TRADINGSTOCKSUSING

CLASSICALCHART

PATTERNS

ACompleteTactical&PsychologicalGuideforBeginnersandExperiencedTradersOver100chartexamplesDetailedentryandexit

strategiesEmphasisonmanagingrisk

ThementalgameBRIANB.KIM

Copyright©2014BrianB.Kim

Formyfamily.

CONTENTS

PARTIAFRIENDLYINTRODUCTION

CHAPTER1OurGoalCHAPTER2Tradingvs.Investingvs.GamblingCHAPTER3EmotionalDetachmentandAcknowledgingOurLimitations

CHAPTER4BasicTradingTools

PARTIICLASSICALCHARTPATTERNS

CHAPTER5Head&ShouldersTopCHAPTER6Head&ShouldersBottomCHAPTER7ContinuationH&SBottomCHAPTER8Rectangle

CHAPTER9AscendingTriangleCHAPTER10DescendingTriangleCHAPTER11SymmetricalTriangleCHAPTER12ContinuationPennant(SmallTriangle)CHAPTER13AscendingWedgeCHAPTER14DescendingWedgeCHAPTER15Flags

andChannelsCHAPTER16H&STopFailureCHAPTER17DoubleBottomCHAPTER18HornBottomCHAPTER19DiamondCHAPTER20SecondandThirdEffortCHAPTER21SupportandResistanceCHAPTER22Pattern

withinaPatternCHAPTER23PatternFailuresandMutationsCHAPTER24DoNotGambleonEarningsReportsCHAPTER25BeingOutofPosition:NotTradingNoMatterHowPromisingtheSet-UpandBreakoutCHAPTER26TakingProfitsCHAPTER27Why

WeMustDiversifyOurTradesCHAPTER28TheTrader’sRoutine:ContinuousPatienceandDiligenceCHAPTER29TradingtheMarketIndexes,andALessoninStubbornnessCHAPTER3050-dayand200-daySimpleMovingAverages

PARTIIICONCLUSIONCHAPTER31LifeandTradingCHAPTER32SuggestedReading

ABOUTTHEAUTHOR

DISCLAIMER

PARTI

AFRIENDLYINTRODUCTION

CHAPTER1

OurGoal

Thisbookteachesyouhowtotrade stocks using classicalchart patterns and relatedprinciples.

Clarityandusefulness

I strived towrite a book thatcovers the classical-chartingapproach to trading in anaccessibleandcomprehensivemanner. This book givesbeginnersenoughinformationto decide for themselveswhether trading in generaland classical charting inparticular fit their interest,temperament, and style. Mygoal is similar if you are anexperiencedtraderwhowantsto learnmore about classical

charting. I tried to give youenough information so youcan decide whether to useclassical charting in yourtrading.

My focus was on clarityand thoroughness. Myexperience with most booksonstocktradinghasbeenoneof frustration and confusion.Whiletheycontainednuggetsofwisdomandsomepracticaladvice, most books did notdescribe the author’s trading

approachinenoughdetailforreaders to carefully try thatapproachforthemselves.

This shortcoming isunderstandable. Writingclearly is difficult. And I’mcertainthatsomereaderswillwish that I had explainedsomepartsofthisbookbetterorinadifferentway.Despitethe challenges of writtencommunication,IthinkIhaveclearly conveyed enoughinformation for readers to

learnclassicalcharting.Youwill find that certain

themes, reminders, andcautions are repeated quiteoften throughout the book. Itwould be too easy to justifyrepetitive writing onnecessity,but,thistime,Iwilluse this excuse. There aremany approaches to trading,but there are relatively fewprinciples that are mostimportant for long-termsuccess as a trader. I tried to

emphasize these timelesstruths in different contextsand situations for maximumretentionandawareness.

Tradingisspeculating

Beforemovingon,let’smakesureweunderstandthatstocktrading is speculating. Eventome,anenthusiasticstudentof the financialmarketswithsignificant tradingexperience, speculation at

times seems the opposite ofthrift, hard work, patience,and all things that buildanything worthwhile.Speculation seems nothingmorethanadoomedget-rich-quickschemebasedongreed,impatience,andlaziness.

This characterization,unfortunately, accuratelydescribesspeculationasdoneby many people. It is anespecially accuratedescription of my early

trading and it will alwaysreflect the truth when wedeviate from good practicesand forget the fundamentals,including controlling ouremotionsandbeingpatient.

It is obvious and true thatthere is no easy road towealthinthestockmarketoranywhere else. I don’t saythis to be condescending.When I started to trade andexperienced some beginner’sluck, I suspected trading

could be the easy road towealth. I was wrong. But Ilearned that trading can be aworthy intellectual andfinancial endeavor if weaccept the fact that goodtrading requires as muchdiscipline and resilience asanything worthaccomplishing. If we try towishaway this truth,wewillfind that trading is a mosteffectiveway to losemoney.Again, informed trading that

maximizes our chances ofsuccessisbuiltonmethodicalrisk management, continuouspatience, and never-endingdiligence. There is no otherway,andweshouldnotwantitanyotherway.

Informed speculationshould meet the followingthreerequirements:

Asystematicapproachthatisunderstandableandrepeatable.

Asystematicapproachthatallowsatradertobeprofitableoveralldespitehavingmorelosingthanwinningtrades.

Asystematicapproachthatstresseslimitinglosses,notmakingmoney,asthemostimportantpriority.

I believe carefullyapplying classical charting

principles meets theserequirements. This bookapplies those principles andwhere productive adds tothemwith theserequirementsinmind.

Classical Charting andTechnicalAnalysis

Iusesolelyclassicalchartingasatraderbecauseitprovidesa simple yet versatile andfascinating foundation on

which to trade stocks. Aclassical chartist tradesgeometric patterns such astriangles, rectangles, wedges,and flags formed by pricecharts.

Classical charting is abranch of technical analysis.Technical analysis is a fancyphrase for using the price ofstocks, or any freely-tradedfinancial instrument such asbonds and futures, to maketrading and investment

decisions. Some traders useprice and many indicators,which are themselves basedon price. I don’t use anyindicators except for theoccasional reference tomoving averages. We willlearn about moving averagesinChapter30.

Iwrote thisbook tobeasclear, practical, and self-contained as possible toeveryone who has a passinginterest in trading. Despite

this nuts-and-bolts approach,I believe that experiencedtraders can benefit from thisbook. Learning is a never-ending process.Many of themost important truths andinsights are the most basicand yet easy to forget.Learning is as much aboutretaining and remindingourselves of old truths aslearningnewknowledge.

All chart patternsdiscussed in this book are

applications of classicalcharting principles that wereexplained by RichardSchabacker in TechnicalAnalysis and Stock MarketProfits, published in 1932,and Robert D. Edwards &John Magee, co-authors ofTechnical Analysis of StockTrends,publishedin1948.

Some readers maydisagree withmy applicationof classical chartingprinciples.Thatisfine.There

is room for disagreementwhen interpreting chartpatterns. Classical chartistshave different trading stylesutilizing different entries,timeframes, profit-takingmethods, and risk tolerances.What is most important, andwhat is not debatable, ismanaging our risk andlimitingour losses.Whateverour interpretation of a chartpattern, our priority ismanaging risk rather than

makingmoney.

Thechartsinthisbook

[T]hereisnothingnewunderthesun.

Ecclesiastes1:9

My impression when I readSchabacker and Edwards &Magee’s foundational worksonclassicalchartingwasoneof fascination but also

disbelief. Sure, those simpleand elegant price patternsmay have formed in stockcharts back in the 1930s,1940s, 1950s, 1960s, andmaybe even the 1970s and1980s, but surely suchgeometric patterns are nolongerfoundintoday’sultra-sophisticated markets? Idoubted, despite my respectforSchabacker,Edwards,andMagee for writing aninteresting analysis of stock

prices,whetherbookswrittendecadesagocouldberelevanttoday.

My doubts werereasonable but I found thattheprinciplesexplainedintheclassic texts continue to beveryuseful.Thefactthatthisbook contains almost 100unique chart patterns thatformed in the U.S. stockmarket just in the pastcouple of years is proof ofthe continuing power of

classical charting. And I didnotincludeeverypatternthatI found. Also, many moretradable classical patternsdeveloped in every freely-traded financial instrument,including bonds,commodities, preciousmetals, and foreign stocks.The financial markets havebeen forming classicalpatterns for a long time andwillcontinuetodoso.

Just because a chart is

includedinthisbookdoesnotmean I traded it. I tradedmany of the patterns in thisbook but itwould have beenimpractical and unwise formetohavetriedtotradeallofthem.

When we look at thecharts, we must not getimpatient and decide to starttrading the next day. Thiscaution applies especially tobeginners. We must firststudy. The market is not

goinganywhere.This book represents an

important fact that all tradersmust remember but tend toforget: there will always bemany more great tradingopportunities. It iscrucial toremind ourselves of this factbecause we will experiencelosing streaks and becomefrustrated. When we areemotionally and financiallydown, we are more likely todo foolish things, such as

making large bets that placeall or most of our tradingcapital at risk in a desperatebid tomakeupour losses. Itis during challenging timesthat it is most important tomaintain composure andexercise strict riskmanagement.Itwillbeeasierfor us to maintain ourdiscipline and calm if wetruly believe and know thattherewillbemanymorechartset-upstocome.

If, instead, we getfrustrated because we thinkwehave“missedallthegoodtrading opportunities,” thenwewilltrytoforcesomethingin unfavorable marketconditions. Knowing thatthere will always be moreopportunities helps uspersevere through losingstreaks. And we will havelosing streaks even if wetradeonlyidealsetups.

Again, prices of financial

instruments have beenforming classical chartpatterns for many years, andthey will continue to do so.Beginners may have a moredifficult time accepting thisfactbecausetheyareeagertostart trading anddonotwanttomiss out on any “once-in-a-lifetime” trade setups thatwill make them richovernight. We must realizethat we will not get richovernight.Wemustnotthink

about how a single trade canmakeus. Instead, our goal isto patiently andmethodicallybuild our experience andcapital.

ThemoreItrade,themoreI believe that surviving andpreservingmytradingcapital,notmakingmoney,ismyfirstand only goal as a trader. Ifwecanhangaround,thenwewill always have theopportunity to swing at veryfavorable trade setups. And

theywillcome.

CHAPTER2

Tradingvs.Investingvs.Gambling

[I]nanastonishinglylargeproportionofthetradingincommonstocks,those

engagedthereindon’tappeartoknow–inpoliteterms–onepartoftheiranatomy

fromanother.BenjaminGraham

This book explains theclassical-chartingapproachtotrading stocks. But what is

trading?One way to understand

tradingistodiscusswhatitisnot.We can compare tradingto other activities such aspicking individual stocks,using low-cost stock indexfunds,andgamblinginstocksbasedon,say,hunchesortipsfromaneighbor.

Let’s first defineinvesting. Inmy opinion, forthe vast majority of peoplelooking to put some of their

savings in stocks, investingshouldmeanbuyingsharesinalow-cost indexmutualfundthat tracks the entire stockmarket and staying investedforatleast15to20years,andpreferably20to30yearsandmore. If we were to stayinvested in low-cost indexfunds for decades, we arelikely to do better than mostmarketparticipants,includingfancy hedge funds and otherprofessional asset managers.

Here is where human naturecomes in. I suspect many ofus do not like the “most”qualifier to this otherwisecompelling proposition.Rather than just doing betterthanmostpeople,wewanttobeat almost everyone. Sowedecide to look for ways tobeatthemarket.

Canwebeatthemarketbypicking stocks by ourselvesor by buying shares in anactively-managed mutual

fund run by professionalstock pickers? Individualstock selection can beinvesting, but can easilybecome gambling. Why?Because it isverydifficult tobeat the market pickingindividual stocks and tryingtodosooftenproducespoor,andevendisastrous,results.

Waitasecond,whataboutWarren Buffett? Let’s saythat Warren Buffett’sincrediblelong-termrecordis

indeedbasedonrealskillandnot mostly extraordinaryluck. By the way, I don’tthink Mr. Buffett’s record isall luck despite the fact thatI’msurehewouldagreethat,aswith anything in life, luckcan play a significant role.Consider thefollowing.Let’ssay that Warren Buffett and100 more extraordinarilyskilled stock pickers, out oftens of thousands, havebeaten by a meaningful

margin the stock market’slong-runperformanceover20to30yearsormore.Nobodycould know 20 or 30 yearsago which stock pickerswould do well. Only thoseinvestors lucky enough tohave picked and stayed withthe chosen few would beatthemarket.That is,evenif itispossibletobeatthemarket,itisnotlikelywewillfindthevery few stock pickers whowill.

We don’t have to believethat it is essentiallyimpossibletobeatthemarket.I think, however, it isimportanttoacknowledgethedifficultyofdoingso.Also,itisgoodtoknowthatlow-costindexfundsareaveryusefulinvestmenttool.

Ournextquestionmaybe:if most people who want toget into stocks should uselow-cost index funds, thendoes that mean trading is

nothing more than recklessandriskygambling?

Every form of financialactivity, from starting abusiness to buying a house,carriesrisk.Evenifweinvestin index funds, we will losemoney if the stock marketremains depressed for yearsand we are unable to stayinvested and sell after amarket decline. As withinvesting, trading can easilyslide into gambling. The

difference between informedtrading and gambling lies inthedegreeandmanageabilityofrisk.

Idifferentiatetradingfromoutright gambling on thebasis of the following twofactors.

First, skilled tradersknowthat they are speculating. Ifwe trade stocks, thenwe arespeculating rather thaninvesting. Never thinkotherwise. Traders know and

acknowledge the risks.Gamblers, in contrast, areoften under the illusion thatthey are engaging in arelatively safe investmentactivitywheninfact theyarejustprayingforamiracle.

Second, skilled traders,because they know they arespeculating, minimize theirlossesonlosingtradessothattheycanbeprofitableoveralleven if most of their tradesare losers. One $100 winner

makes up for many $10losers. Uncompromising,unsentimental, and cold-heartedmanagementofriskisthetrader’stop,andreallytheonly,priority. Ifwe limitourlosses and keep our tradingcapital intact, then we canstay in the game. And whenwe are in the game, we willalwaysfindnewopportunitiesinthemarkets.

So trading, properlydone, is neither investing

nor gambling. Thepossibility ofuncompromisingriskcontrol,which we must implementourselves, and the potentialfor profits is why I use aportionofmysavingstotradethe financial markets usingclassical charting principles.If I did not believe I had areasonable opportunity tomatch and perhaps beat themarketasaclassical chartist,then I would put all of my

savingsintosavingsaccountsand low-cost stock indexfunds. If, after studying thisbook, we do not think thatclassical chartinggivesusanintellectual framework totrade stockswhile effectivelymanaging risk, then weshould not become classicalchartists.We should not riskeven a small part of oursavings in a trading or anyendeavor that we do notbelieve in. There is no law

that requires us to be instocks in anyway.We don’teven have to invest in indexfunds. We don’t have toproveanythingtoanyoneinthe financial markets. Weshould consider becoming aclassicalchartistonlyafterwehave studied themarketsandcarefully considered thepotential risks and rewards.Weshouldtakeourtime.Themarketwillalwaysbethere.

CHAPTER3

EmotionalDetachmentand

AcknowledgingOurLimitations

Survivalistheonlyroadtoriches.

PeterBernstein

Weareoftentaught,wrongly,toavoidfailureatallcost

This chapter, in my veryimmodestopinion,isthemostimportantchapterinthebook.

Discussing the distinctionbetweentradingandinvestingand gambling highlights themost important foundationofthisbookand for traders: the

utmost importance of riskmanagement by limiting ourlosses and keeping ourtradingcapitalintact.

If risk management is soimportant, then why do somany traders fail to managerisk and suffer big andsometimes irreversiblelosses?

