How to Trade Chart Patterns
A User Manual
Using PRS, Vol. 1, No. 5
as an example
  ALOY -- Chapter Three

This one is Alloy, Inc. (ALOY) and it's shown with a big symmetrical triangle in a resuming uptrend (bullish). As stated before, in a bullish pattern, the first point (the point farthest left or the earliest) is at the top. 

You'll notice that we spotted ALOY after its breakout. But since it was still below the 3rd point (green dotted line) (see lower left image) and just a little bit above its breakout point (not to mention having a pattern size suggesting a nearly $9 move), it's a trade that's well worth getting into. And with the market clearly rejecting lower prices, given the reversal from the previous day's low (pink dotted line -- lower left image), we've got a logical stop out point that's quite reasonable (risk/money wise) as well. (The initial stop out point after your entry would be just below the 'reversal' low (just below the pink dotted line). That would be your failure point.

Often times, when getting into a trade before a pattern's breakout or when a market flirts with the breakout point by going back and forth before a convincing move, it's the low of point '4' of the pattern that's typically looked at as the failure point/stop out point.


But in this case, the low of point '4', in comparison to where we want to enter, represents too large of a monetary risk. So a more favorable stop out point (less money at risk) is elected, -- and actually makes more sense.

 

Also, take note of the increase in volume on the first probing breakout. There was a marked increase in volume on its move thru the top of the pattern (1st arrow). ALOY's retreat back into the formation was accompanied by diminished volume, making the drop relatively insignificant. However, the second surge thru the pattern was again made on big volume (2nd arrow). (In fact, it was made with even bigger volume than the first attempt.) That was a telltale sign that the market was probably going test even higher prices.

 

After figuring out the pattern's base (difference between the high of point 1 and the low of point 2 = $8.70), simply add the base to the breakout point of approx. $15.80 to get your measured price target/objective of $24.50. 

 

Before and after. From $16.50 on 11/30/01 when ALOY was 'spotted', to the high of $23.95 on 1/4/02 five weeks later, it gained $7.45 or +45%. Closing at $23.20, it netted $6.70 for a nearly 41% gain.

            

Two days after spotting the pattern, the market continues its up-move, easily closing above point '3' (confirmation point) on good volume. After even more gains, the market then consolidates its recent advance.

After taking out point '3' on the way up, point '3' now becomes our stop-out point on the way down. (Actually, just below it.)

A pull-back after advancing past the confirmation point, will typically consolidate around that area, before resuming its previous move.

Volume becomes even more important as that area is tested. Pullbacks are generally made on diminishing volume. So increases in volume as the market comes down and decreases in volume as the market goes up is cause for concern. 

But in this example, volume is confirming our bullishness. As you can see, volume increased as ALOY continued its breakout thru the pattern. Volume diminished as it pulled back to consolidate its gains (stopping plenty short of point '3') and then exploded higher on its renewed advance. Excellent.

            


However, in the last two days of its climb towards the measured target, it saw higher highs made on lessening volume (price and volume divergence).

 

Now, as a rule of thumb, as the market approaches your measured target, you should always be aware of what the '90% mark' is.

 

In this case, 90% of the anticipated measured move is $7.83 or a target of $23.63. (The difference between the breakout point of $15.80 and the measured move target of $24.50 = $8.70. So $8.70 x 90% = $7.83. Add $7.83 to the breakout point of $15.80 for your '90% target' of $23.63.)

So if you didn't get out on Friday, 1/4/02 when the market closed at $23.20 after hitting a high of $23.95 on decreasing volume, you would have gotten another chance the very next trading day. On Monday, 1/7/02, it opened at the previous day's high, but then spent the rest of the day moving lower. So putting your stop at the 90% mark ($23.63), would have gotten you out as it retreated, for a gain of $7.13 from our 'buy' point of $16.50 on 11/30/02. That's a +43% gain in just 5 weeks. Wow! 

The market then starts to break down even further, forming a head and shoulders reversal pattern in a waning uptrend (bearish) and then a bear pennant in a new downtrend (also bearish).
 

Had you not gotten out earlier to secure your big gains, those bearish patterns would have been clear signals to call it quits.

(More on head and shoulders and bear pennants later.)

Note: The reason I like to use the '90% mark' as a target, is because while these measuring techniques are great indicators for anticipating 'minimum expected price targets', they're better used as target areas as opposed to hard and fast exact numbers. And I have found that getting within 10% of these target areas affords me the opportunity of protecting myself in case of a downturn but also enough leeway to hang in there if even higher prices are to be seen.


© Copyright 2001, 2002  chartpatterns.com, Pattern Recognition Services

End of Chapter Three.    


Chapter One.     Back to Chapter Two.     Chapter Three.

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