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Introduction
Jim is struggling.
He is the owner of JCB Superstores and his competitor across town is beating him up; there is blood all over Jim's ledger. He decides it is time to take off the gloves: JCB goes public. He uses the money from the initial public offering to buy his competitor and add a few more stores around town.
With a growing sales base, Jim's clout allows him to negotiate lower prices for the office supplies he is retailing. He passes on part of the savings to his customers, while watching his margins widen, and plows the profits back into building more stores.
Jim calls his friend, Tom, and tells him of his plans to expand the operation statewide. They chat for a while and exchange business tactics on how best to manage the expansion. When Tom gets off the phone, he decides to conduct his own research on JCB. He visits several stores and sees the same thing: packed parking lots, people bustling around with full shopping carts, and lines at the checkout counters. He questions a few customers to get a sense of the demographics. At a few stores, he even chats with suppliers as they unload their wares. Back at the office, he does a thorough analysis of the financials and looks at the competition. Everything checks out so he orders his trading partners to buy the stock at no higher than 10.
When news of the expansion plan hits the wires, the Street panics. It is, after all, a soft economy and expanding willy-nilly when a recession looms is daft, maybe even criminal, according to them. The stock drops below 10 and Tom's crew makes its move. They quietly buy as much as they can without raising suspicion. The stock rises anyway. It goes back up to 11, then 12, and rounds over at 13 before heading back down.
Several months go by and the economic outlook is as bleak as ever. The stock eases down to 9. After Tom checks in with Jim for the latest public news, Tom's team buys more. It is an easy score because investors are willing to dump the stock especially as year-end tax selling approaches.
Six weeks later the company releases the sales numbers for JCB; they are better than expected. The stock rises 15% in minutes and closes at 10 3/4. And that is just for starters. Six months later, it's clear the economy was never in danger of entering a recession and everyone sees boom times ahead. The stock hits 20.
Years go by, the stock splits a few times, and the holiday season looms. Tom interviews a handful of customers leaving JCB Superstores and discovers that they are all complaining about the same thing: The advertised goods are missing. Tom investigates further and discovers a massive distribution problem, right at the height of the selling season. JCB has overextended itself; the infrastructure is simply not there to support the addition of one new store each week.
Tom realizes it is time to sell. He tells his trading department to dump the stock immediately but for no less than 28 1/4. They liquidate about a third of their large holdings before driving the stock down below the minimum.
Since it is the holidays, everyone seems to be in a buying mood. Novice investors jump in at what they consider a bargain price. The major brokerage houses climb aboard and tout the stock, but Tom knows better. When the stock recovers to its old high, his trading partners sell the remainder of their holdings. The stock tops out and rounds over. During the next month and a half, the stock drifts down, slowly, casually. There does not appear to be a rush for the exits -- just a slow trickle as the smart money quietly folds up shop.
Then news of poor holiday sales leaks out. There is a rumor about distribution problems, merchandising mistakes, and cash flow problems. Brokerage firms that only weeks before were touting the stock now advise their clients to sell. The stock plummets 39% overnight.
One or two analysts say the stock is oversold; it is a bargain and investors should add to their positions. Many bottom fishers follow their brokers' recommendation and buy the stock. Big mistake. The buying enthusiasm pushes the price up briefly before a new round of selling takes hold. Each day the stock drops a bit lower, nibbling away like waves washing against a castle of sand. In 2 months' time, the stock is down another 30%.
The following quarter JCB Superstores announces that earnings will likely come in well below consensus estimates. The stock drops another 15%. The company is trying to correct the distribution problem, but it is not something easily fixed. They decide to stop expanding and to concentrate on the profitability of their existing store base.
Two years later, Tom pulls up the stock chart. The dog has been flat for so long it looks as if its heartbeat has stopped. He calls Jim and chats about the outlook for JCB Superstores. Jim gushes enthusiastically about a new retailing concept called the Internet. He is excited about the opportunity to sell office supplies on-line without the need for bricks and mortar. There is some risk because the on-line community is in its infancy, but Jim predicts it will quickly expand. Tom is impressed, so he starts doing his homework and is soon buying the stock again.
Investment Footprints
If you picture in your mind the price action of JCB Superstores, you should recognize three chart patterns: a double bottom, a double top, and a dead-cat bounce. To knowledgeable investors, chart patterns are not squiggles on a price chart; they are the footprints of the smart money. The footprints are all they need to follow as they line their pockets with greater and greater riches. To others, such as Tom, it is hard work and pavement pounding before they dare take a position in a stock. They are the ones making the footprints. They are the smart money that is setting the rules of the game -- a game anyone can play. It is called investing.
