trendline boundary of a chart pattern, that’s

a buy signal A trading signal can also occur when price closes above the top or below the bottom of a chart pattern

For example, Figure 1.1 shows a double bottom at AB When price closes above the high between the two bottoms (C), it confirms the pattern as a valid one and signals a buy

The sell side is similar Sell signals occur when price closes outside a line boundary or below the bottom of a chart pattern

trend-There’s no guessing about where the signal might be The rules are known

A third advantage is that signals are timely If you have day-traded a stock using a moving average, you may know about this Imagine a stock gap signifi-cantly higher at the day’s open (opening gaps are common)

A 20-period moving average, for example, needs 20 samples to fill the pipeline and give a result If you’re on the one-minute scale, it will be 20 min-utes before you see a simple moving average not influenced by the gap

If you use two days of price data, then the moving average will be enced by the gap up One trader I know didn’t recognize these effects and lost money because of it

influ-Indicators lag price Using our simple moving average as an example, what happened at the gap up to 20 minutes ago influences the current value of the moving average

Chart patterns don’t suffer this type of delay

● Chart patterns do not lag price

One of the things many traders find useful is that chart patterns give an

estimate of where price might go (called the measure rule, which is based on the

height of the pattern) Often the estimate serves as a minimum price move, not

a maximum

● The height of the chart patterns helps set a price target

Disadvantages of Chart Patterns

Chart patterns have their flaws, too You have to find the darn things! If you

don’t see a chart pattern until after the breakout, you may have sacrificed some

profit when price zipped away from you How many times have you pointed to

a chart and said, “I should have bought right there.”

● You have to find chart patterns to use them.

● If you are late finding a chart pattern, its usefulness declines

You have to be patient with chart patterns Yes, you can buy a stock at any time and get lucky when the stock cooperates and moves higher, breaking out upward from a chart pattern But the stock could drop, too Waiting for the breakout is often the smartest option, but it requires patience Patience is an ingredient of many successful traders and investors Do you have what it takes?

● Patience is required to wait for a buy signal

A person I know puts the gas pedal to the floor whenever the stop light turns green It’s a metaphor for his impatience He keeps asking if anyone can make money in the markets Of course, anyone can, but he doesn’t have the temperament for trading stocks Do you?

Another drawback to chart patterns is that stop placement can be tricky How so? Often price will breakout upward and then return (throwback) to the pattern The breakout is still valid providing the stock doesn’t close below the bottom of the pattern If you sell when that happens, then you could suffer

a substantial loss That problem is easily rectified by using a closer stop, of course Correct stop placement is an art that people must master for any trading technique It’s not specific to chart patterns

● As with all trading techniques, stop placement can be tricky

Imagine an unusually tall chart pattern, one that extends from the bottom

of the screen to nearly the top By the time you receive a buy signal, a substantial rise may already have occurred That means you could be closer to the end of the uptrend than the beginning, limiting the upside potential That’s a problem easily fixed by looking for another pattern

● Tall chart patterns may mean you are closer to the end of the trend than the beginning

Finally, like other indicators in the stock market, chart patterns can fail They issue a buy signal, but then price reverses and shoots off in the opposite direction

● Chart patterns can fail

What Does It Mean?

You may have noticed that the number of disadvantages outnumber the tages Don’t let that worry you The advantages say that you can make money

advan-trading chart patterns or use them to improve your advan-trading with other methods The disadvantages say that trading chart patterns isn’t easy In fact, it can be down-right hard to make money consistently But you can say that about any method.You can’t become a skilled brain surgeon overnight Nor can you become

an expert at trading chart patterns quickly Both take experience and a tion to the craft

dedica-In the coming pages, we’ll learn how to find chart patterns, what they mean, and how to profit from them

● Don’t expect to become rich overnight in the markets

What We Learned

Here is a list of the major lessons discussed in this chapter

● Chart patterns are recurring formations that appear on price charts See

“What Are Chart Patterns?”

● Use prior price action to help determine future price movement See

“Enter the Retail Investor.”

● Chart patterns issue clear buy signals See “Advantages of Chart Patterns.”

● Chart patterns issue clear sell signals See “Advantages of Chart Patterns.”

● Chart patterns do not lag price See “Advantages of Chart Patterns.”

● The height of the chart patterns helps set a price target See “Advantages

of Chart Patterns.”

● You have to find chart patterns to use them See “Disadvantages of Chart Patterns.”