Because we are reluctantto admit that we are wrong.We live in a competitiveworld where failure is not

celebrated.Traders think thathonoring their stops andgetting out of a trade at arelatively small loss,repeatedly, means they areadmitting, repeatedly, to theworld that they are lifefailures. So we refuse tohonorourstopsandfailtocutour losses by exiting ourposition. Instead, we stay inuntil “we break even.” Wedon’twanttoadmitfailureona tradebecauseweare smart

and smart people don’t lose,especiallymoney.Yettradingusing classical chartingprinciples almost guaranteesthatwewillhavemorelosingtrades than winning trades.Thepointisnottohavemorewinning trades than losingtrades. The point is to haveseveral $100 winners swampmanymore$10losers.

In short, we have to bewillingtofail,andfailoften.If we think about it, we

cannot accomplish anythingworthwhile in life withoutbeingopentofailure.Letmestressthefollowing:Iamnotsaying that we have to riskfinancial ruin to be asuccessful trader. Quite thecontrary. As I have said andwill repeat many timesthroughout the book, traders’first and only priority isfinancial survival by keepingtheir trading capital intactthrough even lengthy losing

streaks to be able to bet onadvantageous trade set-upsafter gaining experience. Irepeat: I do not meanbankruptcy when I say atradermustbewillingtofail.Successful trading is aboutbeing wrong and losingmoney on many trades andyet being profitable overallbecause the losses areonly asmallfractionofourcapital.

Wemaynotreachourgoal–

andthatisfine

In addition to expecting toloseonmosttrades,Ithinkitis very important for tradersto acknowledge thepossibility that wemight notmakeitastraders.Unlessweacknowledge the possibilityof failure, we will be socaughtup in“making it”andgetting rich as traders that itwill be impossible to tradewell.Howcanwe tradewith

a clearmind and a laser-likefocus on honoring our stops,limiting our losses, andacknowledging losing tradesday after day if we tellourselvesthatourlifeandourself-worth depend on everytrade? That is too muchpressureforanyone.

This destructive potentialapplies to everything in life.It is impossible tosucceed inanything worthaccomplishing if we are

afraid of failing because wewillbetooafraidtotryortryhalf-heartedlyandtimidly.

Don’t get me wrong.Trying our best is a goodthing. But thinking that ourlife and our self-worthdepend on succeeding as atrader or anything else is adifferentthingandharmful.

There is nothing wrongwith learning about themarkets, gaining experiencein the markets with minimal

loss in savings, and decidingour interests lie elsewhere. Ifyoufindthefinancialmarketsto be as fascinating as I do,then by all means applyyourself diligently and withpurpose to become aninvestor, trader, or whateverkind of market participantyouwishtobe.Butdonotletthe markets become adestructive obsession. Thereare so many more things inlife that are far more

important.

Diversifyfinancially

So how do we avoidbecoming dangerouslyobsessed with the markets?How can we push ourselvesto follow a strict risk-managementprocessthatgetsus out quickly from losingtrades? How can we avoidthinking that our livelihood,life savings, and self-worth

depend on the next tradebeingprofitable?

Onewayistonothaveallofoureggsinonebasket.Weshould trade with only aportionofoursavings.

Another way is to havesomeincome,whetherapart-time or full-time job or ourown business. Anything willdo. There is dignity in alllabor.Makingmoneyoutsideof trading will increase ourchances of trading well.

Why?First, the money we earn

will be a source ofpsychological comfort andstrength. We will not be sodependent on trading profitstopayourbills.

Second, because ourelectricity or car paymentdoesn’t depend on “gettingout even,” getting lucky,making money on the nexttrade, or making money onmostofourtrades,wearefar

more likely to tradecorrectlyby doing the right things,mainlybyhonoringourstopsand cutting losses as quicklyaspossible.

Third, doing other thingsandhavingotherinterestsandwill get our mind off themarkets and that is a goodthing. Trading is a mentallyand physically demandingactivity because we mustconstantly fight and controlour emotions. Traders need

regularbreaks.

Diversifymentally

Ironically,notcaringsomuchand thus trading withdetachment is likely tomakeusbettertraders.Experiencedand skilled traders know thatevenastringoflossesresultsinonly a small drawdownoftheir capital if they strictlylimittheirrisk.Thus,theydonot worry about every dollar

and do not obsess overgettingoutofabadtradeonlyafter breaking even. Theyquickly cut their losses andmove onto betteropportunities. They remaincalm through winning andlosing streaks. They are nottoo excited about profits noranguished by losses. Theyfocus on trading well andcutting losses on the next1000tradesandbeyond.Thisvirtuous cycle is every

trader’sgoal.In short, not caring so

muchabout theoutcomeofany individual trade is thesecond crucial foundationthat complements riskmanagementinthetrader’stoolkit.

By all means tradersshould put much effort intostudying the markets andcontrolling their emotions.We must exercise strictdiscipline to trade only

compelling set-ups. But afterallthepreparation,study,anddeliberation, we have to letgo. We have to say toourselves and believe, “I ambiggerthanthistrade.Mylifeis much more than how thistrade turns out or evenwhether I succeed as atrader.” This exercise is notjustamentaltricktomakeusbetter traders. It is the truth.Do we want our lives to bedefined by a series of trades,

nomatterhowprofitable?Oreven a lifetime of successfultrading? Do we really thinkwe are a failure if we don’tsucceedasa trader? Itwouldindeedbealowbartodefineour life based on a series oftradesorwhetherwemake itas a trader.Wehave amuchbetter chance of succeedingastradersifwedon’tmakeitour sole occupation, passion,andinterest.

I often think a 5th grader

could be a formidableclassical chartist likely tooutperform most adulttraders. The kid hunts forwell-formed chart patternsandpicksone.Afterenteringa trade, the mentor tells thekid: okay, go out and play.Exploretheplayground.Rideyour bike. Just go have funand forget about this trade.Eat five scoopsof icecream.Play catch or tag. Linger intheyardasthesunsets.We’ll

comebackinacoupleweeksandseewhathappened.Ifthetradewasprofitable,sobe it.If the trade failed, thenwe’llmove on to the nextcompellingchartpattern.Thiswouldbeanexcellenttradingroutine.

Yes, we should devoteserious effort to studyingclassicalchartingbutwemustalsoliveourlife.Thetruthisthat the best books onclassical charting are not

difficult. The principles andsuggestions are logical andstraightforward. The greatdifficultyisrememberingandfollowing the rules becauseour emotions will constantlypush us to bad tradingpractices. We will find itnecessary to constantlyreview and remind ourselvesof good trading practicesbecausewe tend to forget soeasily and we are so verystubborn. We are our own

worstenemy.SoIamsuggestingthatwe

beopentothepossibilitythatwe may not be successfulover the long run as a charttrader. I believe thisacknowledgement increasesmy chances of being asuccessful trader over thelongrun.Bytradingwithjusta portion of my savings,pursuing other opportunitiesand interests, andcontinuously acquiring

diverseskillsandknowledge,I am not so emotionallycaught up on the success ofmy trading. And thisdetachmentiscrucialtotradewell.

Somereadersmightaskifsuchacknowledgementofourlimitations sets us up forfailure.Thereisachancethatwewillnotcommitseriouslyto studying the markets andtradingwell ifwehaveotherplans.Wouldn’titbebetterto

say there is no turning backoncewestarttrading?Idon’tthink so. Optimism is good,but it must be balancedwithplanning and prudence,especially in trading. All ofuswill fail atmany things inlife, and someofusmaynotbecome successful traders.Failure in trading doesn’tmake us a bad person, norshould it mean losing oursavings.But I believe a “do-or-die” attitude in trading

makes a large financial lossmuchmorelikely.Weshouldbematureenough to tackleanew challenge like tradingwithout confusing thenecessary dedication andpatience with a destructive“my self-respect depends onmaking a fortune in trading”attitude. Mix energy anddedication with intellectualmodesty, maturity, andperspective. Adopting thisoutlook is not preparing for

failure but wiselyacknowledging that wecannot know everything andthat it is smart toprepare forcontingencies.

Benjamin Graham’s doubtsaboutfundamentalinvesting

Letmemakeonemoreappealforintellectualmodestyinallourendeavors.ConsiderwhatBenjamin Graham, a greatinvestorandWarrenBuffett’s

teacher, said about hisprofession(pickingindividualstocks with the goal ofbeating the broader market)in his book The IntelligentInvestor:

[W]emustconsiderthe possibilities …of makingindividual [stock]selections whichare likely to provemore profitable

than an across theboard average.What are theprospects of doingthis successfully?We would be lessthan frank… ifwedidnotattheoutsetexpresssomegravereservations onthis score. …[T]here isconsiderable andimpressive

evidence … thatthis is very hard todo,eventhoughthequalifications ofthose trying it areof the highest.(emphasisadded)

If the founder of value

investing acknowledges thestiff and perhapsinsurmountable challenges ofstock picking, then perhapsclassical chartists shouldalso

consider the limitations ofcharting.Grahamdidnot saythat itwasimpossibletobeatthemarketalthoughIthinkhecameveryclosetosayingso.He said it was very difficultto beat the market and thatintelligent investorsmust nottake unintelligent risks whiletrying. “Margin of safety”was one of Graham’scontributionstoinvesting.Byinvesting in stocks with abuilt-inmarginofsafety,and

it is not easy to find suchstocks, investors reduced theriskoflosingmoneybutwerenotguaranteedofbeating themarket.Similarly,traderscanincrease their odds of, butnever guarantee, long-termsuccess by minimizing theirlosses and only making betson chart patterns with ahighly favorable reward-to-riskpossibility.

The point of quotingGraham is not to say that

Graham urged stock pickerstoabandonfundamentalstockanalysisandbecomeclassicalchartists. He did not. Mypoint is that intellectualmodestyisimportant.Realizethat we are wrong often andthat we do not have all theanswers. It is wise andprudenttonotstakeallofoursavingsonone investmentortradingapproach.

Benjamin Graham on chart

tradingGeniusiseternalpatience.

Michelangelo

Sofewsucceedinthemarketbecausetheywanttogetrich

quickly.

JesseLivermore

What Graham did say abouttechnical analysis andcharting inSecurityAnalysis,his foundational book onfundamental investing, isvery interesting andinformative:

Undoubtedly, therearetimeswhen thebehavior of themarket, as revealedon the charts,carried a definite

and trustworthymeaning ofparticular value tothose who areskilled in itsinterpretation. Ifreliance on chartindications wereconfined to thosereally convincingcases, a morepositive argumentcould be made infavor of ‘technical

study.’ But suchprecise signalsseemtooccuronlyat wide intervals,and in themeantime humanimpatienceplustheexigencies of thechart reader’sprofession impelhim todrawmorefrequentconclusions fromless convincing

data. (emphasisadded)

The point is not that

Graham embraced chartingalthoughit isveryinterestingthat Graham, the father offundamental analysis, saidthat charting can be useful.Graham’s critique points toone of the most importantingredients for success intrading, investing, and manythingsinlife:patience.

As traders, we willperiodically lose focus anddiscipline and makesuboptimalbets.Weweretooimpatient to wait for thecharts to tell a clear picture.Thenweareeagertomakeupthe losses by making morebets on unfavorable set-ups.Weareafraidthatifwedon’ttrade these suboptimalpatterns then themarket willnot offer any more tradingopportunities. We lose more

money and the destructivecycle continues. And we aretoo exhausted mentally andfinancially to take advantageoftheinevitablereappearanceoffavorableset-ups.

If there is only one thingwe get out of this book, thatone thing should be theconfident knowledge thattherewillalways,always,andalways be new tradingopportunities.Bepatient.Themarket is not going

anywhere. Patience gives ustheultimatefreedomtoplacebets only on favorable tradeset-ups. It is accurate todescribe the trader’sroutine as not one ofconstantly trading butmostly waiting, observing,andwaitingsomemoreandonly intermittently enteringtrades.Incidentally,whenona losing streak, closing allpositions and walking awayfrom the screen for a couple

ofdaysorevenweekscanbeveryhelpful.Themarket,andnew opportunities, willalwaysbethere.

Let’s conclude. The mostimportantwayIrecognizemylimitations – that I may bemomentarily lucky, thatclassical charting may be atrading approach with deepflawsthatIdon’tknowabout,or that even if classicalcharting is an effectivetradingmethod Imay not be

good enough to consistentlyprofit from it over the longrun – is that I diversify mysavings.Regardlessofmarketconditions,Ionlytradewithaportionofmysavings.

Knowing that I have afinancial cushion gives methe confidence to takecalculated risks. Andinformed speculating is noneother than taking risks thatoffer a potentially large gainat the risk of a relatively

smallloss.

Wrapup

ExperiencedtradersmayskipChapter3whereIdiscussthemostbasictoolsoftrading.

IwroteChapter3becauseIwanted everyone, includingpeople who have neverlookedatastockchart,tofeelcomfortable learning abouttrading stocks using chartpatterns.Whilemy goal was

not to write an encyclopediaon trading, my goal was togive the novice trader asinviting a learningenvironmentaspossible.

Mygoalisnottomakeallof us classical chartists. Mygoal is todomybest tohelpus decide whether we mightconsider trading stocks usingclassical charting. If wedecideafterreadingthisbookthattradingisnotforus,thenweshouldbeproudofhaving

made the effort to explore anewidea.

CHAPTER4

BasicTradingTools

Simplicityistheultimateformofsophistication.LeonardodaVinci

Barchart

Let’s start from thebeginning. What is a pricechart?ThefollowingchartofCray Inc. (the supercomputermaker) is an example of astock’spricechart.

This price chart records

the price history of Crayusingpricebars.Apricechartthat uses price bars is alsocalledabarchart.Whilethereare otherways to visualize astock’s price history, I preferpricebarsandbarcharts.

Let’s examine thecomponents of the price bar.Lookat the longpricebar inCray’spricechart.Thetopofevery bar tells us the highest

price at which the stocktraded that day and thebottomof thebar tellsus thelowest traded price of theday. The short horizontalhypen-like line sticking outon the left of the price bartellsusthepriceatwhichthestock opened for trading thatday. And the short linesticking out on the right sideof the price bar tells us theclosingpricefortheday.

Timeframes

I use daily, weekly, andmonthly price charts in mytrading. I use weekly andmonthly charts to get a big-pictureviewofastock’spricehistory while I use dailycharts tomakeentryandexitdecisions. On weekly andmonthlycharts,eachpricebarrepresents a week’s andmonth’s worth of trading,respectively.

I almost never look attimeframes shorter than aday. I don’t lookat 1-minuteor 15-minute charts. Ioccasionally look at 1-hourcharts.

I do not intentionally daytrade although sometimes aposition I entered in themorningmay be stopped outbytheendofthedayandthissame-day round-trip is a daytrade.

Chartingprograms

Let’s talk about onlinecharting programs. Chartingprograms displaycontinuously updated pricecharts of stocks and otherfinancial instruments. I useTC2000’s charting servicebecause I have found it easyto use with good customersupport. You may choose touse another charting packageasthereareseveralgoodones

available. Be sure to trydifferent services and choosethe one that you feel mostcomfortable with. I likesimplicity, and I have foundTC2000 allows me to keepthings as simple as possible.Ontherightsideofmymainmonitor is my list of stocksthatIscrollthroughwhiletherestofthescreendisplaysthepricechart.Iuseahorizontalstrip at the bottom of myscreen to view volume bars.

That’s it. I also haveconvenient tab buttons that Ican click to switch betweendaily, weekly, and monthlycharts.

Again, experiment andchooseachartingservicethatmakesthingseasyforyou.

Understand that classicalcharting does not require usto install 20 screens showingdozens of indicators.Successful chart trading doesnot require fancy chart

programs and expensiveequipment.

Themost important battlewill not beon the screenbutinourminds.

Onlinebrokers

I use two discount onlinebrokers. I have my tradingcapitalsplitintotwoaccountsas a form of diversification.Nothavingallofmyfundsinone location acts as a brake

duringboutsofgreedandfearand helps prevent rashdecisions. There are severalgooddiscountonlinebrokers.As with charting programs,weshouldtryseveralofthemand then choose. We maysimply choose the brokerwiththelowestcommissions.That is perfectly fine.Wedonot need fancy brokers withhigh commissions to tradewell.

Online brokers are in a

fiercecompetitiontoearnourbusiness. After we havetradedwithabrokerageforawhile, we can call customerserviceandaskforadiscountonthecommissionrate.Evenif a brokerage advertises itscommission as, say, $9 atrade, it will be open tooffering us a lowercommission to keep ourbusiness. One ofmy brokersreduced my commission by30%.