Whether you choose to use technical analysis or fundamental analysis in your trading decisions, it pays to know what the market is thinking. It pays to look for the footprints. Those footprints may well steer you away from a cliff and get you out of a stock just in time. The feet that make those footprints are the same ones that will kick you in the pants, waking you up to a promising investment opportunity.
This book gives you the tools to spot the footprints, where they predict the stock is heading, how far it will travel, and how reliable the trail you are following really is. The tools will not make you rich; tools rarely do. But they are instruments to greater wealth. Use them wisely.
The Database
If you want to discover how much you do not know about a chart formation, try teaching a computer to recognize one. I spent several months doing that preparing for this book. The program helped me locate, analyze, and log well over 15,000 formations. It is not a substitute for my eyes or my brain, just another tool to augment my talent. Consider it another set of dispassionate eyes, a friend nudging you and saying, "Look at this one here. It's a bump-and-run reversal."
When the starting gun went off, I selected 500 stocks, all with durations of 5 years (each from mid-1991 to mid-1996) of daily price data on which to collect statistics. I included the 30 Dow Jones industrials and familiar names with varying market capitalizations. Stocks included in the study needed a heartbeat (they were not unduly flat over the 5-year period) and did not have consistently large daily price ranges (too thinly traded or volatile).
I usually removed stocks that went below a $1.00, assuming bankruptcy was right around the corner. Most of the names in the database are popular American companies that trade on the NYSE, AMEX, or NASDAQ. The numerous illustrations accompanying each chapter give a representative sample of the stocks involved.
Occasionally a chart formation came along that presented a problem. It was so scarce that 2,500 years (500 stocks times 5 years) of daily price data were simply not enough. So I pulled from the database I use on a daily basis. It contains about 300 issues and begins where the other one ends.
Stock Performance from 1991 to 1996
Before reading about the various chart patterns in this book, it is wise to review the performance of the stock market during the period. Figure I.1 shows a monthly price chart of the Standard & Poor's 500 stock index. Beginning in mid-1991, you can see that the market hesitated until January 1992. It had a wild burst upward, perhaps due to the January effect, but trended downward until May. (In case the January effect is unfamiliar to you, it is commonly attributed to investors selling their stocks for tax reasons near year end then buying back during January. The selling may or may not depress prices, whereas the January buying gives them a temporary lift.) Toward the end of 1992, it looks as if the January effect occurred early, in December, when prices broke through their malaise of consolidation and reached new highs. Then it was off to the races, and prices rose on a steady tear until March 1994. The market stumbled and moved up for 5 months then declined for 4 months. Beginning in 1995, the race resumed, but the pace accelerated. The slope of the trend tilted upward noticeably until running into some turbulence in early 1996.
What does all this mean? Viewed as a whole, the market during the 5 years used in my analyses plus the 2 or 3 additional years used sporadically but not shown in Figure I.1, marks a very bullish environment. While the market as a whole was going up gangbusters, many individual stocks were not so fortunate. Some had steady downward trends. Others moved up smartly, rolled over, and died (check out most semiconductor and semiconductor capital equipment stocks in 1995).
During a soaring bull market, bullish chart patterns are more successful by having fewer failures and longer uphill runs. They perform better, chumming along on a rising tide that lifts all boats.
Common sense suggests that bearish formations might fail more readily with stunted declines. More likely, though, is that bearish patterns just disappear; they never happen. You might think that stocks moving up would form bearish reversals. Instead, they just keep moving up, now and again pausing to catch their breath before continuing the rise.
You can see this trend in the statistics. Bullish formations, those that typically occur after a downward price trend and signal an upward reversal, happen more often than bearish ones. Symmetrical triangles are a good example. Triangles with upside, bullish breakouts occurred 225 times, whereas downside breakouts happened 176 times. A favoring of the bullish trend is also evident in many paired formations. Consider double bottoms and double tops. There were 542 bottoms (bullish) and only 454 tops (bearish).
Even the statistics favor a bull market. A stock moving up can advance 50%, 100%, or even 1,000%. The gains can be unlimited, but what of the declines? A stock can only lose 100%, or all of its value, and nothing more.
Averages and the Frequency Distribution
The frequency distribution mentioned so often in this book deserves special attention. Before I discuss it, however, let me explain averages. An average is the sum of the numbers divided by the number of samples. If you measure the returns from five chart patterns and they are 30%, 40%, 50%, 60%, and 120%, then the average is 60%. That is the sum of the numbers (300) divided by 5 samples.
This example shows the effect large numbers have on the average. If the 120% gain is not in the series, the average drops to 180/4 or 45%. The single large gain pulls the overall average upward, distorting the result. This distortion is important when discussing bullish formations. A 600% gain in one chart formation can make a chart pattern appear more successful than it really is. Instead of dropping off samples (by arbitrarily removing the large returns), I use a frequency distribution.