● If you are late finding a chart pattern, its usefulness declines See

“Disadvantages of Chart Patterns.”

● Patience is required to wait for a buy signal See “Disadvantages of Chart Patterns.”

● As with all trading techniques, stop placement can be tricky See

“Disadvantages of Chart Patterns.”

● Tall chart patterns may mean you are closer to the end of the trend than the beginning See “Disadvantages of Chart Patterns.”

● Chart patterns can fail See “Disadvantages of Chart Patterns.”

● Don’t expect to become rich overnight in the markets See “What Does

It Mean?”

2

Identifying Chart Patterns

Chapter

Learning to identify chart patterns is like learning how to recognize a ball

When someone hands you a ball, your mind forms rules to recognize

it when you see it again Even though the size, color, and texture may change, you can still recognize it as a ball Then you’ll discover what to do when your brother pelts you with a snowball

In this book, we are going to use a similar approach by showing many examples of chart patterns With practice, you’ll learn to identify them, learn how to trade them, and learn to dodge the dangerous ones

The Blank Chart

Let’s begin with a chart with nothing highlighted, shown in Figure 2.1.

This chart uses candlesticks to display price Although I prefer candle charts, many of the ones in this book are bar charts I use bar charts so I can pack more information onto the small real estate afforded by this book

When I look at this chart, my mind draws chart patterns by connecting peaks to peaks and valleys to valleys using curves and straight lines

What can you tell from this chart?

Notice that price trends upward starting in August If you were to draw a line under the major val-leys, it would follow a straight path (or nearly so) That

line would be called a trendline since it follows a line of

trend

Imagine that you own this stock What worries you most about this chart? Answer: that the uptrend will end If the trend ends, how far can you expect price to drop? Chart patterns can help answer that question

Look at the price scale In less than a year, the stock more than doubled

If you had bought the stock near the low in August and sold near the high in March, you would have profited handsomely

Figure 2.2 shows the same chart as the last one, but I added a few lines This chart looks like a staircase with horizontal treads following an upsloping trend In a few cases, price ducks below the diagonal trendline as if looking underneath the stairs, but not for long Price rests on the diagonal line or climbs above it

Figure 2.1 Even a blank chart shows valuable information.

Apogee Enterprises (Building Materials, APOG)

30 29 28 27 26 25 24 23 22 21 20 19 18 17 16 15 14

12 Aug Sep Oct Nov Dec Jan 13 Feb Mar Apr

The price movement, in most cases, does not come that close to the zontal lines Only the period from September to November has the potential to make good contact with the line directly above it That’s important because it forms a chart pattern I’ll discuss in a moment.

hori-● The blank chart shows price movement, uptrends, downtrends, and areas where price moves horizontally

Connecting Peaks

The first step to finding chart patterns is to let your eyes glide over the chart and spot multiple peaks at or near the same price

The twin peaks in the upper left inset of Figure 2.3 highlight a chart

pat-tern called a double top Notice how tops C and D peak near the same price If you find three peaks near the same price, it could be a triple top We’ll go into detail on identifying these patterns later in the book For now, though, just let

Figure 2.2 This uptrend follows a stair step movement higher.

Apogee Enterprises (Building Materials, APOG)

30 29 28 27 26 25 24 23 22 21 20 19 18 17 16 15 14

12 Aug Sep Oct Nov Dec Jan 13 Feb Mar Apr

your eyes search the chart for peaks at (or near) the same price If you find some,

it could be a chart pattern

● Begin constructing chart patterns by visually finding peaks that share similar prices

● Two peaks that top out near the same price could form a double top

Imagine connecting those peaks with horizontal or near-horizontal lines For example, in the middle of Figure 2.3, I drew horizontal line A by connect-ing the peaks That line is also a trendline like the diagonal one in Figure 2.2 except line A is horizontal Trendlines can slope in any direction, and they can

be curved, too

Notice how price touches the top line several times and does not close

above it until after the end of the line when price seems to catch a thermal and

soars A close above the top trendline is called a chart pattern breakout since price

breaks out of the chart pattern

Figure 2.3 Trendlines AB form a rectangle top chart pattern.

