into this situation, so you place a buy stop a penny above C. That gets you into the trade right on time.
How far will price rise? Answer: to D. That's the first knot. The knot is the closest region to the breakout where price moves horizontally for at least 3 days. That horizontal movement is obvious because it rests in the circle to the left of D.
D is your short‐term swing target. The stock will rise and hit that region and likely turn back to the breakout in a throwback (which it did in this example, after reaching E).
Figure 1.9 Here are two setups that work well for swing trading throwbacks.
You can set a limit order to sell at the top of the knot, but the bottom of the knot works better (less risky). In this case, it did work better when the rise to E triggered the order and sold the position. You don't make a lot of money trading the throwback (7% or 8%), so you might have to increase the position size to make it worthwhile. Do place a stop‐loss order a penny below the lower of the two bottoms (below A in this case).
Setup 2
The prior setup captures the run up to the throwback. What if you want to capture more of an advance? This is a more risky setup, but it also works well. Look for the second higher knot. I show that at F. That's your target.
In this case, the knot is composed of peaks, a ragged top with price spiking upward. Price also moves sideways here for at least 3 days, with lots of overlap, so it's a good area of overhead resistance.
The stock recovers from the throwback and rises to G where it hits resistance setup by the second, higher knot, F. After that, price struggles to push through that resistance but eventually does in this example.
Setup 3
The right half of the figure shows a similar setup. A small double bottom is at HI, confirmed when price closes above J (it's hard to see where that is, though). In this setup, we have a measured move down pattern from L to K (first leg), K is the corrective phase, and KH is the second leg.
We know from studying measured moves that price returns to the corrective phase 77% of the time (see Table 46.5, where 23% remain below the corrective phase and 77% move higher). We know price is going to climb to K. K becomes our target. We use a buy stop a penny above the high at J, a limit order to sell at K, and place a stop a penny below the low at H.
Test these setups in the stocks and markets you trade. Make adjustments accordingly so that they work for your trading style.
Performance Contests
Imagine Dave likes to bowl and he plays three games per match. Over a month he competes five times and wins three out of five matches with one tie. If we tally his win/loss record not for the 15 individual games, but for the five matches, we find he wins 75% of the time (three of four contests with one tie). We might conclude that he's a good bowler or those competing against him are not. I built the following tables just like I described with Dave. They show how often an aspect of a chart pattern leads to better or worse performance.
Table 1.1: Reversals versus Continuations shows the results of the first contest: Which types of patterns perform better, those acting as reversals or continuations? Before I answer that, what is a reversal and a continuation?
A pattern acting as a reversal happens when price enters and exits a chart pattern from different directions (down going into the pattern and exiting out the top, or rising into a pattern and breaking out downward). Patterns acting as continuations see price enter and exit the chart pattern in the same direction (down going into the pattern and breaking out downward, or rising into a pattern and exiting upward).
For example, Figure 1.7 shows double bottom AB acting as a reversal because price drops into the pattern and leaves it going upward. The downtrend reverses. The rectangle at C in Figure 1.2 is a continuation pattern. Price rises into the start of the rectangle (from B) and exits out the top. That is, price continues in the direction of the prevailing price trend.
Table 1.1 Reversals (R) versus Continuations (C)
| Bull Market, Up Breakout | Bear Market, Up Breakout | |
|---|---|---|
| Winner | Reversals (55%) | Reversals (73%) |
| Performance | 43% R, 42% C | 30% R, 26% C |
| Bull Market, Down Breakout | Bear Market, Down Breakout | |
| Winner | Continuations (87%) | Continuations (75%) |
| Performance | –14% R, –16% C | –22% R, –23% C |
Winner. Table 1.1 tells us that reversals work best after upward breakouts and continuations work best after downward breakouts. For example, I found 55% of chart patterns acting as reversals outperformed continuation patterns in bull markets after upward breakouts. Almost all (87%) of the chart patterns after downward breakouts in bull markets showed patterns acting as continuations beating those which acted as reversals.
Performance. This line in the table shows the average gain or loss for the contests. For example, reversals in bull markets after upward breakouts gained 43%. Continuation patterns saw price rise 42%. Notice that the differences between the contests are often narrow. Continuations, for example, lead by one or two percentage points. The narrow lead is a warning that the indicator is weak as a predictor of future performance.
Table 1.2: Height. Do tall patterns outperform short ones? Tall or short is a measure of the height of the chart pattern divided by the breakout price.
Winner. This line shows how chart pattern performance varies with height. I contend that tall patterns outperform short ones, and we find that belief is true in all market conditions and breakout directions. For example, tall patterns win all of the contests (100%) after downward breakouts in bull markets.
Performance. The performance averages are wide, too, with tall patterns gaining an average of 46% and short ones gaining just 39% (bull market, up breakout). I believe height is a key indicator of future performance, so you'll want to trade tall patterns and avoid short ones.
Table 1.3: Width. Do wide patterns outperform short ones? I measure width from the start to the end of the pattern.
Winner. The numbers in the table tell how well width works as an indicator of chart pattern performance. Contests from patterns in bull markets perform better when they are wide. Bear market patterns show a tie.
Performance.