The esoteric name frequency distribution is appropriate. To create a frequency distribution, find the highest and lowest values to give you the range. Divide the range by 10 because you want to sort the numbers into 10 bins (10 is arbitrary, but commonly chosen). Then, you do just that -- sort the numbers into one of 10 ranges and place them in the bins. When finished, count how often the numbers appear in each bin (the frequency). Note that you do not add up the numbers, you just count how often they appear. It is a lot like seeing troops on a battlefield. You really do not care how tall each one is, only that they outnumber you. The results are the same: You wet your pants and run!
An example makes this clear. Look at Table I.1. Suppose I am studying a chart formation and have the gains for 50 patterns. For simplicity, suppose the gains range from 5% to 95%. The first column in the table holds gains less than 10% and the last column holds gains over 90%. I do not show them all in the table, but I begin placing the gains into the different bins, and the first 10 gains are 8%, 35%, 70%, 13%, 95%, 9%, 6%, 33%, 3%, and 63% (see Table I-1). When I finish placing the gains from the 50 formations into the table and sum the columns, I see which column has the highest frequency. A count of each column appears as the last row in the table and assumes all 50 formations were sorted.
From the numbers in the bottom row, we see that the first column has the highest frequency and represents those formations with gains of less than 10%. We might conclude that if you invested in a similar chart formation, your gain is likely to be between zero and 10%, since that is where most (40%) of the formations reside. The average of the 50 gains will likely be higher than 10%, especially if the higher ranges show either a large number of entries or represent large gains.
I call the column with the highest frequency the most likely gain. Sometimes the sum of the columns are near to one another and so the most likely gain is a range of values, such as 10% to 20%. Just because a chart pattern has a most likely gain of 10% does not mean that you will have a 10% gain from trading your chart pattern. After all, if you trade the pattern well enough and often enough, you should approach the results represented by the average. However, I feel that the most likely gain gives the investor a better understanding of the performance or reliability of the chart pattern.
I use a frequency distribution any time I want to see which range occurs most often (or any time I think outliers distort the average). It is just another perspective, a useful tool in the hands of an investor.
Investing Using Chart Formations
I could give a dentist's drill to any person walking by, but I would not let him or her near my teeth. This book is just like that. It gives you the tools to invest successfully . It suggests which chart patterns work best and which ones to avoid. Whether you can make money using them is entirely up to you.
I call this book an encyclopedia because that is how I use it. Whenever I see a chart pattern forming in a stock I own, or am thinking of buying, I read the applicable chapter. The information refreshes my memory about identification quirks, performance, and any tips on how I can get in sooner or more profitably. Then I search for similar patterns in the same stock (using different time scales), and if that does not work, I search for similar patterns in stocks in the same industry. I look at them closely to determine if their secrets are applicable to the current situation. I try to learn from their mistakes.
At the same time, I am paper trading chart formations in the 250 or so stocks I follow on a daily basis (relax, a review only takes me an hour). Even though I consider myself an experienced investor (after nearly 20 years, what do you think?), the constant paper trading keeps me sharp. It has moved pulling the trigger (buying or selling a stock) from a conscious effort to a rote reflex. The constant checking on how the chart pattern is faring forces me to develop an intuitive feel for the formation, the stock, and the market.
Developing an Investment Style
The question I am asked most often is, how do I develop an investment style? It is usually not asked like that. Most take a more direct approach: How do I make money trading stocks? When first asked this question, I stumbled over the answer. I think it is like showing four people the color blue and asking them to describe it. One person is color blind so you automatically throw out whatever he says. One says it is solid blue. Another says it is not blue at all but green, while the third says it looks like a combination: blue-green. To each individual, blue looks like blue -- just do not try to compare answers.
Developing a trading style is a lot like that. It is an individual endeavor that has a lot in common with experience. I cannot give you experience; I can only suggest ways to acquire your own.
If you read a chapter on a chart pattern and buy the first stock showing the pattern, you will probably be successful. The first trade nearly always works for the novice, maybe even the second or third one, too. Eventually, though, someone is going to pull the rug out from under you (who knows, maybe it occurs on the first trade). You will make an investment in a chart pattern and the trade will go bad. Maybe you will stumble across a herd of bad trades and get flattened. You might question your sanity, you might question God, but one thing is for certain: It is not working!
Most people buy stocks like they buy fruit. They look at it, perhaps sniff it, and plunk down their money. We are not talking about $1.59 here. We are talking about thousands of dollars for part ownership in a company.
If you have ever been a board member, you know what I am talking about. You have a fiduciary responsibility to the people who elected or appointed you to that position. Not only should you study the material handed to you by the staff, but you have to get out in the field and kick the tires. Do not assume that what the staff says is always correct or represents the best solution. Question everything but learn in the process and try to be helpful without being a pest (I always seem to fall into the pest category). As a shareholder -- an owner of the company -- should it be any different?