Apogee Enterprises (Building Materials, APOG) C

A B

E F

D

30 29 28 27 26 25 24 23 22 21 20 19 18 17 16 15 14

12 Aug Sep Oct Nov Dec Jan 13 Feb Mar Apr

Connecting Valleys

Let your eyes search for valleys that bottom near the

same price

The lower right inset of Figure 2.3 is an example

of a pattern called a double bottom The two valleys at E

and F bottom near the same price

It’s easy to find peaks that align and valleys that

align All it takes is practice

● Search for chart patterns by looking for valleys

that bottom near the same price

I drew a horizontal trendline along the valleys at B Price rests on it

Price does not close below the line even though one of the lows does poke

through

Line B is an example of multiple valleys aligning to form a line of trend Again, use your eyes to find two valleys near the same price and then look for other valleys that may also be near the same price Imagine connecting those valleys with lines to form shapes—chart patterns

● If multiple peaks stop near the same price, look at the valleys between the peaks for a better clue to their type They could be triple tops, an ascending triangle, or a broadening pattern

● Multiple valleys at a similar price could be a triple bottom, descending triangle, or a broadening pattern

Patterns with Curves

After training your eyes to find peaks that form straight lines and valleys that form straight lines, let’s throw a curve ball Sometimes patterns form with

curved lines Figure 2.4 shows three examples.

These patterns are called inverted and ascending scallops because of their upside-down bowl shape They remind me of kitchen ladles (without the handle hook) or inverted and backward Js Price trends in a straight line upward until rounding over at the top and then retracing a portion of the prior gain

One interesting aspect of inverted and ascending scallops is that as they approach a trend change (the end of a trend), they tend to get shorter That doesn’t always happen I’ve seen some where the opposite occurs: they get taller

chart pattern breakout

when price closes outside of

a trendline (chart pattern) boundary,

it is said to break out.

There are four varieties of scallops: inverted and noninverted, ascending and descending They are plentiful, but not well known Yet they perform well Sometimes the rounding turn appears better on the inside of the chart pattern rather than the outside Either works, so check for peaks and valleys that form turns.

Perhaps you have heard of a cup with handle pattern How about a ing top or bottom? Those patterns have rounded turns, too

round-Let your eyes drift over the price chart and trace imaginary lines along the peaks or valleys to form curves They can be cup-shaped or inverted cups The cups can be tilted on their sides so that if they contained milk, it might fry your keyboard That happened to me once with a laptop computer and a glass of wine Let’s just say I use a desktop computer now

● Look for curves on the price chart and connect those curves with nary lines to form chart patterns

imagi-● Curves appear in scallops, cups with handles, and rounding tops and bottoms

Figure 2.4 These chart patterns use curved lines.

Oxford Industries (Apparel, OXM)

68 66 64 62 60 58 56 54 53 52 51 50 49 48 47 46 45 44 43 42

13 Mar Apr May Jun Jul Aug Sep Oct

Patterns with Diagonals

Peaks, valleys, and curves What’s left? Diagonals Many chart patterns use onal lines, such as triangles (ascending, descending, symmetrical) and ones from the broadening family (broadening tops, bottoms, wedges, and the right-angled ascending and descending brothers), to name a few

diag-● Several types of chart patterns use diagonal lines Look for trendlines that slope upward or downward when searching for chart patterns.After using imaginary lines to connect peaks, look at the valleys and see

if a diagonal line would touch the bottoms of several valleys The reverse is true, also If you spot valleys that align, perhaps the peaks also align using a diagonal

If you spot a curve, look for a diagonal extension off that curve like the scallops in Figure 2.4

Yes, the three tools of straight lines, curves, and diagonals may sound like finding chart patterns is easy It is All it takes is practice to train your eyes to spot them in the price landscape

Let’s delve into patterns that use diagonals

Figure 2.5 shows a combination of lines—straight and diagonal ones—that bound patterns Pattern A is called a symmetrical triangle It uses two diagonal trendlines to bound price movement The two lines converge and join

at the triangle’s apex

Notice that price nears or touches the top trendline multiple times Along the bottom, price finds support at the lower trendline multiple times, too.The breakout from this pattern occurs at B when price closes below the bot-

tom trendline Only a close below the trendline counts as a breakout The spike at

C, for example, should be ignored even though it does suggest price is going down.Pattern D is an ascending triangle although it’s not well-formed The top trendline is horizontal, and price touches it several times The bottom trendline

is where the problem occurs Price touches the trendline multiple times, but only at the start and near the breakout at E Yes, price is busy moving up toward the top trendline in the middle of the pattern, but I’d still like to see one bottom touch in the middle of that lower trendline

