Encyclopedia of Chart Patterns. Thomas N. Bulkowski

(B).

      You can wait for price to close above the highest peak at B and ride price upward to G. Below the bottom of the diving board (B) provides a good stop location, too.

      The ride upward to G may not be as smooth as shown on this chart or in Figure 1.2 as price climbs from C to D. It might be as treacherous as the climb to D in Figure 1.1. When I look at this chart, though, I see dollar signs in the form of profit. All you have to do is find this pattern and have the courage to trade it.

Another Setup

      Figure 1.5 shows another setup but one you should avoid (at least from the bullish side). The setup begins with price making a strong push higher, often in a straight‐line run (but be flexible as in this example). I show that upward move at A and then B. The uptrend lasts several months and takes price from about 9 to 13 (which means, a good rise).

Price moves horizontally at C as if trying to catch its breath (ignore the downward February spike at C). The horizontal move should be proportional to the AB move. If AB shows a breathtaking rise, then expect C to be a long horizontal move while the bulls and bears regroup. In this example, AB is about 4 months long and C is 6 months long.

Figure 1.5 This U‐shaped pattern delivers a failure.

      After the topping pattern (C), price forms a chart pattern just below the base of the peak. I show that pattern at DE (a double bottom). The double bottom confirms at F when the doji (hard to see) closes above the top of the peak between valley's D and E. Price climbs only to G before reversing.

      After G, the stock drops all the way to H. Traders expecting the double bottom to deliver profits to their wallet find holes in their pockets and the money gone.

      I see this setup a lot. Price moves up, goes horizontal, and then a chart pattern appears (which can be any bullish pattern, like head‐and‐shoulders bottom, double bottom, or triple bottom). The pattern confirms as valid and price rises some before reversing and heading lower. The pattern busts its upward breakout, handing bulls a loss.

      Just recognizing the double bottom (DE) as a tradable pattern isn't enough. If you research the setup by looking at other charts, you'll see how this setup can lead to a failure of a chart pattern.

      This (the double bottom, or head‐and‐shoulders, or any bullish pattern at the end of the horizontal top) is a setup you'll want to avoid.

Pothole Setup

      Figure 1.6 shows a rare setup on the weekly chart, but it's a variation of the pattern shown in the prior figure.

      Figure 1.6 A pothole setup happens after a drop and flat base.

The company runs into trouble that lasts for the long term (months). That trouble takes price down from A to bottom at B. At B, the bears want to see the stock continue to drop, but bottom fishers like me see a good value. Buying demand keeps the stock from dropping much farther. A stalemate emerges with neither the bulls nor the bears winning, so the stock just lines sideways (the B to C move).

      If the B to C move represents a highway, then CD is a pothole. It's a bear trap, though. Price drops to C and makes another bottom at D, forming a double bottom in this example. The CD move can represent any bullish pattern, like a head‐and‐shoulders bottom or triple bottom. Anyway, price climbs out of the hole and climbs and climbs and climbs (E).

      If you're lucky, the stock will rise like it did here, but don't depend on that happening. I also find this example suspicious because it happens in 2013–2014, the same period as Figure 1.3. Still, it provides the template for the pothole setup.

      The key to this pattern is the stock forming a bottom (flat base) followed by a pothole. Make sure the flat base appears after a downtrend. You don't want to go long if price trends up into the pattern (like Figure 1.5). See if you can find a reason why the stock wants to climb (during E in Figure 1.6). The reason could be a good quarter with a positive future outlook issued by the company. Maybe the cost of ingredients is going down or the company can raise prices on the goods they sell because the market for widgets is firming up.

If you look back at the figures in this chapter, they all have a flat base, a period of time where the stock goes horizontal. After that horizontal move, a pattern appears. In the first four figures, price drops (after the horizontal move). In the last two figures, a double bottom reversal sends price higher, at least for a time.

      If you research these setups (that is, find examples in the stocks you trade), that will give you the confidence to trade a similar setup when it appears in a stock you'd like to own.

      Here's another idea to help ease the research burden.

Patternz

      I wrote pattern finding software for Windows that I call Patternz and made it available for free to download and use (visit my website: www.ThePatternSite.com). One of the things it does is simulate trades. I load up a bunch of stocks, tell it to find double bottoms (as an example, but they happen often), and let the program find them. Then I look at the context: the double bottom in the surrounding price landscape. I'll guess whether to make the trade or stay in cash, and then let the stock play out. It's like day trading on the 1 millisecond scale (you control playback speed). In seconds, I'll know whether the trade made money or not.

      What I'm doing is training my brain not only to view the chart pattern, but to get a feel for the conditions where the pattern will thrive or fail. It's an easy way to train your brain to recognize winning and losing setups.

      Suppose you find a stock showing a chart pattern you wish to buy. Spend an hour searching for similar setups using the Patternz simulator and you'll be able to tell whether your trade will likely work or not.

      It's easy to find chart patterns. The Patternz software will find them for me. But having the experience to know whether they will work is what separates a seasoned professional from amateurs.

      Amateurs are the ones paying for the dreams of the professionals. Stop giving away your money. Take the time to do the research to discover when a chart pattern will work and when it won't. Then put that knowledge to use to fill your wallet or purse.

      That's how you trade chart patterns and make money doing it.

Another Way

I mentioned this setup in the introduction to this chapter. Look for a bullish pattern and buy it when it confirms. Sell when a bearish pattern appears. For example, Figure 1.7 shows a double bottom at AB. The two valleys bottom near the same price. The squiggles turn into an actual double bottom when price closes above the horizontal line. That happens at C (the breakout). The next day, D, you buy the stock at the opening price and receive a fill of 7.40.

Figure 1.7 Here is a swing trade using a double bottom and a double top.

      From then on, you look for a bearish pattern, one that