Ourchartingprogramandbroker should always play amere secondary role in ourtrading. No amount of high-end customer service or themost sophisticated chartingfeatures will guaranteeprofits.Howwellwe controlouremotionsandapplygoodtrading practices willdetermine our long-termsuccess. Keep it simple andbepatient.

We’reready

Now we know how to readthepricechartofastockthatis displayed on our chartingprogram.Andwearereadytospotpatternsonastockchart.At first we may see patternswhere none exist. We willforce meaning onto a chartfor the sake of finding apattern.Wemighteven thinkthatallgoodpatternsaregoneandthatwewillhavetoforce

it to make money. We willalways bewrong ifwe thinkthat good patterns will stopforming. We need to bepatient.

Spotting classical chartpatterns does not guaranteeprofits.Justbecausewefindatextbookchartpatterndoesn’tguarantee that we willsuccessfully manage ouremotions to properly enterand manage the trade. Also,the “perfect” chart pattern

may fail to break out or failafter breaking out andtransform into somethingentirely different. The onlything we can do is to entercompelling set-ups withadvantageous reward-to-riskpossibilities and, as wediscussedinChapter3,letgo.

Let’sbegin.

PARTII

CLASSICALCHART

PATTERNS

CHAPTER5

Head&ShouldersTop

The first classical patternwe’ll look at is the Head &Shoulderstoppattern.AH&Stop can form after asignificant uptrend andindicates a possible trend

reversal that leads to a pricedecline.

Boeing:2-yearH&Stop

The following weekly chart,where each price barrepresents a week’s pricerange, shows a massivetextbook H&S top thatformed in Boeing fromMay2006 to June 2008 with adecisive breakdown thatpenetratedthenecklineinlate

June2008:

FIGURE1

A valid H&S top pattern

must have 3 peaks with themiddle peak, the head, risingabovetheshoulderpeaksandthe two shoulders must havesomeoverlapinprice,andthemore overlap the better. Thepattern should form after asignificant rise in price. Thatis, a reversal pattern musthavesomething to reverse.AH&S top’s neckline connectsthe bottom of the left

shoulder to thebottomof thehead. A H&S top iscompleted when pricesdecisively close below theneckline after forming therightshoulder.

Beyond these essentialfeatures, there are manyvariationstotheH&Stop.Aswegainexperiencelookingatcharts,wewill learn to focusour attention on well-formedpatternsandignoretherest.

Every chart offers

important lessons. Some ofthe takeaways fromBoeing’sH&Stopare:

First, we, especiallybeginners, should strive totrade only chart patterns thatare as well formed as thisH&S top. Of course justbecauseapatternistextbook-perfect doesn’t mean thepattern will work and beprofitable. In fact, even“perfect”-looking patternswillfailmostofthetime.The

point is that we should notforce meaning onto chartswherethereisnone.Wemustnot project our hopes,dreams, and wishes ontocharts. Classical chartpatterns that are potentialcandidates for trading shouldbeclearlydefinedandeasytospot. There was no doubtwhenlookingatFigure1thatBoeing was forming apossibleH&Stoppattern.

Second, aweekly chart is

avaluablewaytoseethebigpicture. Though I makealmost all entry and exitdecisions based on a stock’sdaily chart, I always checkthe weekly chart to get asenseoftheoverallcontextinwhichapatternisforming.

Thismassive H&S top inBoeing was so big that atrader would have likelymissed this toppingpattern iflookingonly at adaily chart.Itwouldhavebeena caseof

losing sight of the forest forthetrees.Andwhilesuchbigpatterns are not verycommon, they are commonenough to justify the regularreviewofweeklycharts.

Third, and this point willbe stressed many times, wemust be patient. Manypatterns take months andsometimes, like Boeing’sH&S top, years to develop.While therearemanyshorterpatternsrangingfromdaysto

several weeks discussed inthis book, know thatsignificant reversals of trendtake time to develop. Alsonote how prices entered anarrowtradingrangeforthreemonths after breaking downthrough the neckline. Threemonths is a long time to bestaringatourscreeneverydaywaiting for the big movedown.Thesmarttraderwouldenterthetrade,setastop,andgodootherthings.Ofcourse

Boeing’s stock could havemoved up and triggered ourstop-lossorder.Ifso,sobeit.We incurredasmall lossandwould move on to other set-ups.

Apple:5-weekH&Stop

Our next H&S top is a 5-week pattern that formed inApple from September toOctober of 2012. This H&Stopwas small in sizebutnot

in effect as it started a 40%pricedeclineinAppleshares:

FIGURE2

What can we learn from

thispattern?First, every principle has

exceptions. While majorreversal patterns can takemonths or years to develop,theycanalsoformquicklyasit did in Apple. Thus, wemust never place a betwithoutregardtoriskrelyingonarulethatis“supposedtowork.” There is no suchthing. Price is the ultimate

rule.Second, we should never

ignore H&S patterns,including small ones. H&Spatterns are one of the mostreliable classical patterns.TheyarealsooneofthemostversatilepatternsbecauseifaH&S top doesn’t work, a“H&S top failure” is adistinct pattern that can offercompelling tradingopportunities. We’ll coverH&S failure patterns in

Chapter16.Third, notice that prices

broke down through thenecklineof theH&S topandthe 1-year trendline at thesame time. Such interestingcoincidences are common inclassical charting. The factthat these two developmentscoincided did not guaranteethat the pattern would work.But, at least in my mind,these twin developmentsincreased the likelihood of a

powerfultrendreversal.Fourth,notethehardretest

of the neckline. Retests areprice reversals afterbreakout that re-challengethe breakout boundary.Here, after breaking downthrough the neckline of theH&Stop,pricesreversedandclosed slightly above theneckline before breakingdown in a sustaineddowntrend.Someretests leadtopatternfailurewhileothers

stop at or short of thebreakout boundary. Allretests challenge our poise.We cannot know if or whenretests will occur. We mustbereadyforthem.

Afterweviewsomemorecharts to get a feel forclassical chart patterns, wewilldiscuss indepthhowwecanenter tradesandsetstop-loss orders. There is no rulethatworksideallyeverytime.Fornow,knowthatretestsof

key pattern boundarieshappen often and that theonly thing we can control isourentryandstoppoints.

Lastly, let’s discuss shortsales of stocks. Shortingallowsa trader toprofit frompricedeclinesinstocks.Sincethere are both bullish(pointing to a possibleincreaseinprice)andbearish(pointingtoapossibledeclinein price) classical chartpatterns, buying and shorting

stocks allows us to use thefull range of classicalchartingtools.

That said, I understandsome of us may beapprehensiveaboutshortingastock, especially if we havenever done so. I wasunfamiliar with the conceptof shortingwhen I started totrade. Some of us may haveethicalobjectionstoshorting.We don’t have to shortstocks, but we should make

our decision after learningaboutshorting,and,ifweareopen to it, trying some verysmall short sales to gainfamiliarity.Weshoulddecidebased on knowledge ratherthanfear.Andifwedecidetoadd shorting to our tradingkit, we can always trade asmallersizewhenshortingasIusuallydo.

ICA:11-weekH&Stop

As noted, there are manyvariations to each classicalpattern. The following H&Stop in ICA, a Mexicanconstructioncompany,showsoneofmy favoritevariationsinaH&Stop:

FIGURE3

First,notetheheadofthis

4-monthH&Stopwasitselfasmaller H&S top pattern. Ifind this pattern-within-a-patternveryinterestingjustasa visual phenomenon. It canalsohavegreatpracticalvalueas it can offer us theopportunity to enter a tradeearlier than otherwise. Forexample, here, we mightconsidershortingsharesuponthecompletionofthesmaller

H&S top pattern, thenperhaps shorting additionalsharesuponcompletionofthelarger H&S top. Everysituationwillbedifferent,andjust because we have apattern-within-a-pattern doesnot mean we will have anearly, or any, entryopportunity. And we mustremember that even themostpromising textbook patternsfail,andfailoften.

Second, note the down-

sloping neckline. Necklinesand key boundaries need notbe perfectly horizontal. Theycan be up-sloping or down-sloping. I prefer to tradepatterns with boundaries thatare as horizontal as possiblebecause they clearly indicatethemajorhighsandlowsthatmust be overcome for adecisive breakout. We willtalkmoreabout themeritsofhorizontalvs.slantingpatternboundariesinlaterchapters.

Third, despite there beingmany legitimate andcompelling variations to thetextbook H&S pattern, weshould try, especially asbeginners,tostickasmuchaspossible to trading patternsthat resemble the textbookform.Too often traders labela chart as a H&S top eventhough none of the basicrequirements of the patternaremet. Traders who appearin themedia arenot immune

from making this error. Ithinkitisbeneficialtofollowthe principles spelled out bySchabacker and Edwards &Magee, especially regardingpatternshape.Idonotfolloweverything that the foundersof classical charting say intheir books, but I do followtheir physical requirementsfortheclassicalpatterns.

LifeLock,Inc.:2-monthH&Stop

ThenextH&Stopisachanceto apply what we learnedfrom Apple’s H&S top. Wesee LifeLock breaking downfrom a H&S top, and thisbreakdowncoincidedwiththebreaking of a yearlonguptrendline:

FIGURE4

The next chart zooms in

ontheH&Stopandbreakoutarea:

FIGURE4.1

Let’stalkabouthowmuch

we might risk on a trade. Itseems most professionaltraders risknomore than1%of their trading account on asingle trade. I think mosttraders and especiallybeginners should not riskmore than 0.4% to 0.8% oftheir account on a trade.While our risk tolerance andtrading capital will vary, wemustpursueriskmanagement

andthelimitationoflossesasourmostimportantgoals.Forexample, if our tradingaccount is $50,000, weshould risk no more than$200 (0.4% of $50,000) to$400 (0.8% of $50,000) onany individual trade. Theseare general guidelines and Ithink the more cautious weare,thebetter.

Let’s use the next chartthat shows a H&S top thatformedinQQQ,theETFthat

tracks theNasdaq100 index,to see what these riskguidelines mean in terms ofthenutsandboltsofenteringandexitingatrade.

Classical patterns form inthe major stock indexes andtheETFs that track themjustas in individual stocks. Ialways watch closely theindex ETFs – SPY for S&P500, QQQ for Nasdaq 100,DIAforDowJonesIndustrialAverage, and IWM for the

Russell2000index–togetasense of the overall market.While I trade mostlyindividualstocks,Ialsoknowthat most stocks move withthe overall market. So if themarket indexes are droppingsharply, then I will be morecautiousabouttradingbullishset-ups.

QQQ:6-weekH&Stop

The following chart shows a

H&S top that formed inQQQ,theETFthattrackstheNasdaq 100 index, fromAugusttoOctober2012:

FIGURE5

If we have a $30,000

tradingaccountandwedon’twant to riskmore than 0.7%of our account on any singletrade, then we have $210(0.7%of $30,000) to risk onthis H&S top. Let’s say thatwe decide to short shares atthe breakout day’s closingprice of 67.26. Where mightwe place our buy-to-coverstop order that will cut ourlosses should the breakout

reverseandthepatternfail?Iuse the last day rule, aconcept I learned from PeterL. Brandt, to place most ofmystops.Howdoesitwork?Forshorttrades,weplaceourstopjustabovethehighofthelast day in which pricestraded above the breakoutboundary.Forlongtrades,weplaceour stop just below thelow of the last day in whichprices traded below thebreakoutboundary.

Here, following the lastday rulewouldmeanplacinga stop just above 68.18, say,at 68.20 or so. Some of usmay prefer to give morecushion to our stops. If wedo, then we must keep ourpotential loss within ourmaximum risk tolerance.Notethatabuy-to-coverstoporderat68.20isveryclosetoandbarelyabovethenecklineof the H&S top. A stop at68.20seemsatriskofgetting

triggered by mere normalprice volatility in QQQ.Indeed, QQQ experienced ahard retest after breakingdown through the neckline.While prices did not closeabove the neckline, they didtrade above it by trading ashighas68.30.Placing a stopat68.20oreven68.25meantwegotstoppedout.

By the way, there isabsolutely nothing wrongwith getting stopped out.

Remember,classicalchartistscan have more losing tradesthan winning trades and stillbe profitable overall. Riskmanagement, not profits, isour priority. So gettingstoppedoutforaverymodestlossmeans we aremanagingrisk.

As we noted, every rulehas exceptions. While Ifaithfully apply the last dayruleinmostofmytrades,theparticularities of this H&S

topmeantwehadtoconsiderplacingourplaceastopabitfarther away from theneckline to account fornormal price volatility,includingapossibleretest.Sowe modify the last day rule.Here, I would look at thepricerangeonthedaybeforethe breakout. The closingprice on the day before thebreakoutwas68.35.Placingastop just above this closingprice, say, at about 68.37 or

68.40, isareasonablechoice.Ifwewantevenmoreleeway,thenwemaychoose toplacea stop just above the high ofthe day before the breakout.Remember that the moreleeway we give a trade, themore likelywehave touseasmaller position to keep ourpossible loss under ourmaximum-risklimit.

Every chart presentsdifferent entry and exitscenarios. Still, I have found

inmytradingthatthelastdayrule usually works very wellby placing my stop at areasonable distance from thebreakout boundary and fromnormal volatility and fromeventhereachofhardretests.When the last day rule doesnot produce a satisfactorystoppoint,Iimprovise.HowIimprovise is far lessimportantthanthatIkeepmypossible maximum losswithin my risk tolerance.

Sometimeswe’ll justhave topick a spot. Nothing canprotect us from prices justbarelytriggeringourstopandthen reversing and making apowerfulrun.Wemustnotletsuch events frustrate us toomuch.Suchhit and runswillhappentoeveryonenomatterwhatruleweusetoplaceourstops. There is nothingmagical about the last dayrule. It is simply a tradingtool to manage risk. Some

trades work out and otherswillnot.Wemustacceptthisreality. Such ever-presentuncertainty is the price wepay to limit our losses andstayinthegamelongenoughuntil we gain enoughexperience to take advantageof great market conditions.Remember, therewill alwaysbeothertrades.

Let’sgobacktotheQQQset-up.Let’ssaywedecidetoplace our stop at 68.37, just

abovetheclosingpriceoftheday before breakout. Weshorted shares at 67.26 andplacedourstopat68.37.Thatmeans we are risking $1.11for every share of QQQ thatwe short. If we have a$30,000accountandwewanttorisknomorethan0.7%onany single trade, then wehave $210 to risk for thistrade.Divide $210 by $1.11,the distance in dollars from67.26 to 68.37, and we get

189.1. So we can short 189shares and likely limit ourpotential loss to $210 at ourchosen entry (where weshorted) and exit (where wemay buy to cover) spots. Ialways like to stayundermymaximum risk, so I wouldshort only about 180 shares.Ofcourse,wemaychoosetofurther reduce our positionsize. A 180-share shortpositionis themaximumsizegivenourriskparameters.

There are several morepointstodiscuss.

First,tradingcommissionswill be another cost. If ourbrokerchargesus,say,$8pertrade, that means our roundtrip trading costwill be $16.Commissions add up. Theyare another reason why weshould trade only compellingset-ups.

Second,wemaylosemorethan we had planned if astock gaps up or down. A

gap up happens if, after weshorted180sharesofQQQattheclosingpriceof67.26andplacedabuy-to-cover stopat68.37, the next day QQQstarts to trade at, say, 69.50.Thisovernightprice jumpupthat produced a gap betweentoday’s and yesterday’s pricebars is called a gap up. Anovernightjumpdowninpriceis a gap down. The result isthat instead of losing only$1.11 a share, we would be

stopped out with a loss of$2.24 for every share weshorted for a total loss of$403.20 plus tradingcommission. We lost almosttwice as much as we werewilling to risk on this trade.This scenario doesn’t happenoften but it is commonenough that we must alwaysbe mindful of it and is onemore reason why we mustalways diversify our tradesandneverbetourentirestake

on one or even a series oftrades. It is perfectlyacceptable and expected tolose more than we hadplanned on some of ourtrades. What is important isthat such greater-than-expected losses, which areunavoidable at times foreveryone,meannothingmorethanminoradditionallosses.