Notice that both chart patterns break out downward and drop just a bit before shooting out the other side “Way cool!” you could say It’s as if the first pattern is the template for the second Unfortunately, chart patterns usually don’t work that way But it pays to search for chart patterns in a historical price series for hints on how a new pattern might unfold

● Use prior price action to help determine future behavior

That’s a Wrap

Of all the chart patterns, those with diagonal or curved trendlines (Figures 2.4 and 2.5) occur most often It’s rare for price to move horizontally as in a rectan-gle (see AB in Figure 2.3) However, you will frequently see two peaks (double top) or two valleys (double bottom) form near the same price Those peaks and valleys show where resistance and support are, respectively

Practice searching for chart patterns to train your eyes to see them Begin looking for peaks that form near the same price Those could be double tops and triple tops

If you find multiple peaks that line up, look between those peaks to the valleys below They may also align along a line of trend (horizontal, but more often diagonal) Those could be from the triangle family: ascending, descend-ing, or symmetrical

Other patterns may use curves, so look for peaks to round over and valleys

to round up (or the reverse, of course) Curved shapes that form patterns are harder to spot than straight lines

If you see peaks or valleys that align along a diagonal, then that forms a simple chart pattern (a trendline) Look at the side opposite the diagonal to see

Figure 2.5 Chart patterns also form using diagonals.

Northwest Pipe Co (Building Materials, NWPX)

A

B C

D

E

31 30 29 28 27 26 25 24 23 22 21 20 Jan 13 Feb Mar Apr May Jun Jul Aug

if it’s a more complex pattern like one of the triangles or one from the ing family where price oozes out like a megaphone.

broaden-Near the back of the book is a visual index of chart patterns It shows the ideal appearance, so you might want to look at them now to familiarize yourself with their shape In the coming chapters, we’ll look at many of those patterns and tell you exactly what to look for

The guidelines that we’ll discuss have important rules, such as the measure rule and learning what confirmation means

What We Learned

Here is a list of the major lessons discussed in this chapter

● The blank chart shows price movement, uptrends, downtrends, and areas where price moves horizontally See “The Blank Chart.”

● Begin constructing chart patterns by visually finding peaks that share similar prices See “Connecting Peaks.”

● Two peaks that top out near the same price could form a double top See “Connecting Peaks.”

● Search for chart patterns by looking for valleys that bottom near the same price See “Connecting Valleys.”

● If multiple peaks stop near the same price, look at the valleys between the peaks for a better clue to their type They could be triple tops, an ascending triangle, or broadening pattern See “Connecting Valleys.”

● Multiple valleys at a similar price could be a triple bottom, descending triangle, or a broadening pattern See “Connecting Valleys.”

● Look for curves on the price chart and connect those curves with nary lines to form chart patterns See “Patterns with Curves.”

imagi-● Curves appear in scallops, cups with handles, and rounding tops and bottoms See “Patterns with Curves.”

● Several types of chart patterns use diagonal lines Look for trendlines that slope upward or downward when searching for chart patterns See

“Patterns with Diagonals.”

● Use prior price action to help determine future behavior See “Patterns with Diagonals.”

● Diagonal trends occur in many broadening patterns, diamonds, and wedges See “Patterns with Diagonals.”

● Review the Visual Index of Chart Patterns at the back of the book for

a visual reference

Trading stocks using chart patterns is a lot like fishing—patiently waiting

for a chart pattern to appear and excitement when the chase begins If you’re lucky, the sweetness of success will overcome the bitter taste of failure You will have both, but trendlines can help

Trendlines are overlooked chart patterns, but serve as wonderful tools to help gauge where price is going They are the logical choice to begin our explo-ration of chart patterns

What Are Trendlines?

If you look at almost any price chart, your eyes will find prices that zigzag but

still follow an imaginary path That path is called a trend If you draw a line

con-necting the peaks or valleys along that trend, you get a trendline A trendline

can outline a chart pattern as we will see in Figure 3.1 (the falling wedge), or it

can highlight a price trend (trendline C) Trendlines indicate buying or selling opportunities when price crosses them

● When price trends, a line connecting them is called a trendline

A Trendline Example

Figure 3.1 shows examples of several trendlines Trendline C is a good example

of a trendline Price touches the line multiple times along its length and seems

to find support at the line Notice that price does not plunge through the line until it approaches the valley between AB

