How to Trade Chart Patterns

A User Manual

Using PRS, Vol. 1, No. 5
as an example

  AZO -- Chapter One

Symmetrical triangles in uptrends are bullish, while symmetrical triangles in downtrends are bearish. For a bullish pattern, the first point (the point farthest left or the earliest) is at the top. For a bearish pattern, the first point is at the bottom.

The first one we'll look at is AutoZone (AZO) and it's shown with a 'symmetrical' triangle in an uptrend (which is bullish). A quick way to tell if it's a bullish triangle or a bearish triangle is to see where the first point of the triangle begins.

Since the market in this example is at the very top of the pattern (the market should not go into the apex), simply getting in ASAP would be a low risk entry for a high probability trade. 'Low risk entry' because since the breakout point is immediately above and the failure point is such a short distance below, the risk to reward ratio is clearly in your favor. And for these tight little patterns, you can place your stop at a true failure point, rather than at a simple testing of the bottom of the pattern (which is often times insignificant).

You'll also want to determine your minimum price target by measuring the projected move. To do this, you'll want to find the size of the pattern's base and then add that to the approximate breakout point to come up with your measured move. To find the size of the base, subtract the low of point 2 from the high of point 1.

Instead of a $4.14 measured move from its breakout point of approx. $67.60, it soared nearly 3 x that to close at $79.15 on 12/5/01. From when we 'spotted' this on 11/30/01 at $67.30, to its close on 12/5/01 at $79.15, it was up 17.61%.

Here's another shot of that huge one-day move, without any annotations on the chart, so you can see just how spectacular of a move that really was. These kinds of 'gifts' are rare and you're truly lucky to catch something like this. And while no one could have predicted a $12 one-day up move, the pattern did predict an upside breakout. And if you got in because of that, you would have been in for the big move that followed.

Now let's take a look at the market in the few days prior to its up move up and then we'll talk about exiting your trade.

In each of the last two days prior to its big move, there was a minor test of the downside (support). A quick yet anemic probe of the downside on weak volume is no cause for concern. And a close above support confirms the pattern's intact. (The close of those 2 days are emboldened in blue.) As a rule of thumb (assuming your personal money management rules/risk of loss are followed), a move through the 4th point (see the dotted blue horizontal line) is your failure point. In this example, it remained unchallenged. However, it should noted, that a breaking of support on gaining volume (the 4th point notwithstanding), is a cause for concern and should be considered a cue for failure and exit. 

On 12/5/01, the market gapped open $7.44 higher to $74.00 ($2.26 above the measured price target of $71.74). It then backed off a bit, putting in a low of $71.85 (still staying above the $71.74), before racing higher to $79.90 and settling at $79.15 for a one day gain of $12.56.

The measured price target of $71.74 is important because, when a market blows past your target price, that marker should now become your stop-loss point.

As you know, there are different types of gaps (ordinary, breakaway, measuring and exhaustion), with the breakaway and the measuring gap being bullish, offering support to the market.

But often times, figuring out what kind of gap you're dealing with isn't always that easy. So determining your sell points are important. And with a big score like this one, I'd be willing to see what more is in store for the stock, but I wouldn't be willing to let a big gain like that disappear entirely.

So the first course of action would be to place you stop at your first measured price target of $71.74.

Now with a more than $7 move right on the open, you might have been tempted to take your money and run. And if you did, there's nothing  wrong  with  that.  In fact, I'm a big  advocate  of taking your windfalls as soon as they happen  (before it turns out to no longer be a windfall).

But, when something big happens, often it gets even bigger. So instead of exiting to secure a certain dollar gain (whether it be $7, $6, $5 or $9), let the day play out with your stop in place. The rationale being; if it keeps on going higher, you're in, and if it goes down and actually stops you out with a profit, you're still a winner because that's what you were hoping to make in the first place when you put on the trade.

After the day's action is done, you can now refine your exit points to try and lock in more of your gains.

In trying to determine your extended price targets and additional stop-loss points, go back and re-evaluate the pattern.

Measuring the preceding uptrend is a good place to start. In this one, the preceding uptrend (the rapid advance) could be interpreted as a 'pole'; as in the up-move prior to the forming of a bull flag and/or bull pennant. In a bull flag and bull pennant, the rise prior to the forming of the consolidation pattern is usually so big and so quick, that the move (usually just one or a few days), appears to have gone nearly straight up, resembling a pole waving a flag or pennant. (More on flags and pennants and  their  'poles'  later.)   While   the  prior  move  in  this  example  isn't

technically a 'pole', measuring the move nonetheless, is still an excellent way to find extended upside objectives. To measure the preceding move, just subtract the low of the start of the advance from the high point (point 1) of the pattern. (In this case, the 'symmetrical' triangle.) Add that to the breakout point for your extended price target.

Now it's time to determine our possible exit points.

When doing so, especially with a big, quick move like in this example, I'll often ask myself a question: What would make me most upset? Being in (going for a bigger gain) and seeing the market go down and having to give back 'x' in profits, or being out (having secured my profit) and watching the market go even higher and missing out on the extended move?

Answering that, will help you determine your most appropriate course of action.

In fact, you may have answered that question before the end of the day and decided to get out on the close. I've done that many times.

But for this example, let's assume we're still in and let's take a look at our choices and how we arrive at them.

Since we have about a $12 gain, I'm definitely not allowing a retracement back to the breakout point. Since this 'gap and run' was made on extremely heavy volume in a mature uptrend, there's a chance it could be an exhaustion gap, so I'm also not willing to let the market go much into the gap. (My measured price target, which is now a potential stop-out point will take care of that.) And since even a 33% or 50% retracement of the move (common retracement figures) equals a $4.14 and $6.26 pull-back respectively, I'll choose a different point. (That's way too much to give back.) By the way, when I'm figuring the 'move', you can choose to use the entire day's move (previous close to the new high) or the day's net change (previous close to the recent close). Since this move took place in just one day and it closed near its highs, I've chosen to use the net change as my 'move'. (As you can see, determining your stop points is part science and part personal risk tolerance.) Anyway, it's my contention that giving it 20% leeway is the right place to call it quits. I believe 10% is too little for such a big advance, but anything more than 20% sacrifices too much money.

So simply figure out the size of the move and then subtract 20% for your stop-out point. In this case, subtract the previous day's close ($66.59) from the recent close ($79.15). That's a $12.56 move. Then subtract 20% of the move (less $2.51) from the recent close ($79.15) for your stop-out point of $76.64.

Let's see how it played out.

The market continues to erode, forms a sloppy 'bearish flagging' pattern and then quickly erases all of its gains and then some. This is why a well thought out exit strategy is so important.

If neither the extended price target or stop-loss point is hit, I'll typically watch and see if a new pattern forms. And based on whether it's a bullish or bearish pattern, you can either hold on, buy more, get short or just get out.


Copyright 2001, 2002, Pattern Recognition Services


End of Chapter One.

Chapter One.     To Chapter Two.     Chapter Three.

The complete User Manual is coming soon. 40 chapters (each chapter analyzes a trade) and over 160 pages of info just like this. The most authoritative User Manual on How to Trade Chart Patterns available. This is not chart patterns 101, like most of the books out there. This is straight talking, practical and useful information. We show winners, losers, how to buy and when to sell. No fluff and no nonsense. As you can see from this first chapter, it's jam packed with information from page one to the very end.

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