Third, we might havenoticed that Ididnot includethevolumebarsforthecharts

we have analyzed so far. Ihaveincludedvolumebarsinlater charts where I thoughtvolume was one of thedecisive factors in making atrading decision. But Ipersonally have found thatvolumeisoftennotadecisivefactor inmany ofmy trades.Edwards&Magee stress theimportance of volume. Andvolume is often a vital clue,especially in situations whenthe volume conforms to the

textbookdescriptionslaidoutby Edwards&Magee. But Ihave found that textbookclassical patterns form andwork a lot of times withoutvolume confirmation. So,volume, while important, isonly one factor in mydecision-makingand the lackof volume confirmationdoesn’tdisqualifyapatterntome. In short, volume is likeany other factor in tradingand classical charting: it is

not a guarantee that “must”and “should” work. Priceswilldowhatevertheywanttodo. Risk management is theonlythingwecancontrol.

However, volume isalways a crucial factor inthinly-traded or low-volumestocks.Thinstockstendtobemorevolatileandmorerisky.I often pass on a promisingpattern developing in a low-volume stock because theextreme volatility makes

entering and exiting a tradewithinmy riskparameters sodifficult. The lure of thinstocksisthatpowerfulmoveshappen quickly and thus wemay make a lot of moneyquickly.ButIhavefoundthatit ismucheasier to losea lotof money quickly with thinstocks.SoIusuallystayawayfromthem.

Fourth, where might wetake profits if the trade issuccessful? So far, we have

concentrated, properly, onplacingourstoporderssothatwe limit our losses if thetrade fails. While riskmanagement isour firstgoal,wetradetomakemoney,andtakingprofits is an importantskill. Classical chartingprovides a general guidelinefor takingprofits in the formof thesizeof thepattern thatlaunches the up or downmove. The height of aclassical pattern’s widest

point is used to project or“measure” the possible up ordown move from thebreakout point. So, in theH&StoppatterninQQQ,wemeasurethedistancefromthetop of the head to theneckline and project thatdistance down from thebreakout point. Thismeasurementistheminimummovethatcouldhappen.

But, again, as with all“rules” in classical charting,

these profit-projections aregeneralguidelines.As Ihaverepeatedandwillrepeatmanymore times, the only thingtraders can control is riskmanagement. Patterns, evenafter decisive breakouts, failoften. When prices, after adecisive breakdown from atextbook H&S top pattern,reverseandgostraightup,wemust take our small lossaccording to our pre-determined stop-loss level

and get out of the trade.Wemustnotstayinthetradeandrefuse to take our nowrapidly-growing lossesbecause “the measurementrule guarantees that priceswill soon go in the rightdirection (down) again andproducetheprojectedprofit.”Wrong.Theonlyguaranteeinthe financial markets is thatrisk, indeedcatastrophic risk,is everywhere. Traders workwith this harsh reality, but

traders can do so on theirterms by always diversifyingtheir trades, always honoringtheir pre-determined stops,and getting out with a smalllossif thetradedoesn’tworkout.

We said that the generalrule is that the projectedmove is the minimum movethat could happen. Lookagain at the small H&S topthatproducedamassive40%decline in the price ofApple

shares. The takeaways fromApple’sH&Stoparethatweshould never ignore a H&Stop pattern whatever its sizeand that there is no correctanswer as to when to takeprofits.Therewas noway toknowthatthissmallH&Stopwouldleadtoa40%decline.Ifwetookprofitsaftera20%decline and happily lookedelsewhereforother tradeset-ups, then we should not beangry or embarrassed about

the stock continuing to drop.Evenherewemustrememberthattherewillalwaysbemoreopportunities.

CHAPTER6

Head&ShouldersBottom

The head and shouldersbottom pattern is just that: aH&S top pattern turnedupsidedown.

Caesars Entertainment: 5-

monthH&Sbottom

HereisourfirstH&Sbottompattern:

FIGURE6

TheH&Sbottomhasthree

valleys with the middlevalley, the head, deepest.NotehowthisH&Sbottom’sright shoulder took the formof an ascending triangle.Wewill discuss ascendingtrianglesinChapter9.Sowehave another pattern-within-a-pattern and a decisivebreakout from the ascendingtriangle coincided with thebreakout from the H&S

bottom. As we will see hereandinothercharts,themorepowerful the breakout, themoredifficultitcanbe,andsometimes too risky, toenter the trade. The nextchartfocusesonthebreakoutfromtherightshoulder:

FIGURE6.1

Caesars Entertainment’s

stock jumped 11.5% on thebreakout day. Buying sharesataroundtheclosingpriceofthe breakout day and placingour stop just below the lowmeant risking over 11% ofour position. That is a lot toriskandIwouldavoidtradingsuch a set-up unless thepattern was very promisingandthebreakoutdecisive.Asthis H&S bottom had good

formandproducedadecisivebreakout, I would look totrade this breakout if I canbuy a reasonably-sizedpositionwhile stayingwithinmyrisklimit.

If our trading account is$50,000andwedon’twanttorisk more than 1% of ouraccount on any single trade,that means we have $500 toriskonthis trade.Enteringat8.71 and placing a stop at7.80 means risking $0.91 on

everyshareofCZRstockwebuy. We divide $500 by$0.91andget549.So,wecanbuy around 540 shares for$4703 and stay under ourmaximum risk barring anygapdownsinprice.(Iusuallyround down to account forcommissions and to get aneven number.) I think thisentryandstop-lossplacementconstitutes a prudent andpromising trade given thepatternandbreakout.

Therearealternativeentryandexitstrategies.

One option is to buy alarger position at the closingprice of 8.71. Assuming thesame $50,000 account, howdowe risk nomore than 1%of our account on this trade?We move our stop up andplace it closer to thehorizontal upper boundary ofthe ascending triangle. If weraise our stop to, say, $8.08,ratherthanputtingitat$7.80,

then we can buy 790 sharesfor$6880andstaywithinour$500maximumrisk.Ididnotuse a magic formula to pick8.08 as an alternative stopplacement. I picked 8.08because it seemedreasonablyfarbelowtheupperboundaryof the ascending triangle tonotgettriggeredtooeasilybynormalvolatility.Thatsaid,ahard retest or even justnormal volatility has amuchhigher chance of triggering a

stop at 8.08 than at 7.80. Ifourhigherstopsurvives,thenwe make more because wehave a larger position.But ifprices trigger our stop andthen turn around and shootup, then we lose $500 andmiss a 60% surge in twodays. We took a calculatedrisk and lost. But we tradedthe set-up well. We took agood swing at a compellingset-up while staying withinour risk parameter. We

sufferedaminor lossandwemove on to the nextpromisingpattern.Wecannotcontrol prices. We can onlycontrolhowwemanagerisk.

There is a second option.We can place a buy-stoporder in anticipation of abreakout from the rightshoulder. So far we havediscussed stop orders in thecontext of getting out of atrade if the trade doesn’twork.Stoporderscanbealso

beusedtoentertrades.IntheH&S tops discussed above,we could have placed a stoporder to sell short a chosennumber of shares at a levelsomewhere below thenecklines. Such an orderwould be filled by ourbrokersifpricestradedatthatlevel.

For CaesarsEntertainment’sH&Sbottom,we can place a stop order tobuy a certain number of

shares at a price somewhereabove the upper boundary ofthe ascending triangle rightshoulder:

FIGURE6.2

Let’s say we choose to

place a buy-stop order at8.30, which is above thehorizontal boundary of theright-shoulder ascendingtriangle and just below theslightlyascendingnecklineofthe larger H&S bottom. Ifprices trigger our buy-stoporder at 8.30 andcontinue togo up to break out of theH&S bottom, then we havethe advantage of having

entered earlier at a lowerprice. Entering earlier meansthat we can buy a largerposition and still place ourstop below the low of thebreakout day. If we have a$50,000 account andfaithfully follow themaximum 1% loss per traderule,wehave$500toriskonthis trade. Entering the tradeat8.30andplacingourstopat7.80 means I can risk $0.50pershare.Wedivide$500by

$.50 and get 1000. We canbuy 1000 shares, which is a25% larger position thanbuying at 8.71 and using ahigher stop, for $8300 pluscommissionsandyetgiveourposition much more cushionto survive normal volatilityand even hard retests. Wealsohavethepotentialtoearnsignificantly more profitsshouldthetradework.

Importantpoint:wheneverI use a stop order to enter a

trade, I always use it as partof a One Triggers Another(OTA) order. For example,thenightbeforewhatmaybethe breakout day for CaesarsEntertainment’sH&Sbottom,I enter a stop order to buy1000 shares at 8.30 that,when triggered, entersanother order, a stop-lossorder that will trigger if thebreakout fails and pricesdecline tomypre-determinedstop level. Every trade must

haveanexitorder,asellstopforalongpositionandabuy-to-cover stop for a shorttrade.

Drawbacks to using stoporderstoentertrades

Aswithanytradingtool,buy-stopandshort-sell-stopordersdo not always work well.Here are some of theirdrawbacks.

First, our buy-stop order

could be triggered by a falsebreakout or an out-of-lineprice move. These are pricemovesthatspendonlypartofthe day outside the patternboundary and then retreatback inside the boundary bythe end of the trading day.Theseretreatscanalsotriggerour stops. Again, there isnothing wrong with beingstopped out for a small loss.As we know, we must beready to take many small

losses.Butlossescanaddup,and more importantly, theycanexhaustusmentally.Andpreserving our mentalcapital is just as importantassafeguardingourtradingaccount. Every trade is acalculatedleapoffaith.Whilewe can keep risk atmanageable levels by alwaysdiversifying our trades andfollowingotherprudentrules,we still need confidence totake swings at set-ups. Ifwe

lose our nerve, then wecannot trade well.Repeatedly getting stoppedout by false breakouts willweaken our trading psyche.So when the real breakouthappens, we feel too spentfinancially andpsychologically to make anappropriatebet.Wehavelostour nerve. And the inabilitytotakecalculatedriskscanbejust as frustrating as a stringoflosses.

Thus,thereareadvantagestowaitingtowardstheendofthetradingdaytoseeifpriceswill close decisively abovethepatternboundaryandthenmanually entering a trade.Theclosingprice is themostimportant price because itindicateswheremany tradersfeltcomfortableholding theirpositions over night. Myexperiencehasbeenthatmosttrades, includingmanyof thebest set-ups, gave me plenty

of time to enter manuallytoward the end of thebreakout day. Looking at thechartsabove,wedidnothavetousestoporderstoshorttheH&S top patterns in Apple,LifeLock, and QQQ. Wecouldhaveenteredaroundtheclosingpricetowardstheendofthebreakoutday.

Of course, there will beset-upswhennotusingastoporder to buy or short willmean missing the trade

because it would be too lateand too risky to enter afterprices have broken out andtravelled far away from theboundary. But that’s trading.Wecatchsome,andwemisssome. If wemiss a breakoutfrom a pattern that we’vebeen watching for weeks,months, or even years, wehave to remember that therewill always be more andbetteropportunities.Sowhen,not if, we miss a trade, we

mustquicklymoveon.The second potential

drawback to entering a tradeusing a stop order is our oldenemy: gap ups and gapdowns. Actually, we canthink of gap ups and downsas valuable friends becausetheever-presentpossibilityofprice gaps forces us to neverrisk too much on any trade.As we will see, devastatingprice gaps of 40% and 50%,while rare, do occur. Such a

huge loss on a position thatrepresents8%or10%ofourtradingaccountwillstingbutoverall is still a verymanageable setback. But a50% loss on a position thatrepresents our entire accountis far, far worse andsomethingthatwemustavoidthrough prudentdiversification and riskmanagement.

Coming back to CaesarsEntertainment, let’s say that

thestockpricehadopenedat9.50onthebreakoutdayafteranovernightgapupandthenimmediately reversed anddropped straight down backinto thepatternand triggeredourstop.(Inreallifethestockopened at 7.85 and closed at8.71 on the breakout day.) Ifwe had a buy-stop order for1000 shares at 8.30, thenwewould find that this buy-stoporder,whichisamarketorderthat triggers at the current

trade price, was filled oncepriceswereatorabove8.30.Since the stock, after theovernight gap up, started totrade at 9.50, our buy-stoporder was filled at 9.50. Wepaid$1.20morethanwehadplannedforeachofour1000shares. And when our stopwas triggered at 7.80, ourlosses were $1.70 per sharecompared to the $0.50 persharethatwehadallottedforthistrade.

The result is that we lost$1,700 on this trade. If wehave a $50,000 account, a$1,700lossrepresentsa3.4%loss of capital. Such a lossstings, but it need not beanythingmore than that.Ourtrading account is stillessentially intact and wesimplymoveon.

We cannot predictovernight price gaps, but wecan still mitigate theirpotentialdamage.Onewayis

toonlyrarelyusestoporderstobuyorshort.Anotherwayis to use a smaller positionsizewhen using a stop orderto potentially enter a trade.We can always add to ourposition if circumstancespermit.

Ifwe feel that a potentialbreakout from an explosivepattern seems “catchable”only through a stop order tobuyor shortbutweprefer toenter a trade manually, then

we can simply not trade. Ittakesmuchwisdom,patience,and strength to pass on atrade.Itwillbeeasiertopasson a trade if we rememberthattherewillalwaysbemoreopportunities.

A couple of othertakeaways from this H&Sbottom in CaesarsEntertainment.

First, always look forpatterns within largerpatterns. The smaller pattern

can give us an early entrypointandalsohelpusidentifyandmake sense of the largerpattern.

Second,mostpatternstaketime to develop. This H&Sbottom took five months toform.

Third,breakoutscanmoveveryfast.Sofast,infact,thatwe may miss it or we maydecide to not trade it. Ourtask is not to trade everybreakout. Our task is doing

the right thing, and that canmeannottradingabreakout.

Callidus Software: 10-monthH&Sbottom

This H&S bottom’s rightshoulder was a rectanglepattern:

FIGURE7

Thenext chart focuses on

the breakout from the rightshoulder:

FIGURE7.1

Let’s again assume that

we have a $50,000 tradingaccountandwedon’twanttoriskmore than 1% ($500) ofourtotalcapitalonanysingletrade. Entering at the high(5.20) of the breakout dayand placing our stop justbelow the low, say, at 4.84,meanswe risk$0.36a share,which still allows us to buyalmost 1390 shares ($500divided $0.36) for about

$7,200. Such an entry andexit gave us the possibilitybutneveraguaranteetoprofitsignificantlyfromacontinuedbreakout from a promisingpatternwhileplacingourstopreasonablyfarawayfromtheupper boundary of the right-shoulder rectangle to surviveretests and significantvolatility.

IfthebreakoutinCallidusSoftware reversed and wewere stopped out, this losing

tradecostusabout$500fromour$7,220position.That’s a6.9%lossonourpositionbuta 1% loss of our tradingaccount. Most traders,especially beginners, wouldbewisetokeepourmaximumpossible loss on anyindividual trade under 1% ofourtotalaccount.Asnoted,itseems most professionaltraders stay under the 1%figure. If I were starting outagain,Iwouldtrytokeepmy

loss on any single trade tounder 0.5% of my account.Wewilllosethemostmoneywhen we lack experience inthemarkets.Weneedtimetolearn, and we might as wellloselessmoneywhenweareatourworst.

Quarterlyearningsreports

All publicly-tradedcompanies report theirfinancial results every three

months. We must watch forupcomingearningsreports. Itis entirely unpredictable howinvestors and traders react toearnings reports. A “good”earningsreportcanbeseenasbad if there wasn’t enoughgoodnews.A“bad”earningsreportcanbeseenasgood iftherewas lessbadnews thanexpected. Moreover, stockpricescancrashevenafteranobjectively good earningsreport for any or no reason.

Thereisnowaytopredictthemarket’s reaction to earningsreleases.Thus,weshouldnotenterapositionjustbeforeanearnings release nor hold aposition through an earningsreport.