Consider the trading setup shown by the falling wedge The two lines surrounding the wedge slope downward, joining at the wedge apex some-time in the future Volume also slopes downward as it does in many chart patterns Breakout day volume—the day price closes above the top pattern line—is high, but not worth writing home about The upward breakout con-firmed the falling wedge as a valid chart pattern and signaled a buy Should you take the trade?

trend-Based on a study of 481 falling wedges in a bull market, 66% of them saw price rise to at least the top of the wedge If the rise stops there, the trade would

be worth only two points More likely, though, is that price will push higher until

it hits a trendline connecting peaks A and B With a declining price trend, the

Amgen Inc (Biotechnology, NASDAQ, AMGN)

73 71 69 67 65 64 63 62 61 60 59 58 57 56 55 54 53 52 51 50 49 48 Dec Nov Oct Sep Aug Jul Jun May Apr Mar

2003

Falling Wedge

A

B

C

FigurE 3.1 A falling wedge with an upward breakout marked a buying

opportunity until a trendline, drawn along the tops connecting points A and

B and extended down, warned that price might stall when it reached the trendline.

chances are good that price will rise to meet the trendline and then plummet faster than a hot air balloon out of propane If traded perfectly, you’d make 10%.

In early February 2004, the stock reached a high of 66.88, one point above the downsloping trendline before the stock reversed and sank to a low of

52 and change

● Beware buying a stock when a trendline marks nearby overhead tance

resis-Trendlines: External, internal, and Curved

Trendline types come in three flavors: external, internal,

and curved External trendlines are straight lines drawn

so that the line rests on the peaks or grips the bottom

of valleys We saw an example of that in Figure 3.1,

trendline C

Internal trendlines cut through price by trying to

better position the line so that it follows the majority of

price movement

Curved trendlines can be external or internal,

depending on whether the line skirts price or cuts

through it

Let’s take a closer look at the three varieties

External Trendlines

Figure 3.2 shows an external trendline starting in

September 2001 and running until mid-2002 Upsloping

trendlines connect the valleys of a rising price trend That

way, when price crosses the trendline, it is an indication

of a possible trend change from up to down In the stock

market, knowing when the trend will change is worth big

bucks Notice that price zigzags as it moves higher, but it

still follows the straight trendline

● Upsloping trendlines connect the valleys of a

ris-ing price trend

The downsloping trendline beginning in

mid-2003 is also an external trendline, but it rests on the price peaks Draw downsloping trendlines along the price peaks to indicate a possible trend

trendline types

trendlines come in three varieties:

external, internal, and curved External trendlines

do not cut through price along its length Internal trendlines slice through price frequently Curved trendlines describe the shape of the trendline, but they can be external or internal.

change from down to up Notice that both external trendlines in Figure 3.2

do not cut through price but rest along the tops or bottoms of the peaks or valleys Cutting through price is what differentiates an internal trendline from

an external one

● Draw downsloping trendlines along the price peaks to indicate a sible trend change from down to up

pos-internal Trendlines

Internal trendlines are lines of trend drawn so that they rest on the flat portion

of peaks or valleys—and frequently cut through price If the price peak were a hill, an internal trendline would rest on the ground An external trendline, by contrast, would only connect the tops of the tallest trees Figure 3.2 shows one example of an internal trendline Notice how the line cuts through price instead

of resting on it

One technical analyst argues that internal trendlines better represent the trading behavior of the masses, whereas external trendlines show the behavior of just a few traders, the ones that traded at the price extremes

FigurE 3.2 Shown on the weekly scale are the three types of trendlines:

external, internal, and curved The curved trendline highlights an ascending and inverted scallop chart pattern.

BJ Services (Oilfield Svcs/Equipment, NYSE, BJS)

Curved Trendline Internal

Trendline

External Trendline

Downsloping Trendline

54 52 50 48 46 44 42 40 38 36 34 32 30 28 26 24 22 20 18 16 14 ASO J MJ FMA ND04 SO D03

D02 F J J A S O N

J A SO N

J

Most chartists use external trendlines, especially when drawing chart terns, and that is my personal preference Sometimes I’ll use an internal trend-line to highlight a trend better, especially an unusually long trend, or a chart pattern with a few price outliers.

pat-● Draw trendlines so that they highlight price movement best

Curved Trendlines

Occasionally, the price trend is not straight, but curved as Figure 3.2 shows Draw a curved trendline along the peaks or valleys to highlight the price pat-tern Often curved trendlines will slice through price, but there’s no need to dial

911 Price can’t feel the pain What’s important is that the trendline highlights the curve, allowing your eyes to better fashion a chart pattern For example, the curved line in the figure shows a chart pattern called an “ascending and inverted scallop.”