I recently was considering buying a position in a company showing an upside breakout from a symmetrical triangle. My computer program told me the company is a member of the machinery industry and further research revealed that it makes refractory products. I continued doing research on the company until the message gnawing at me finally sank in. I did not have the foggiest idea of what a refractory product was. Despite my search for an answer, I was not getting the sort of warm fuzzies I usually get when researching a possible investment. So, I passed it over. I am trading it on paper, sure, but not in real life. Call it the Peter Lynch Syndrome: Do not invest in anything you cannot understand or explain in a paragraph. Good advice.
Of course, if you blindly invest in chart squiggles and it works for you, who am I to tell you you are doing it wrong? The fact is, you are not. If you consistently make money at it, then you have developed an investment style that fits your personality. Good for you!
My investment style, as you might have guessed, combines fundamental analysis, technical analysis, emotional analysis, and money management. Just because I rely on technical analysis does not mean I do not look at the price-to-earnings, price-to-sales, and other more esoteric ratios. Then there is the emotional element. After going for months without making a single trade, suddenly a profitable opportunity appears and I will take advantage of it. Three days later, I will want to trade again. Why? Am I trading just because it feels good to be finally back in the thick of things? Am I trading just because the single woman living nearby does not know I exist and I am acting out my frustrations or trying to impress her with the size of my wallet? That is where paper trading comes in handy. I can experiment on new techniques without getting burned. If I do the simulation accurately enough, my subconscious will not know the difference and I will learn a lot in the process.
Once I come to terms with any emotional issues, I look at money management. How much can I realistically expect to make and how much can I lose? What is the proper lot size to take? When should I add to my position? How long will it take for the stock to reach my target and should I invest in a less promising but quicker candidate?
Investing using chart formations is an exercise in probability. If you play the numbers long enough, you will win out. Sure, some of your investments will fail, and you must learn to cut your losses before they get out of hand. But the winners should serve you well, providing you let them ride. Just do not make the mistake of watching a stock double or triple only to reverse course and drop back to where it started. Or worse.
Day Traders, Position Traders, Buy-and-Hold Investors
As I was writing this book, I kept asking myself what is the time horizon for chart patterns? Are they best for day traders, position traders, or buy-and-hold investors? The answer I kept coming up with is: Yes! Chart formations can be profitable for day traders -- those people who are in and out of a trade during a single day. Many day traders have trading styles that depend on chart formations, support, and resistance. They concentrate on reliable formations that quickly fulfill their measure rule predictions.
For position traders, those who hold the trade longer than a day but not forever, chart patterns offer convenient entry and exit points. I put myself in this category. If the trade goes bad, I am out quickly. If it is profitable, I see no need to cut my profits short. When the gains plateau, or if the stock has moved about all it is going to, I consider moving on. Like the day trader, I try to maximize turns by buying formations that promise reliable returns and reach the ultimate high quickly.
For the long-term investor, chart patterns also signal good entry and exit points. I recently purchased an oil services company knowing that the investment would not make a significant return for 2 or 3 years (I was wrong: It doubled in 3 weeks). It is my belief that in 3 years' time, the stock will be in the 30s, a sixfold increase from its low. It probably will not qualify for a ten-bagger, but it is not small change either. In the short term, the road is going to be rocky and I have added to my position as the stock has come down. Since I am in it for the long term, I have an outstanding order to buy more shares. If this stock goes nowhere, then my analysis of the market trends was wrong, and I will have learned a valuable lesson.
The Sample Trade
The Sample Trade sections that are included in many of the chapters in this book are fictitious except for one: the trade I made using a symmetrical triangle bottom. Each sample trade uses techniques I wanted to illustrate, incorporating fictitious people in sometimes unusual circumstances. Call it poetic license, but I hope they give you some ideas on how to increase your profits or to minimize your losses.
If You Like This Book . . .
When I plunk down my hard-earned money for a book, I expect to get a good value. Many times I have complained that I did not learn anything from a book. At other times, the information is exciting and new, but I cannot use it because the tools the author presented are either too esoteric or too expensive.
I vowed to give the reader real value in this book. The information is easy to find, from the alphabetical chapter layout, to the statistical snapshot at the start of each chapter, to the advice and suggestions all laid out in easy reference tables. The chapters are replete with pertinent illustrations. However, I fear that if you try to read this book from cover to cover, it surely will put even the most hardened insomniac to sleep. Use this book as a reference tool. Refer to it before you make a trade.
If this book saves you money, gives you the courage to pull the trigger with a little bit more confidence, or makes you a whopping profit, then I will have done my job.