Evenifitseemspricesareabout to break out of apromising pattern, I standaside andwait if an earningsreport is to be released soon.It can be frustrating to nottrade a promising breakout

because of an imminentearningsrelease.Butwemuststand aside because the utterunpredictability of themarket’s reaction to earningsmeansthatwehavenowaytomanage risk. Here, again, ithelps to remember that therewill always be other patternstotrade.

Here, the market reactedfavorably to CallidusSoftware’s earnings report.The stock jumped the day

after earnings were released.Itwas not until the next dayprices went up again andbroke through the upperboundary of the rectangleright shoulder and decisivelyclosedaboveit.Thetimingofthe earnings release and themarket’s reaction to it werefavorable. The market’sreaction was not so positiveas to cause an explosivebreakout that made enteringthe trade too risky. Prices

increased stronglybut still ina controlled pace that gavetraders plenty of time to buysharesatpricesthatofferedafavorable reward-to-riskpossibility. Also, we couldhave more confidence in thebreakout because theuncertainty surrounding theearnings release was out ofthe way. Note also that thevolume on the breakout daywas heavier than in previousdays. Such volume

confirmation makes it morelikely, but never guarantees,that the breakout issignificant.

Therearenoguaranteesintrading except that we willlose a lot ofmoney ifwedonot respect risk. One factorthatincreasedtheriskonthistrade was that CallidusSoftware is a relatively low-volume stock. I considerstocks whose daily volumeis often under 100,000

shares to be thinly traded.And I usually avoid stockswhose daily volume is oftenunder 50,000 shares as theycan be even more volatile.Wecanrefertoastock’sBetato get a sense of the stock’svolatilitybutIrelymostlyonwhat I see on the chart:CALDsharesoftenhadwidedaily trading ranges. Forexample, the stock jumped7.6%, 8.8%, 5.5%, and 3.9%in the days around the

earnings report andbreakout.Isn’t that good for the traderwho owns this stock? Wemust remember that whatgoes up quickly can comedown even faster. Therewasno guarantee that thebreakout from this H&Sbottom would work evenafter prices closed decisivelyabove the upper boundary ofthe right-shoulder rectangle.The market could havechanged its initial positive

reactiontotheearningsreportand pushed down pricesanytime after breakout. Andrelatively low-volume stockscancrashveryquickly.Giventhisriskinlow-volumestockslike CALD, a fine idea is totradea smaller sizehere.Wedon’t have to risk ourmaximum on every trade.Maybewedecidetoriskonly0.5%orevenless.Orperhapswe decide to skip this trade.Thatisperfectlyacceptableas

well. We always have achoice. Nobody forces us totrade. We need to evaluateevery breakout with oneoverriding question in mind:dowehavea favorableentryspotthatlimitsrisk?

As we’ve repeated manytimes already and aswewilland must hear many moretimes:ournumberonetaskastraders is tomanage risk andnot to make money. Putanother way: concentrate on

doing the right thing ratherthan making money. Whenwe manage risk in asystematic way, we will beabletotradeforthelongrun.

The financial markets arealways unpredictable, andquarterlyearningsreportsaddanother layer of risk andvolatility. We can avoid themarket’s unpredictablereaction to earnings reportsbysimplynottradingthroughearningreleases.Andriskand

unpredictability arecompounded in low-volumestocks.

Hewlett-Packard: 10-weekH&Sbottom

The next chart showsquarterly earnings reportsproducing very volatile pricemoves in Hewlett-Packardshares:

FIGURE8

I know what many of us

arethinkingbecauseIhadthesamethought:those12%and17% one-day price jumpsseem too good to pass up soI’ll just hold my positionthroughearningsreleasesandhope that the market reactspositively to the earningsnews. But these priceincreases could just as easilyhave been comparable orworse price drops. Indeed,

Hewlett-Packard’s stockdeclined by more than 12%on the third earnings reportshownonthechart.

Recall our discussionabout thedistinctionbetweeninformedtradingandoutrightgambling.Informedtradingisaboutenteringataspotonthechartthatmaximizespotentialgains while defining andlimiting risk.Yes,we expectto have more losing tradesthan winning trades. Yes,

price gaps, up or down,unrelated to earnings newsmean sometimes we losemore than we had planned.Yes, all financial activitiesinvolverisk.Butwemustnotthink that just because thefinancial markets aresynonymouswithuncertaintythat there aren’t degrees ofrisk. Trade entries and exitsthat are likely to keep losseswithinourriskparametersarenotthesamethingastakinga

position before an earningsreportonsimplythehopeofapositive market reaction tothenews.Wehavenowaytoquantify the market’s futurereaction to a report thecontents of which we knownothingabout.

That said, some of us (orisitallofus?)will,hopefullyonlyoccasionally,gambleonearnings reports. We shouldnotdoit,butsomeofuswillgivein to thetemptation.IfI

were to hold a positionthrough earnings reports, thefollowing situation would bethe only instance when Iwouldconsiderdoingso.Thenextchart focuseson the leftportionofFigure8wheretheH&Sbottomformed:

FIGURE8.1

We have a H&S bottom

andabreakoutonagapupinprice. My experience hasbeen that breakouts on pricegapstendtoworkmoreoftenthan not. That said, wemustnever go all-in on any singlepattern no matter howpromisingthebreakout.Eventextbook-perfect patterns failoften. Here, the gap-up inprice was just another factorto consider when deciding

whethertotradethispattern.Iwouldtradethispatterngiventhe symmetry of the H&Sbottom (the left and rightshoulders were about thesamesize), thebreakoutonagapup,andafavorableentryspot. As noted on the chart,we risked about 2.3% of ourposition had we boughtshares around the closingpriceofthebreakoutdayandset our stop somewherereasonably below the

neckline.If we had bought shares

uponthebreakout,wegainedabout15%onourpositioninthe next two weeks. Thenprices traded in a narrowrangefor thenextmonthandthe quarterly earnings reportwas to be released soon.Whatnow?Thecorrect thingto do is to sell our entireposition and book a 15%profit.Butwearehuman,andwe want more. If we are

going to gamble, then weshoulddosowithonlyaverysmall position. In this case,we would get lucky as thestock jumped 12% on theearnings report. Yes, we cando the wrong andirresponsible thing and getlucky and make money. Butwe will run out of luck andtakealargehittoourtradingcapital ifwecontinue to takesuchgambles.Doingtherightthing means doing the

unexciting thing over andover: honoring our stop, notchasing a missed breakout,not gambling, and justwaiting.Doingtherightthingdoesn’tguaranteeprofits, butitisthebestwaytobealong-term player in the tradinggame, and longevity is thebest way to be profitable inthelongrun.

Lannett Co.: 5-month H&Sbottom

Our next chart is anothervariationoftheH&Sbottom:

FIGURE9

Note that the right

shoulder of the H&S bottomismuch smaller than the leftshoulder. While symmetrybetween the left and rightshoulders is one of thedefining traits of a textbookH&S pattern, as with allpattern “rules,” there areexceptions. A H&S bottomsuch as this one where theright shoulder is significantlysmaller than the left can

launchapowerfulmove.Itisasifthestockisitchingtogetmoving and doesn’t have thepatience to form a rightshoulderthatisofsimilarsizetotheleftshoulder.

Note also that this patterngave us plenty of time toenter the trade. We couldhave bought shares towardthecloseof thebreakoutdayor anytime during the nextday. It was not necessary touse a buy-stop order to trade

thisbreakout.So was it as easy as

buying shares once pricesclosed above the neckline ofthe H&S bottom? Themajorstrikeagainstthispatternwasthatthestockwasverythinly-traded. Less than 20,000shares traded per day onmany days during patternformation.Asnoted,Iusuallyavoid stocks whose averagedaily volume is less than50,000 shares. And I would

recommend that beginnersavoid entirely such low-volume stocks. As we gainexperience,wemaydecidetotrade, very carefully, somepatterns that form in thinstocks. If Iwere to trade thisH&Sbottompattern,Iwoulduse a position that was atmost 30% to 40% of mynormalpositionsize.

Would I trade this set-upusingasmallerposition?Yes.The 6-month H&S bottom

lookedverypromisingwithaclearly defined left shoulderand head. Another reason isthat, despite the low volume,the stock traded relatively“cleanly,” especially duringthe formation of the rightshoulder. Thinly-tradedstocks can jump wildlyaroundandmakeriskcontrolvery difficult if notimpossible. A stock’s chartlookscleantomewhenthereare few price gaps unrelated

to pattern breakouts. Asnoted, breakouts on pricegaps support but does notguarantee the validity of thebreakout.Thechartsof somevolatile stocks have pricegaps almost every day. Incontrast, Lannett’s stocktraded cleanly and in a tightrange during the weeksleadinguptothebreakout.

Of course explosivevolatilitycanappearanytime,especially in thin stocks, but

thecleanpriceactionandlowvolatility during theformation of the rightshoulder would be animportantfactorinsupportofnot eliminating this patternfrom my list of tradecandidates.Yet it isperfectlyacceptable to pass on thispatternbecauseofthestock’slowvolume and the risk thataccompanies a thin stock.Again, I recommendbeginnerstotradeonlystocks

whose average daily volumeisatleast200,000shares.

PennVirginiaCorp.:8-monthH&Sbottom

Thenextchartshowsanotherpattern-within-a-pattern.Notehow the breakout from thesmall symmetrical trianglelaunched the breakout fromthelargerH&Sbottom:

FIGURE10

Now let’s zoom in on the

rightshoulderarea:

FIGURE10.1

The breakout from the 4-

week symmetrical trianglethat constituted a portion ofthe right shoulder of thisH&S bottom was an idealspot to go long. This entireset-up – from the year-longH&S bottom pattern (thelengthier the build-up, themore powerful the breakoutmay be), the symmetrical-triangle right shoulder thatoffered an opportunity to

enter early, and the textbookbreakout on heavy volume –wasverypromising.Indeed,Iwould seriously considerrisking more than mystandard maximum risk andbuy a larger position size.That said, I would still notrisk more than 1.5% of myaccount even on such apromising pattern becausethere are no guarantees intrading. There are no rulesthat are supposed to work.

This enticing H&S bottomthatseemssopromising?Themarket could care less as itcan crash prices even after adecisive breakout. Thepattern boundaries we draware just that: nothing morethan lines that we use astradingtools.Themarketandprices will do what they do.Theyareneverwrong.

Alwaysbecautious

Bynowwemayhavenoticedarecurringtheme.Wediscusssome exciting aspects ofclassical chart trading andthen immediately remindourselves of the utmostimportance of caution. Wemay wish it were otherwisebut catastrophic risk lurkseverywhereintradingandthefinancial markets. If we arenotcareful,thenwemayloseit all. But we need not bepessimistic. We can learn to

implement anuncompromising riskmanagement strategy thatallows us to be long-termplayers in the trading game.Theonlythingstandingintheway of prudent riskmanagementisourselves.

Compelling set-ups suchas this H&S bottom in PennVirginia Corp. shouldmotivate us to do the utmosttopreserveourcapitalforthereallypromisingcharts.Such

patterns can reaffirm ourpassionfortrading.Ofcoursewedon’tknowwhichset-upswill work as even textbookpatterns fail often. But onedecisivewinnercanmakeupfor many more small lossesand produce overallprofitability. If we lose ourcapital on suboptimal tradesbychasingmissedbreakouts,enteringatunfavorablespots,or just gambling outright,thenwewillbetooexhausted

financially and mentally toplace ameaningful betwhena truly compelling patternemerges.

I have experienced thispainful situationmany times.After losing money chasingbreakouts and trading poorlyformed patterns, I havesimplylostthenervetomakeameaningful bet on the nextpromisingtrade.ThenIwatchfrom the sidelines as thispattern launchesanexplosive

and very profitable trend. Iget more frustrated. I chasethisbreakoutbyenteringataspot that carries more riskthanmymaximum-losslimit.I get stopped out and losemore money. I have lost notonly my nerve, but also mydetachment and my form. Iam in a destructive cycle ofnegative feedback loops.When traders are in thissituation,andallofuswillbein this situation from time to

time, we can exit ourpositions,walkawayfromthescreen,andtakeabreakfromthemarket.Wemust rebuildourmentalstrength.Wemustregainournerve,perspective,and balance. We must takeour time. The market willalwaysbe therewhenwearereadytotradeagain.

Constantly remindingourselves that there willalwaysbemoregreat set-upscanhelpusnotchasemissed

breakoutsandalsogiveustheconfidence to take a break.Even if wemissed this PennVirginia set-up, the existenceof this and many otherexciting patterns shouldremindusthatwewillalwayshavetheopportunitytomakeacomeback.Thekeyistobestill standing when favorablemarket conditions reappear.And effective riskmanagement keeps us in thearena.

UnitedCommunityBanks:7-monthH&Sbottom

Our next example shows yetanothervariation to theH&Sbottompattern.Thistime,theright shoulder took the formofasmallH&Sbottom:

FIGURE11

Thenext chart focuses on

therightshoulder:

FIGURE11.1

Here, we again have a

situation where the nextearnings report was to bereleasednot so longafter thebreakout.Ifweboughtsharesaround the closing price ofthebreakoutday,wewereupby about 8-9% on ourpositionrightbeforeearningsrelease.What shouldwe do?Analmost10%profit in lessthanamonthisagoodtrade.I would sell my entire

position,bookmy10%profit,andmoveontootherset-ups.But the reality is thatwe areall susceptible to thetemptation to gamble onearnings reports. And if wechoose to gamble, and it’s achoiceasnooneisforcingusto stay in this trade throughtheearningsreport,Ithinkweshould gamble with nomorethanone-thirdofouroriginalposition.

CHAPTER7

ContinuationH&SBottom

A continuation H&S bottomis a H&S bottom that formsafterasustainedriseinpricesand signals possibly anotheruptrendinprices.

Deluxe Corp.: 2-monthcontinuationH&Sbottom

Our first continuation H&Sbottompattern:

FIGURE12

Deluxe’s stock had been

inasustaineduptrendfortwomonths when the stockpaused (left shoulder),declined and then increasedagain (head), andpausedanddipped again (right shoulder)before shooting up(breakout). The result was awell-defined continuationH&S bottom. Note thehorizontal neckline,abbreviated right shoulder

(breakouts from which canlead to powerful trends), anda clean decisive breakoutthroughtheneckline.

All trends, up or down,pause at some point. Thepause can take the form ofprice gyrations that do notformanyclassicalpattern.Orthe pause can be in the formof price action that evolvesinto a classical pattern. Andthat classical pattern can beeither a continuation pattern

that continues the previoustrendorareversalpatternthatreversestheprevioustrend.InDeluxe Corp., the pauseformedacontinuationpatternin the formof a continuationH&Sbottom.

Thus, when I see a stockinasustainedtrend,Iwaitforthe inevitable pause becausethatpausecantaketheformatradable classical pattern thatgives me an entryopportunity.Before,Iusedto

ignore stocks in sustainedtrends because I thought, “Imissedthatbreakout.NothingI can dohere.” It is smart tonot chase breakouts. Mymistakewasfailingtorealizethat every chart can form acompelling set-up at anytime, even after making astrongrun.

Wehavetoacceptthefactthatwewillmissmanygoodtrades. In fact, we must nottry to find and trade every

compelling set-up. We needto concentrate when trading,andweshouldnotspreadourattentionandcapital too thin.Mostimportantly,wehavetorememberthatmoneywedidnot make is not money welost. Missing a breakout orchoosing one pattern thatlater fails over another thatturnsouttobeabigwinnerispartoftrading.Nobodyknewwhichpatternswouldwork.Itis foolish to get angry over

something that we have nocontrolover.Itisfarbettertomiss a trade than to losemoney.

Note: not every pricemove is due to a breakoutfrom a classical pattern.Strong trends start withoutany connection to a classicalpattern.Asclassicalchartists,we don’t buy shares justbecauseastockisgoinguporshort shares just because thestockisgoingdown.Welook

for tradable classical patternsthat provide favorable entryspots.