Sometimes traders get excited about a stock and push price up (or down)

at faster and faster rates The price trend moves up at a good clip (30 to 45 degrees) and then starts curving upward in a parabolic arc These vertical climbs can be both thrilling and scary because price moves higher than you expect, but you know that the rise is going to stop eventually Then, everyone races for the exits, forcing price to plummet When price closes below a rising but curved trendline (the parabolic arc), that is the sell signal, and it can help you be one of the first out the door A sharp reversal often follows the breakout from a para-bolic or steep trendline

For all three varieties of trendlines—external, internal, and curved—traders simply refer to them as trendlines Whether you use an internal or external trendline is a matter of personal preference

● Curved trendlines frequently cut though price What’s important is that the curve outlines price movement the best

Touch Spacing

When I wrote Trading Classic Chart Patterns (John Wiley & Sons, 2002), I

con-ducted research on trendlines and proved what others had merely speculated I looked at about 200 trendlines with narrow and wide touch spacing and found that larger price moves occurred after a breakout from a trendline with widely spaced touches

Figure 3.3 shows that line AC has four trendline touches and the line is five months long On average, the touches are widely spaced Trendline AB has

five trendline touches; four of the touches are just a day apart That trendline has narrowly spaced touches.

I found that when the average spacing between touches was less than the median 29 days in a downsloping trendline, the resulting price rise after

an upward breakout averaged 36% Trendlines with touches that were spaced wider than 29 days showed prices climbing 41%

The same applies to upward-sloping trendlines There, the median was

28 days between touches, and narrow trendline touches gave declines averaging 14%, but widely spaced touches showed declines averaging 19% The results from these tests are for perfect trades without any fees, so don’t expect to repli-cate them in actual trading

● Trendlines with touches spaced widely apart (about a month apart) form better than do those with narrowly spaced touches

per-If you are considering trading a trendline with four touches in a month compared to a longer trendline with four touches each one month apart, trade the one with wider spacing It will be more reliable, meaning that price is less likely to pierce the trendline and reverse (a false breakout)

FigurE 3.3 Trendlines with widely spaced touches perform better than do

ones with narrow touches.

Albemarle Corp (Chemical (Diversified), NYSE, ALB)

40 39 38 37 36 35 34 33 32 31 30 29 28 27 26 Jan 05 Dec Nov Oct Sep Aug Jul Jun May Apr

A 1 2

2 3 B

C

3 4

4

5

Mar

Trendline Touches

I also looked at the number of times price touched a

trendline Experienced traders say that the more times

price touches a trendline, the more significant becomes a

breakout from the trendline I proved that true

I looked at 85 downsloping trendlines with price

touching the trendlines three times After an upward

breakout, price climbed an average of 33% Then I

com-pared it to 40 trendlines with five touches and found that

the postbreakout rise averaged 57%

To check this result, I split the trendlines into those

with four touches or fewer They showed gains

averag-ing 35% Those trendlines with more than four touches

climbed an average of 48% Again, those trendlines with

more touches led to better performance after the breakout

I conducted the same research using upsloping

trendlines and found similar results, but with a closer

performance difference

● The more times price touches a trendline, the

more significant becomes a breakout from that

trendline

Trendline Length

Of all trendline features, length is one of the important

ones Do long trendlines perform better than short ones

after a breakout? Yes I found that the median length for

downward-sloping trendlines that I used was 139 days

Trendlines shorter than the median saw price climb an

average of 33% after the breakout, but long trendlines

saw price soar 43%

As a check, I used another method and sorted the

trendline length into three categories: short term (0–3

months), intermediate term (3–6 months), and long

term (more than 6 months) Short-term trendlines had

postbreakout rises averaging 34% Intermediate-term

and long-term trendlines had gains averaging 35% and

46%, respectively I found similar results for upsloping

trendlines

median

median value

is the middle one in a sorted list of values such that half the values are below the median and half above

If no middle value exists, the average of the two closest values is used For example,

in the list 10,

15, 30, 41, and 52, the median is 30 because there are two values

on either side

of it.

short term

lasts up to three months.

intermediate term

between three and six months.

Trendlines are like diving boards: You get a better bounce from a longer diving board than a shorter one.