Flotek Industries: 6-weekcontinuationH&Sbottom

Here, a breakout from a 6-week H&S bottom was partof a price action that alsobroke above a multi-monthdecliningresistanceline:

FIGURE13

AsFlotekwas ina steady

downtrend from October2013 to January 2014, wemight call this pattern areversalH&Sbottom.But asFlotek had been in a year-long uptrend before thisrecent decline, it is alsoreasonable to label thispattern a continuation H&Sbottom. The label isunimportant. The importantthing is whether a pattern

offers an advantageous entryspotwithafavorablereward-to-riskpossibility.

Note the powerfulbreakout from the 6-weekH&S bottom as pricesjumped5.8%onthebreakoutday. Buying shares towardthe close of the breakoutmeant risking more of ourposition than required formostof thepatternswehaveexaminedsofar.Still,tradingthis breakout would have

been a reasonable decision,especially if we decided touse a smaller position tomake sure we stayed belowour maximum risk. Nottradingthisbreakoutwasalsoareasonabledecisionastherewill be many more set-upswithlessriskyentrypoints.

Wecouldhaveanticipatedthe breakout and placed abuy-stoporder justabove theH&S bottom’s neckline.Here, such a buy-stop order

wouldhaveworkedwell.Butrememberthateverysituationis different and that buy-stopordersdonotalwaysworktoour advantage.We discussedhowtheycanproducebigger-than-expected losses ifpricesjump overnight and thenreverseandtriggerourstop.

Wecannotandshouldnottrade every breakout. Ourtask is to learn the manyvariationsinclassicalpatternsand figure out the kinds of

set-upsthatwelike.Classicalcharting does not have toomanyfundamentalprinciples.But countless interestingpossibilities arise from therelatively-few bedrockguidelines.Wearefreetouseour imagination anddiscipline to apply classicalcharting in ways that weprefer if we keep riskmanagement as our toppriority. Trading is in someways the ultimate freedom.

Isn’tthatabigpartofwhyweareinterestedintrading?

Taser International Inc.: 9-month continuation H&Sbottom

Taser International’s stockhadmorethandoubledinsixmonths and then started totrade in a range for ninemonths starting in late 2012.Itturnedoutthatduringthesenine months the stock was

buildingabasefromwhichtolaunch another powerfuluptrend. The base was thefollowing 9-monthcontinuationH&Sbottom:

FIGURE14

Another pattern within a

pattern. The right shoulderdeveloped in the form of adescending flag. Thebreakoutfromtheflagstartedthe breakout from the largerH&Sbottompattern.

Let’szoominontherightshoulder:

FIGURE14.1

Note the unmistakable

increase in volume atbreakout as indicated onFigure14.Whilebreakoutonheavy volume can neverguarantee the pattern’sultimatesuccess,itisastrongindicator of a significantbreakout from a meaningfulboundary.

This set-up also produceda fast breakout.Let’s saywehad been monitoring this

pattern develop and saw thebreakout from the rightshoulder.Towards theendofthebreakoutday,weseethatentering around what wasgoing to be the closing pricemeant that we had to riskalmost 7.5% of our position.Andapossible7.5%lossonanormal-size position is likelyto exceed our maximum-losslimit for a single trade. Onother hand, the pattern looksvery promising and the

heavy-volume confirmationonbreakoutmakesthepatternevenmoreenticing.Whatcanwedo?

While there is nothingwrong with not trading abreakout because, forexample,wefeelenteringthetrade means chasing abreakout, we can alwaysconsider using a smallerposition. Using a smallerposition helps us trade withless emotion and thus

correctly. A smaller positionallowsus to setour stop-lossorderat amore logical level:reasonablyfarawayfromthebreakout boundary to giveour position a reasonablechance to survive normalvolatility and possible retestswhile still keeping ourpotential loss under ourmaximum-loss limit. Alwaysconsiderwhetherwe can usea smaller position to trade apromising pattern that has

experienced an explosivebreakout.

CHAPTER8

Rectangle

Our next pattern is thehumblerectangle.

Chiquita Brands: 3-monthrectangle

Hereisourfirstrectangle:

FIGURE15

Let’s focus on the

breakoutarea:

FIGURE15.1

Even the simplest-looking

pattern and breakout offertrading challenges. Note thesomewhat indecisivebreakoutwithmultipleretestsof the upper boundary. Thefirst retest was especiallytricky because it would havetriggered a stop-loss orderthatwasplacedjustbelowthelow of the breakout day.Here, placing our stop usingthe last day rule was

problematic because thebreakout day had very littleprice action below the upperboundary of the rectangle.Astop-loss order placed justbelowthelowofthebreakoutwas simply very close to thebreakout boundary andexposed to getting triggeredon retests and even normalvolatility.

Whatareouroptions?We could have set our

stop a bit lower, say, just

below the opening price ofthedaybeforethebreakoutorevenfurtherdownandreduceour position size accordinglyto stay within our riskparameters.

Another option is to re-enter this trade if we gotstopped out. If we gotstopped out after placing astop at, for example, 5.57,thenwecouldre-enterontheday after the first retest andplace a stop just below the

lowof thehardretest,say,at5.54. There is no guaranteethat this second stop willsurvive. We are simplyplacingourstopataspotthatseems to have a reasonablechanceof survivingvolatilitywhile stayingwithin our risklimit. Risk management, notmaking money, must remainour priority, especially whenmakingmultipleattemptsataset-up.Here,thesecondstop-loss order would have

survived the second retestthatcamethreeweekslater.Iwill always consider re-entering a trade if I amstoppedoutbyaretestwherepricesdonotdecisivelyclosebelowthebreakoutboundary.SometimesIwillenterforthethirdtimeifthepatternseemspromisingenoughandIhavesuffered negligible losses onmyinitialattempts.Thatsaid,becoming fixated on anypattern because we think a

pattern “owes” us isdangerous and unnecessary.There will always be otherset-ups to trade. We shouldalmost alwaysmove on aftertwoattempts.

AcrucialtakeawayfromChiquita’s chart is that wemustexpectretests,andwemust learn to deal withthem.Oneof thebestwaysto deal with retests is toignore them. That is, weenteratanadvantageousspot,

placeourstopatareasonablelevel, and we move on.Anxiously watching everypricetickinfearthatourstopwillget triggeredwill leadtomental exhaustion, andwhenwe trade while tired, largelosses are not far away.Perhaps an even moreimportant lesson is that wemust be patient and give thepattern time to work. Afterbuyingsharesandsettingourstop, we had to be patient

throughtwohardretestsoverthreeweeks.Thestockstartedtomakebiggainsfiveweeksafterbreakout.

The Chiquita chart alsoshows the importance ofdetachment.Theidealwaytotrade is to dispassionatelyenter and set a stop and thendo other things. Agonizingover whether our stop willsurvive a retest is the worstthingwecando.Ifourstopistriggered, so be it. We

consider re-entering ifpracticalandadvantageoustodoso.Ifwedecidenottore-enter,thenwemoveon.

LionsGateEntertainment: 6-weekrectangle

FIGURE16

After the decisive

breakout, a retest challengedbut did not penetrate theupper boundary of therectangle. It is fascinatinghowoften pattern boundariesturn back retests. But wemust not get overconfidentand assume the inviolabilityof boundaries. The marketdoes not care where or howwedrawboundaries.Decisivebreakoutscanbefollowedby

tough retests that penetratedeepinsidethepatternand,ofcourse, even lead to patternfailures. No matter howdecisive and indisputable abreakout looks, we mustalways stay within our riskparameters and enter a stop-lossorderassoonasweentereverytrade.

A pattern is almost alwaysopen to multipleinterpretations

I think we had twocompelling ways to interpretthefollowingchartofLincolnNational. The firstinterpretation of the priceaction is a breakout from arectangle:

FIGURE17

Theother interpretation is

a breakout from acontinuationH&Sbottom:

FIGURE17.1

Note theabbreviatedright

shoulder, which can signal apotentially powerfulmove tocome, and the slightly risingneckline.

Both interpretations arecompelling and provide aclearentryandexitstrategy.

A caution regarding thefreedomwe have in drawingboundaries and interpretingcharts: we must not imposeour wishes onto charts by

drawing lines that reflect ourhopes rather than the priceaction.Inabattleofwills,themarketwillalwayswin.

Let’sexamineathirdwayto interpret LincolnNational’s chart, that of abroadening triangle, alsocalled a megaphone, toemphasizethepointthatchartpatterns are simply tradingandrisk-managementtools:

FIGURE17.2

Amegaphone isusuallya

bearish chart pattern whereprices decline after breakingbelow the lower boundary.But prices do not have torespect our boundaries orexpectations. All classicalpatterns can launch apowerful move in thedirection opposite theexpected direction. Themegaphone, as it did here,can launch a powerful

uptrendafterpricesdecisivelyclose above the upperboundary.

A lesson is that we mustalways keep an open mindrather than being obsessedwith a particular outcome –ourpreferredoutcome.Allofuswillattimesfight,withnosuccess, the price action.Wedo not want to and cannotbelieve what we are seeingbecause the price action isdoing something that it is

“not supposed” to do. In abattle between our fantasyand reality, guesswhich sidewins?

If we remained flexible,weweremuchmorelikelytospotandtradewellabreakouteitherway.Spottingapatternandthebreakoutareonlypartof trading well. We need todetermine a good entry andexit strategy that managesrisk. And the megaphoneinterpretation simply did not

giveusasfavorableatradingstrategy as the rectangle andcontinuation H&S bottominterpretations. It was notimpossible to trade thisbreakoutwellon thebasisofa megaphone interpretation.But the rectangle andcontinuation H&S bottominterpretations providedclearer and more favorableentryandexitpointsbecauseof modest differences in thedrawing of the pattern

boundary.Wecouldenterthetrade a bit earlier using therectangle and continuationH&S bottom interpretationsand also benefit from theirhorizontal or nearlyhorizontal breakoutboundaries. As we willdiscuss further later, patternswith horizontal boundariesoffer some advantages overslantingboundariestotraders.

Skechers:4-monthrectangle

Onemorerectangle:

FIGURE18

The breakout was clear

and gave traders plenty oftime to enter.We could buyshares towards the close ofthebreakoutdayandeventhenext day and staywithin ourriskparameters.Andnotethattheminimumpricetargetwasquickly met. While thegeneral rule is that ameasured price target isusually the minimum pricemove, it is also true that at

anytime prices can reverseand lead to pattern failure. Ialmostalwaystakeprofitsonmost of my position when aprice target ismet.When, ashere, the price target is metand the next quarterlyearningsreport isduesoon,Iwill exit entirely from myposition.

CHAPTER9

AscendingTriangle

The ascending triangle is apattern that indicates apossible upward price move.It has a horizontal topboundary and a rising lowerboundary with increasinglyhigherlows.

Marchex Inc.: 10-monthascendingtriangle

FIGURE19

Thenext chart focuses on

thebreakoutarea:

FIGURE19.1

One of the ironies of

trading is that an explosivebreakout both confirms thesignificance of the patternandmakestradingthepatternmore difficult. The powerfulbreakout in Marchex is anexample. Placing a buy-stoporder in anticipation of abreakoutwould haveworkedwell in this case, butrememberthatastopordertobuy or short is not a perfect

tool.We face a tricky situation

here. We know in hindsightthat Marchex went on apowerful run after breakingoutof theascending triangle.Inhindsight it iseasy to say,“we should have bought alargepositionafterbreakout.”Butwetradeinrealtime,andinreal time thedilemmawaswhether tobuy shareson thebreakout day and risk up to10%ofourposition.Another

factortoconsiderwasthefactthatMarchexwasarelativelythinly-traded stock. So wehadapowerfulbreakoutfroma textbook pattern in a low-volume and volatile stock.What are some of ouroptions?

First, we can simply nottrade. It is better to miss atradethantochaseabreakoutand lose money. Let it go.Therewillbeothers.

Second, we could have

placed a buy-stop order inanticipation of a breakout.This option is no longeravailableafterbreakoutbutitis still worth mentioningbecause buy-stop orders canbe a valuable tool especiallyif we learn to use a smallerpositionsize toaccount forapossible gap up in price.Again, buy-stop orders arenot foolproof and canproducebigger-than-expectedlosses.

Third, we can buy asmaller-than-normal positionataroundtheclosingprice.

There isnocorrectchoiceamong these options.Sometimes one option willworkbetterwhileothertimesa different choice willproduce the better outcome.Whatever option we choose,we must be guided by ourmost important objective:controlling risk and cuttinglosses.

CheesecakeFactory:3-monthascendingtriangle

Thenextchart showsawell-formed ascending triangle inCheesecake Factory fromJulytoOctober2013:

FIGURE20

Sometimes the earnings-

induced breakout is sopowerfulthatitputsthetradeoutofour reach.Other timesthe earnings news willproduce a decisive yetmanageable breakout thatprovides a favorable entryspot, as happened in thisascending triangle.We couldhave bought shares aroundthe breakout day’s closingpriceandsetastopjustbelow

thebreakoutday’slow.Note the earnings news

ledtoabreakoutonagapupinprice.Notallpricegapsaresignificant,butpricegapsthatovercome key resistance orsupport levels are oftendecisiveclues.

After breakout, the stockreached its measured pricetarget,which is the height ofthe ascending triangle as itswidest point – here, $5 –projected upward from the

breakout level. The pricetarget was met on the dot. Ialmost always take profits atthe measured price target.Although price targets aregenerally minimum pricegoals, I still exitmost ofmyposition when targets arereached. Ifpricescontinue togo up or down and leave usbehind, then so what? Webankourprofitsandmoveontootherset-ups.

After reaching the price

target, Cheesecake’s stockprice went sideways for twomonths before breakingdown. Note that the stockformed a 2-month H&S topfrom which the declinestarted.

Some takeaways fromCheesecake’schart:

First, the importance oftaking profits when themeasured price target isreached. Many good traderssaythatitisthesittingonour

position, never our thinking,that makes the big money.This idea can work well,especially in powerful bullmarkets, but as witheverything, not always.Depending on marketconditions,Imaytakeprofitswellbeforethepricetargetisreached.

Second, again, we mustnot gamble on earningsreleases by entering a largeposition just before earnings

news.Lastly, in this case there

was an attractive entry pointeven after the powerfulbreakout on earnings. As wenoted, most trades, includingmanyof thebest trades, giveus plenty of time to enter.They key is to be notmentally and financiallyexhausted when the fat pitchisserved.

Dollar Tree Stores: 8-week

ascendingtriangle

Hereisanotherbreakoutonagapupinprice:

FIGURE21

Sucha“breakoutgap,”the

same one we saw inCheesecake Factory’sascending triangle in Figure20, is more often than notevidence of a meaningfulbreakout.

Also notice that we needtomodifythelastdayrule tosetour stophere.Becauseofthegapup,therewasnopriceaction within the pattern onthe breakout day. One

alternativeistosetastopjustbelowtheclosingpriceoftheday before the breakout. Or,if within our risk parameter,wecansetourstopbelowthelow price of the day before.Every stop placement willdependontheparticulartraitsof each pattern. Here, thebreakoutonagapupwasnotso powerful as to makebuyingsharestoorisky.

After reaching the pricetarget, prices traded in a

narrow range until thequarterly earnings report.Again, I would have exitedfrom my entire positionbefore the earnings release.Here,thestockpricedroppedsharplyonearningsnews.

Dollar Tree Stores:Was thata continuation H&S bottominstead?

Is it possible to interpretFigure21inadifferentway?

The following chart showshow we could haveinterpreted it as acontinuationH&Sbottom:

FIGURE21.1

How we interpret and

label thepriceactionisuptoeachofus.Wecouldcallthischart an upside down Mt.Everest. What is notdebatableistheimportanceofriskmanagementandlimitinglosses.

Michael Kors Holding: 5-monthascendingtriangle

The next ascending triangledeveloped a symmetricaltriangleinsideitsboundaries:

FIGURE22

The next chart zooms in

onthebreakoutarea:

FIGURE22.1

Iamalwaysinterestedina

pattern-within-a-patternbecause it often provides anopportunity toenter the tradeearlier than otherwise. Forexample,herewehadagoodrationale for buying shareswhenpricesclosedabovethesymmetrical triangle’s upperboundary but before closingabove the ascendingtriangle’s upper boundary.Doing so meant buying

shares two or three daysearlierthanhadwewaitedforprices to close above theupper boundary of theascending triangle. A coupleof days may not seem likemuch but slight edges canmake a big difference.Classical charting is aboutexploiting small edges overmany trades. In thiscase, theadvantage of entering a fewdays earlier was not onlyhigher profits should the

pattern work but simplysecuring an entry in thistrade. For if we had waitedforamoredecisivebreakout,we would find that buyingshares required taking onsignificantly greater risk asprices gapped up three daysafter they initially closedabove the symmetricaltriangle’supperboundary.

Caution: the chance ofbeing left behind is never agood reason to enter a trade.

Here, I think the breakoutfromthesymmetricaltrianglewas a good spot to buyshares.Thatsaid,Ialsothinkwaiting for a more decisivebreakout from both thesmaller symmetrical triangleand larger ascending trianglewas a reasonable decision.We could not know thatprices would gap up threedays after they broke out ofthe symmetrical triangle.Even after the gap up, we

could buy a smaller positionto enter this trade and staywithinourriskparameters.Orwecoulddecidetotradeotherset-ups instead. There willalwaysbeothers.

Nu Skin Enterprises: 7-weekascendingtriangle

Nu Skin Enterprises formedan ascending triangle fromMaytoJuly2013:

FIGURE23

The breakout from the

ascending triangle was clearenough but not explosive. Ilike such a “controlledbreakout” because it almostalways creates a favorableentryspot thatdoesn’taskusto risk too much of ourposition. Prices steadilymoved higher the next twodaysandthenjumped20%onthe third day after thebreakout.Prices paused for a

week before moving higheragain. This simple 7-weekpatternproduceda30%profitintwoweeks.Alessonisthatweshouldnotplacetoomuchemphasis on spotting andtrading thegiantmulti-monthor multi-year patterns.Relatively small patterns likethis ascending triangle thatformafterapowerfulrun(NuSkinstockhadgoneupmorethan50%inthethreemonthsprior to forming this

ascending triangle) oftenlaunch another powerful run.Thesemodest but potentiallypowerful patterns are calledhalfwaycontinuationpatternsbecause they often form atabout the midpoint of theoverallmove.

Sealed Air Corp.: 14-weekascendingtriangle

We have a decisive breakoutfrom a well-defined

ascendingtriangle:

FIGURE24

The stock is making a

goodrunandseemspoisedtoreach its measured pricetarget. But the next earningsreport is to be released soon.Whatshouldwedo?

My opinion is that weshould sell our shares ratherthanstayinandhopethatthemarketreactspositivelytotheearnings report. If we muststay in, despite nothing andnooneforcingustoholdour

shares through an earningsrelease, then we shouldgamble with just a smallportion of our originalposition, say, no more than20%to30%.

What we must not do iskeepourfullpositionbecausethe stock price “should” and“must” reach its measuredprice target. No. Wrong.Never. There are no suchguarantees in the markets.Measured price targets are

just possibilities. They serveasusefulreferencepointsbutneverasscientificcertainties.Themarketdoesn’tcarewhatthe price target is. How themarket reacts to earningsnews is entirelyunpredictable. The onlycertaintyisuncertainty.Itisahighly unoriginal statement,but it is true, and oftenforgotten.Good earnings canbeseenasbadwhilebadcanbegood.Or,goodcanbenot

quite good enough and thusbad but the stock price mayskyrocket anyway. Or crash.Nobodyknows.Wemustnotgambleonearningsreports.

SealedAirCorp.:wasFigure24asymmetricaltriangleandnotanascendingtriangle?

Someofusmayobjectthatitismoreaccurate todrawandlabel the Sealed Air Corp.chart as a symmetrical

triangleasfollows:

FIGURE24.1

Drawing our boundary as

anascendingtrianglemeantahorizontal upper boundarywith only one price touchpoint. There were two otherpricepeaksthatcameclosetothe upper boundary. Incontrast, interpreting this 14-week pattern as asymmetrical triangle anddrawingaslightlydescendingupper boundary created anupper boundary with three

solid price touches. Moretouches on a boundary aregood. Then is there areasonable basis forinterpreting thispatternasanascendingtriangle?

First, the two highs cameclose enough to the upperboundary for it to bereasonable to label this chartas an ascending triangle.Remember that patterns donot have to be perfect to beuseful.Patternboundariesare

just lines that we draw anduse as trading tools andnothing more. There is norulethatsaysthatpricesmuststay within their “proper”(our) boundaries. Prices willgowherevertheywanttogo.While it is fascinating toobserve how often prices dostay within the lines that wedraw, we must never forgetthat prices can run over ourlinesanytime.Itcanbecostlyto draw very precise pattern

boundaries because we thenexpect and demand prices torespectthesesacredlines.Webecome too invested in theinviolability of our chosenboundary. And when pricesviolate our lines, we go intodenial and become blind totheactualpriceaction.

Second, some traderswillsay,withmerit,thatwhateverwe call this pattern, abreakout of significance willhave to close decisively

aboveameaningfulresistancelevel. Here, the upperboundary of the ascendingtriangle was such a levelbecause that line representsthe highest price reachedwithinthepatternandalevelofresistancethathasrejectedthreeattemptstoovercomeit.Sosometraderswillsayfine,we’ll call this pattern asymmetrical triangle if youwish, but a breakout from asymmetrical triangle is not a

true breakout until it closesaboveasignificantpriorhigh.

The next exampleillustratesthispoint.

SpringNextelCorp.:6-monthsymmetricaltriangle

Let’s see how this set-upillustrates the previous point.First,thebig-pictureview:

FIGURE25

Thenext chart focuses on

the second half of thesymmetricaltriangle:

FIGURE25.1

And thenext chart zooms

inonthebreakoutarea:

FIGURE25.2

The stock closed above

the symmetrical triangle’supper boundary but wasturned back on its firstattempt to close above thehorizontal resistance formedby the previous significanthigh. The rejection led to ahard retest where pricestradedbutnotclosebelowtheupper boundary of thesymmetrical triangle.Another,somewouldsay the

real, breakout came eightdays later when the stockdecisively cleared thehorizontal resistance level.Some will argue that theinitial close above the upperboundary of the symmetricaltriangle was a good entrysignal.Afterall,astopplacedatareasonabledistanceawayfrom the boundary wouldhave survived even the hardretest.Alongpositionenteredat the initial breakout would

have meant an earlier andthus more profitable entry.Thisanalysis,too,hasmerit.

I think we shouldincorporate the wisdom ofboth sides in our trading.Breakouts are aboutovercoming key resistanceand support levels. Whilesloping lines can be preciseresistanceand support levels,horizontal lines present theclearest picture of supportandresistance.Butchartingis

also about exploiting smalledges, andwemay prefer toenter abit earlier as signaledby the symmetrical triangleinterpretation. After all, afailed breakout means just aminorlosswhileasuccessfulbreakout means we have arunningstart.

Symetra Financial Corp.: 4-monthascendingtriangle

Our last ascending triangle

shows the upper boundaryoffering stiff resistanceagainst multiple breakoutattempts:

FIGURE26

The many decisive

breakouts we have analyzedso far may give us theimpression that all breakoutsare very clean and easy totrade.Thisimpressionisfalseand dangerous. While it istrue that many of the besttrades start with cleanbreakouts, some struggle togetgoing.

In Figure 26, thecongestion at the upper

boundary that seems likenothing in hindsight lasted aweek.Wehave to accept thefactthatnotallbreakoutswillbe clean. All we can do isenter and set our stop at aspotthatlimitsourrisk.Ifweget stopped out, no problem.Ifthetradestartstowork,wefind out when the nextearnings report is due andwherewemight take profits.Whatever happens, we moveontootherset-ups.Thereare

alwaysmore opportunities tobefound.

CHAPTER10

DescendingTriangle

Our next pattern is thedescending triangle, whichindicates a possibledownwardmove in prices. Ithasaflatlowerboundaryanddescending upper boundarywithlowerhighs.

Caesars Entertainment: 4-weekdescendingtriangle

Our first descending triangleissmallbutwell-defined:

FIGURE27

The breakdown through

thelowerhorizontalboundarywas decisive. When themeasured price target wasreached in a week, I wouldcover my entire position.Thencamearetestwherethestock nearly reached thelower boundary of thedescending triangle. If wemissed the initial breakout,the retest offered a secondchancetoenterashorttrade.

Anoteofcaution:Ialmostalwaysuseasmallerpositionwhen entering a trade in astockthathasalreadyreachedits price target and then hasreturnedtoretestthebreakoutboundary.Myrationaleisthatthe pattern breakout hasalready served its purpose.This situation is differentfrom the common andexpected retest that occurswithin a few days or a fewweeks of a breakout and

where prices have yet tomake significant progresstowardthepricetarget.

With CaesarsEntertainment,shortingagainorforthefirsttimejustunderthe lower boundary duringthe retest level would haveworked well as prices againdeclined. Note the upcomingquarterlyearningsreleaseandthe cautionwemust exercisebycoveringourshortpositionandgettingoutofthistrade.

NutriSystem Inc.: 4-monthdescendingtriangle

An upcoming earningsrelease again affects ourtradinginthenextexample:

FIGURE28

NutriSystem formed a

textbook descending triangle.After a decisive downwardbreakout, the downtrendpaused and prices tradedwithin a narrow range for aweek until the earningsreport. If we had shortedshares after the breakout,wewould cover our sharesbefore the earnings release.Prices declined 12% on theearnings news and then

declined another 12% in thefollowing days. Yes, wewould have made a largeprofit if we had stayed withourshortposition.ButIhaveno doubt that staying in ourshort position would havebeen the wrong thing to do.We have to remember thatwhile doing the right thing,which should be ourdefinition of trading well,doesnotguaranteeaprofit,itdoes dramatically increase

ourchancesofpreservingourcapital. Incontrast,doing thewrongthingbytakingontoomuch risk or gambling onearnings can sometimes leadto large profits but itdramatically increases theodds of crippling losses.Nobody knew how themarket would react to theearnings report. That 12%decline could have been a20%orevena40%increase.

The following are some

questions we might haveaboutthisset-up.

First, since the nextearnings report was due aweek after the breakout,should we have traded thisbreakout?My opinion is thatwe should consider tradingevery decisive breakout,including a breakout veryclose to the next earningsreport, because prices cantravelfar inashort time.Forexample,itwasverypossible

forNutriSystem’sstock,afterbreaking down through thelower horizontal boundary ofthe descending triangle, todecline another, say, 10% to20%inthedaysleadinguptothe earnings release. If thisdeclinehadoccurred,thenwewould cover our shortposition before the earningsreleaseandbookasignificantprofit. A week and perhapseven a couple of days isenough time for a stock to

make a significant move inthe anticipated direction tomake breakouts in situationslike NutriSystem’s worthtrading.

Second, was thebreakdown from thedescending triangle inanticipationofabadearningsreport? Some traders andinvestors made a bet on thebasisoftheiropinionorguessthat the market would reactnegativelytoearnings,butno

one knew for certain. It isobvious but worth repeating:no one and no chart knowsthe future direction of stockprices.

We must not risk ourprecious capital on theutterancesofthosewhoclaimtoknowsomething.I thinkitisacommonmistaketothinkthat those in Wall Streetknow,oratleasthaveabetterideaof, the future.The samecaution must be applied to

our charts, especially with abreakout from a pattern justbefore an earnings release aswe are tempted to think thatthe price action must bereflective of somebodyknowing something and is areliableforecastofthefuture.The market can coldlyreverse a decisive breakoutanytime it wishes andproduce outright patternfailure.

Athirdquestionmaybe:if

NutriSystem’s stockincreased on earnings news,then wouldn’t our stop betriggered and we would beoutofourpositionwithjustasmall loss?So isn’t it awin-win strategy to stay in ourshort position? If the pricecontinues todecline, thenweprofit. If the price goes up,thenwegetstoppedoutforasmallloss.

My response is that if itwereguaranteedthatourstop

wouldbe triggeredatexactlyor nearwherewe placed ourstop, thenyes, staying inourshort position through theearnings release is thedominant strategy.Butthereare no such guarantees intrading. While the stockgapped down on earningsnews, it could have gappedupjustaseasily.Andthegapupcouldhavebeenhuge.I’veseen price gaps measuring20% to 40% and more. And

even larger gaps havehappened and will happen.Bygettingoutofourpositionbefore the earnings release,we avoid this immeasurable,unpredictable, andunnecessaryrisk.

Let’s review. We shouldnotholdapositionthroughanearnings release, no matterhow promising the chartpattern and how clean thebreakout.TheonlytimeIwillseriously consider holding a

very small position throughearningsisifIamsittingonasignificant profit. Even areduced exposure does notguarantee that we will makemoneyinthetrade.Theprofitthatwemadewhenweexitedmostofourpositionmayturninto an overall loss if pricesgap in the direction oppositethe anticipated direction.Wemay even suffer a very largeloss if the price gap is largeenough.

The only guarantee intrading is that wewill sufferpsychologically andfinanciallyifwedon’trespectrisk.Ourpriorityisprotectingour capital.An intact tradingaccount allows us to takeadvantage of favorablemarket conditions and highlyadvantageousset-ups.

CHAPTER11

SymmetricalTriangle

Unlike ascending ordescending triangles,symmetrical triangles do notindicatethelikelydirectionofthebreakoutbecauseboththeupper and lower boundaries

converge to an apex. Thus,pricescanbreakupordown.Still, I would say that mostsymmetrical triangles arecontinuation patterns thatcontinuetheprevioustrend.

Chicago Bridge & Iron: 4-monthsymmetricaltriangle

Thefirstsymmetricaltrianglewe will look at formed inChicago Bridge& Iron fromMay to September 2013. It

had textbook form andproducedacleananddecisivebreakout:

FIGURE29

Thistextbooksymmetrical

triangle was one of themostmeaningful classical patternsformein2013.

Why?BecauseIdidnottradethe

breakout despite havingwatched the pattern developformonths.Ididnottradethebreakout because I did notbelieve the breakout. I sawthe breakout, but I didn’tbelieveanythingwouldcome

fromit.Why?The stock had made an

incredible run and was justunder theoldhigh set beforethe financial crisis of 2007-2009. I thought that theuptrend was surely over.Eventhehumbleold-industryname of the companycontributed to my inaction.Couldsuchaheavy-soundingname continue to go up? Ofcourse nobody knew that the

stock would make anotherpowerful run after thedecisivebreakoutfromthis4-month symmetrical triangle.Not knowing the future wasnotmymistake.Mymistakewas ignoring the breakoutand eliminating the patternfrom trade considerationbecause the stock was doingsomething that I didn’t wantittodoandcouldn’tbelieveitcoulddo:continuetogoup.

This humble, textbook

symmetrical triangleremindedme, again, that myjob as a trader is to believewhat I see, what the price isdoing, rather than believewhat I want to believe orwhat“should”happen.Spotapattern,observethebreakout,enter if there is a favorableentry point, and place a stopthat limits the potential loss.Thenmoveontoothercharts.Repeat.

Here, we would have

risked less than 3% of ourposition to enter a promisingtradebybuying shares at theclosing price of the breakoutday, $62.98, and setting ourstopjustbelowthelowat,forexample, $61.11. Yet I didnottakeaswingatthisset-upbecause I refused to acceptwhat my eyes were tellingme:adecisivebreakout froma textbook symmetricaltriangle. We’ll talk moreabout Chicago Bridge &

Iron’schartinChapter21.

Central European Media: 3-month reversal symmetricaltriangle

A reversal symmetricaltriangle reverses theprevioustrend. The reversalsymmetrical triangle inCETV featured a textbookshape and a hard retest afterbreakout:

FIGURE30

From May to August

2013, Central EuropeanMedia formed a textbook 5-point reversal symmetricaltriangle. The pattern formedafter a steep multi-yeardecline in which the stocklost more than 90% of itsvalue.

Prices closed above theupper boundary on August12. For the next four daysprices retested but did not

trade below the upperboundary. On the fifth daytherewasahardretestwherethestockpricepenetratedtheupperboundaryandtradedaslowas$3.61.Thishardretestwastrickybutalsosupportedthe idea that the initialbreakout had significancebecause even this deep retestwould not have triggered astop-lossorderset justbelowthe low of the breakout day.Also, prices reversed and

closed above the upperboundary by the end of thedayofthehardretest.