● Long trendlines outperform short ones

Trendline Angles

Another important consideration is the angle that the trendline makes with the horizontal The steeper the trendline, the worse the performance That’s the conclusion I reached when I researched trendline angles I measured the angle from the horizontal and sorted the trendlines by the angle they made For both up- and downsloping trendlines, the distance that price moved (after the break-out) decreased the steeper the trendline became (For upsloping trendlines, a

trendline breakout means a close below the trendline; for downsloping

trend-lines, it’s a close above the trendline.)

Look for trendlines that slope 30 to 45 degrees Trendlines with those angles can last a long time However, if the trendline slopes upward at, say,

60 degrees or more, then you’d better tighten your stop That means adjusting your stop-loss order often, mov-ing it closer to the current price as the stock rises The price may continue soaring, but when the turn comes, the resulting decline will likely be rapid A tight stop lim-its the dollars you give back

● The steeper the trendline, the worse the mance

perfor-One caution comes to mind Be aware of the aspect ratio That’s the ratio of the width to the height of a chart

If you draw a trendline at 45 degrees and move either axis, the trendline angle will change That’s why a movie shown

in a theater will fill the screen but the same flick at home will show a black band

at the top and bottom of the screen

My computer screen may show a trendline at a 45-degree angle but when

I print out the chart, it might look like 30 degrees The angles of trendlines shown in this book will likely differ from the same chart shown on your com-puter screen

● The aspect ratio describes the relationship of the width to the height of

Trendline and Breakout Volume

Does breakout volume influence how far price will move

after a trendline break? Yes Let’s take trendline volume

first I did a study of volume and trendlines and found that

upsloping trendlines that had volume trending upward

over their length resulted in a decline averaging 19% after a

downward breakout When volume receded over the length

of the trendline, the decline averaged just 14%

For downsloping trendlines, when volume climbed

over the course of the trend, price climbed 30% after the

upward breakout A receding volume trend had prices

climb by 45% In short, here’s what I found:

● Expect a larger price decline after a breakout from

an upsloping trendline if volume is trending up

● Expect a larger price rise after a breakout from a

downsloping trendline if volume is trending down

What about breakout day volume? I compared

volume on the day price staged a breakout to the

three-month average and found the following to be true:

● Upsloping trendlines with heavy (above aver age)

breakout volume mean a larger decline—19%

versus 16%

● Downsloping trendlines with light (average or

below-average) breakout volume mean a larger

rise—39% versus 36%

Because the performance difference is not massive, don’t bet that a large price change will occur, and don’t think that price will rise by 39% As I men-tioned, the statistics in this chapter are for comparison purposes only because they result from 200 perfect trades They represent the price rise or decline after

a breakout to the ultimate high or ultimate low, respectively.

Measure rule for Trendlines

When price closes below an upsloping trendline, how far will it fall? One answer

to that question comes from the measure rule.

breakout volume

the volume level on the breakout day.

ultimate high

the ultimate high price is the highest high before price drops at least 20%.

ultimate low

the ultimate low price is the lowest low before price rises at least 20%.

Figure 3.4 shows an upsloping trendline The sure rule is a tool used to help predict how far price will decline after a breakout.

mea-To use the rule, find the breakout where price closes below the trendline (point D) Then look for the widest distance between price and the trendline until the last time price touched the trendline The last touch happened at point C, so the largest vertical distance is between points A and B The price difference between those two is 20.75 points in this example Subtract the difference from the breakout price (point D, the point where price intersects the trendline) to get the target price, which turns out to be 12.25 Price reaches the tar-get (not shown) in September 2001

If the prediction is a negative number then discard it.The measure rule works 63% of the time for upslop-ing trendlines and 80% for downsloping ones, according

to my tests

You can apply this technique to downsloping trendlines in the same manner Find the largest distance between price and the trendline from the breakout to the prior trendline touch and project the difference upward from the breakout price

When predicting a target, be conservative and assume that the stock will fail to reach the target Consider taking the height and converting it to a percentage of the stock’s price (100 × height ÷ breakout price) If the percentage is unrealistic, then don’t depend on the measure rule

● The measure rule is a tool used to help predict how far price will move (up or down) after a breakout from a chart pattern

● Convert the measure rule height for a trendline into a percentage price change to see if the target represents a realistic move

Drawing Trendlines

Now that we’ve explored trendline features, what’s left? Answer: figuring out how to draw them Some analysts argue that it’s harder than just connecting several peaks or valleys It’s not, unless you are searching for a trend change I’ll discuss that in a moment