If we had already boughtshares after the August 12breakout, we could consideradding a modest position toouroriginalpositionafter thehardretest. Ifwehadnotyetentered this trade, the retestdaywasagood time toenterwhile setting a stop justbelow the low of the retest.Prices jumped 8.4% the next

dayandsurgedhigherforthenext2months.

This example is a goodtradebutalsoaset-upthatwehad to be extra careful withforseveralreasons.

While CETV was not alow-volumestock,itisalow-price andveryvolatile stock.Extra caution is warranted ifwe choose to trade suchstocks.Itisagoodideatousea smaller position in thissituation. It is also perfectly

fine to avoid stocks tradingunderacertaindollaramountnomatter howpromising thepatternstheyareforming.Wehave to remember that therewillalwaysbemoregreatset-ups. Look again at thesymmetrical triangle thatformed in ChicagoBridge&Iron inFigure29–ahumblename,anold-schoolindustry,a textbook pattern, a clearbreakout, and not even aretest of any kind to deal

with.Never forget: therewillalways, always, always beotheropportunities.

We might have guessedwhatournextpointofcautionis. Our good friend thequarterly earnings report.How many times have wesaidthatweshouldn’tgambleon earnings reports?CETV’spowerful uptrend wasannihilatedbyabadearningsreport. The stock dropped54%inoneday.

There are so many basiclessons to be repeated here.Never bet our entire tradingaccount on one stock. Takeprofitsonallorat leastmostof our position when themeasured price target isreached. Gamble with just asmall slice of our originalposition if we decide to takeanunnecessarygambleonanearningsrelease.Let’ssaywewere happy to sell all ourshares with a 30% gain on

this trade. Thenwho cares ifthe stock gains another 50%after we sold? Yes, we arehuman, so we will besomewhat disappointed. Butthe trader who is successfuloverthelongrunwilltakethe30%gainandmoveontothenext opportunity. Becausethere will always be moregreatsetups.

Lastly, it was possible tointerpret the CETV chart asanascendingtriangle:

FIGURE30.1

Aswenoted,sometraders

prefer to interpret a priceaction as a pattern with ahorizontal boundarywheneverreasonabletodoso.Note that the initial breakoutthat occurred in thesymmetrical triangle was nota breakout in the ascending-triangle interpretation. Thedecisive breakout from theascending triangle came fivetradingdayslater.

Again, there is merit inboth interpretations. Thesymmetrical-triangleinterpretationallowedatradertoenterthetradeseveraldaysearlierandthehardretestalsoprovided a second chance toenter. The ascending-triangleinterpretation signalled thetrader to wait for a moresignificant breakout becauseit was the 8.4% price jumpthatdecisivelyclosedaboveasignificant prior high within

the pattern. The interpretivechoice is ours depending onour temperament and tradingstyle. Whicheverinterpretation we choose, wemust stay under ourmaximumriskwithourentryandexitpoints.

Chiquita Brands: 4-monthsymmetricaltriangle

Wehaveanotherwell-shapedsymmetricaltriangle:

FIGURE31

Note that the breakout

came on a large gap up inprice. Let’s zoom in on thebreakoutarea:

FIGURE31.1

We saw how powerful

breakouts,whileexcitingandpossibly indicating a bigmove to come, can makeentering the trade difficult orinadvisable by forcing us toriskalargerpercentageofourposition than we would like.For example, here, thebreakoutcameona11%one-day jump. Fortunately, wedidn’thavetorisk11%ofourposition to enter this trade.

Even entering around theclosing price of the breakoutday and setting our stop justbelow the low price of thebreakout day meant riskingunder5%ofourposition.Thespecific price action in everybreakout will be differentand, in this case, there wassignificant trading within thepattern boundary on thebreakout day to givereasonable cushion to a stopplaced just below the low of

theday.Whilethisstopcouldstill get hit by a hard retest,the stop was reasonably faraway from the patternboundary and the closingprice to make, in my mind,thetradeaworthwhilerisk.

Prices increased another10% in the days after thebreakout. Then the stockpaused. And the nextquarterly earnings reportwasdue to be released within aweek. Iwould sellmy entire

position before the earningsreleaseandbookasignificantprofit. I would also continueto monitor this chart. Wedon’t need to check everyhour. A quick but focusedlook once a day is sufficientto spot interestingdevelopments. The stockneither surged up nor brokedown in response to theearnings report. Instead, thestock continued to tradewithinanarrowrange.

This range-bound actionwas potentially significantbecause small continuationpatterns such as pennants(small symmetrical triangles)andflags(smallrectanglesorparallelograms) can formafter the initialbreakout.Thefact that Chiquita’s stocktraded within a relativelynarrow range in the daysleading up to the earningsreportandcontinuedtodosoin the days following gave

rise to the possibility that acontinuation pennant or flagwas forming. Pennants andflags are by definition, giventheirsmallsize,patternswithnarrowpricefluctuations.

The range-bound priceaction was also significantbecause it offered anadvantageous place to enteran anticipatory trade. I sayanticipatory because therewas not yet a decisivebreakout from a well-formed

pennant or flag. I do notusually enter anticipatorytrades and I think classicalchartists should mostly tradebreakouts from classicalpatterns. Still, there is valueto considering differentwaysto apply classical chartingprinciples.Wecanadoptonlythose methods that we feelcomfortable with. Here, wecould consider entering ananticipatory trade because alow-riskentryspotarose two

daysaftertheearningsreleasewhen thestockcloseda littleabove the retest low. If wewere to buy shares at thispoint, and if the stock pricesubsequently declined belowthelowestpointof theretest,thenwewouldbestoppedoutfor a very small loss barringanypricegapsdown.Instead,the stock price jumped 7.9%nextdayandbrokeoutofa2-week pennant. Of coursenobodyknewthestockwould

jumpnearly8%.Andsomeofus may feel that anticipatorytrades, including this one,blur the line betweendisciplined trading of clearbreakouts and randomtrading. But others maydecide to make thisanticipatory trade becausetheysawasmalledge.Thereis no single correct way totrade.We can choose a stylethatsuitsusbest.

It is sometimes the case

with small continuationpatternslikethispennantthatwe see the pattern only afterthe breakout. Hence theusefulness of an exploratoryposition that tries toanticipate a breakout. Myguessisthatmostofuswouldnot have entered ananticipatoryposition,andthatis fine. I think itwould havebeen reasonable to buy asmaller than usual positionevenafterthe7.9%breakout.

With theearningsreleaseoutof the way and a decisivebreakout from a pennant,entering a smaller positionthat kept our potential lossunderourmaximumriskwasaworthwhiletradetomake.

One last word onanticipatorytrades.Ihesitateddiscussing such entriesbecause they can lead usaway from thedisciplineandstrict risk management thataresoimportanttolong-term

survivalandprofitability.Wemaygettheideathatwehavea good excuse to take largerandrecklessrisksinthenameof anticipating a breakout.This danger is why I repeatagain and again, and willrepeat again and again, thatevery tradeweentermustbeat a spot on the chart thatoffers an advantageousreward-to-riskpossibility andkeepsourpotentiallossunderourmaximumrisk.

Itisvitalforustoembracethese cautionary principlesand to recognize that suchrules are not meant toneedlessly limit our trading.Instead,anticipatoryentrieswhen properly done canreduce risk and increaseprofits. They can be theprofitable outlet fordisciplinedcreativity.

Energen Corp.: 2-yearsymmetricaltriangle

This symmetrical triangle isone of the largest patterns inthe book. Let’s first look atthe weekly chart as itprovides a useful big-pictureviewoftheset-up:

FIGURE32

Note the crash due to the

financial crisis of 2007 to2009 when Energen, likemany stocks, lost more than50% of its value. The stockstartedtorecoverin2009andpeaked in the early part of2011.Then the stockmadeaseries of lower highs andhigherlowsoverthenexttwoyears. A giant symmetricaltriangle was forming.Wouldthe triangle launch another

upwardrunorstartadecline?Whichever way the stockbroke, the size of the patternsuggested that the movecouldbeverypowerful.

Ithinknowisagoodtimeto remind ourselves of theimportance of not gettingobsessed with any set-up.Recallourdiscussiononhowwe need to trade withemotional detachment. Thedanger with massive multi-yearpatternslikethistriangle

isthatwecangettooattachedto them.We imagine all themoneywe’llmake if amegapattern reaches its measuredprice target. So we mighteven plan to go all in. Wemust never try to define ourtrading career in a singletrade. If we do, our careermay end, and not in thewaywe hoped. Even the mostpromising, textbook-perfect,straight-A-plus, well-mannered, and superfood-

eatingpatternmustbelookedatintermsofthecoldbottomline:isthereanadvantageousentry point with a favorablereward-to-risk ratio?Successful trading is aboutpatiently implementing arepeatable process thatmanages risk over manytrades.

Another fact we mustremember: all patterns canfail any time, even after adecisive breakout that seems

toconfirmwithoutanydoubtthe significance of thepattern.Let’ssaytherewasadecisive upward breakoutfrom a hypothetical 3-yearsymmetricaltriangle.Webuysharesatthebreakoutandweare quickly up 15% on ourposition. We are very happyand excited. Then the stockprice starts to come backdown and soon retests thebreakout boundary. Then thestock closes below the

boundary. We are frustratedand hope our stop won’t betriggered.Butwearestoppedout the next day. We areangry. How could thishappen? There was a perfectbreakout from a perfectpattern. So we enter againwith a very large positionwithoutanyjustification.Thestock continues to decline.We double our position. Thestock will turn around soon.We know it. The perfect

patternwon’tallowustolosemoney. The stock continuesto crash andwe lose a lot ofmoney.Thelessonis thatwemust not get attached to anysingletrade.

Tradingwellisnotaboutfinding perfect patterns ormaking money. It is doingthe right thing over andover by trading onlyadvantageous set-ups andwaiting patiently whentherearenone.

Let’sreturntotheEnergenset-up and look at a dailychart to get a better view ofthebreakout:

FIGURE32.1

A closer look at the

breakout and ensuing actionshows that thebreakout fromthis massive pattern did notlead toeasyprofits. It is truethat the stock made steadygains for a week afterbreaking out. Then pricespaused and traded in achoppy and somewhatdownward manner for amonth.That’safullmonthofthe stock going nowhere.No

easy profits so far. Then thestockdeclinedfarther todoahardretestofthesymmetricaltriangle’s upper boundary.During the retest, the stockpricetradedbelowbutdidnotclose below the upperboundary. This developmentdid not guarantee that thepattern would work. But itdid support the view that theupper boundary was now animportant support level andthat the initial breakout still

had significance. Theresilience of the upperboundarywasgoodnews,butthehardretesttriggeredstopsset close to the boundary,includingastopbasedonthelast day rule. That’s no bigdeal. Our stop served itsfunctionandwewouldbeoutwithasmallloss.

The next question iswhether we should re-enterthis trade after gettingstoppedoutbythehardretest.

If I were stopped out by thehard retest on June 24, Iwould have reentered thistradearoundtheclosingpriceof the retest day and set mystopjustbelowtheretestlow.

I would re-enter for thefollowingreasons.

The stock price closedabove the pattern boundaryafter the retest. And mostimportantly, the retest daycreatedafavorablereward-to-risk scenario with logical

entry (closing price) and exit(just below the lowest reachofthehardretest)points.Letus repeat: the fact that pricesclosed above the patternboundaryafterthehardretestdid not guarantee that thepattern would work and thatthere would be no furtherretests. But it did create anentry spot with a potentiallyvery favorable reward-to-riskpossibility.Thatdidnotmeanwehadtoenterthetrade,but

ifwedid,itdidmeanthatwehad a justifiable reason forthe trade and that any losswould be very small. Ifanother retest triggered mystop order, then I would beout again with a small lossandIwould thenmoveon toother charts. But if the stockstartedtomoveupfromhere,then my position’s upsidepotential was much greaterthanmypotentiallossbarringa price gap down. The stock

went up about 10% in thenext month. That’s a goodgain,butamonthofpatiencewas required.Again, nothingeasysofar.

Furthermore, we are nowonly days away from thequarterly earnings report. Ialmost always exitmy entireposition before the nextearnings report. Oneexception iswhenI’msittingon a substantial profit anddecide to keep atmost about

athirdofmyoriginalpositionthrough the earnings report.Here, if I had bought sharesafter the hard retest, I wouldbe sitting on a 10% profit.AndImayunwiselydecidetorisk a small portion of thisprofit through the earningsrelease. Doing so is a puregamble. The fact that pricesbroke out of a mega patternandthatthepatternsurvivedahard retest do not predict orguaranteethatthemarketwill

react positively to theearningsreport.Priceswilldowhatever they want. In thiscase, the market reactedpositively to the earningsreport. But staying in, evenwithasmallposition,wasthewrong decision and a badtrade.

Evercore Partners: 4-monthsymmetricaltriangle

Our next example presents

another situation where theearningsreportwasdueafewweeksafterthebreakout:

FIGURE33

Notice the six solid price

touches with the upper andlower boundaries. Also notewhenthestocktradedbutdidnot close outside the lowerpattern boundary. That iscalled an out-of-linemovement. Remember thatprices do not have to staywithin our boundaries. Thelines we draw allow us tovisualize thepriceactionandhelpusspotlogicalentryand

stop points that keep uswithin our risk parameters.Patterns don’t have to beperfect to be very usefultradingtools.

Itwaspossibletointerprettheout-of-linemovementasabreakout attempt to thedownside from a 5-pointreversalsymmetricaltriangle.And some of us may haveenteredashortpositionwhenprices broke down throughthelowerpatternboundary.If

so, we would also place abuy-to-cover stop order,perhapsjustabovethehighofthe day. By the end of thetradingday,however,wesawthat the stock price closedback above the patternboundary. We may havedecided to exit our shortposition then or, if not, wewouldhavebeenstoppedoutthe next day when the stocktradedabovethehighofwhatturned out to be a one-day

out-of-linemovement.Thelosswesufferedfrom

this unsuccessful shortposition would be nothingmorethanaminorannoyanceif we used the appropriateposition size. We couldconsider it a bet that wasworthtakingbecausetheriskwaswelldefinedandlimited.

Whetherornotweentereda short trade due to the out-of-line movement, it wasproductive to continue to

monitor the pattern. It wasclear that priceswere coilingand still possibly forming asymmetricaltriangle.

The next breakout was tothe upside. Had we boughtshares at around the closingprice of the breakout, ourposition would be up byabout 7% by the timeearnings were due to bereleased. That’s a good gainin such a short period. Itwould bewise and proper to

sell our entire position andmoveontootherpatterns.

But let’s assume that ouremotions push us to gambleand we decide to sell two-thirdsofouroriginalpositionand keep one-third throughthe earnings release. In thiscase, our irresponsible andunnecessary gamblesomewhat “worked” in thatprices initially increased butprices soon stalled and didnot go higher for a month.

Had we chosen to unwiselygamble on the earningsreport,wewererewarded(forour bad and risky behavior)with significant gains only ifwe stayed patient for severalmonths. Prices rarely gostraight up or down. Theyoften build a foundationbefore starting a trend andalsotakefrequentbreaks,andsome of these foundationsand breaks take the form ofclassicalpatterns.Remember

thatnotallpricemovescanbe explained by classicalpatterns. Prices go up,down,andsidewaysforanyornoreason.Notalltrendsare launched by classicalpatterns.

GenworthFinancial:2-monthsymmetricaltriangle

This pattern shows again theutmost importance ofpatience:

FIGURE34

Afteracleanbreakout,the

stock stalled and traded innarrow range for 3 weeks.That’s right: that little areaenclosedinthesmallboxwasthree weeks. It was possibleto interpret this 3-week priceactionasasmallrectangleoracontinuationflag.Whateverour label, we had to waitpatiently for almost a monthuntil prices broke out of itand made large gains. If we

cannot control our emotions,do not learn to relax, and donot learn to step away oncewe have entered a position,there is little chance that wewould have had the patienceand peace of mind to staywith our position until therealuptrendbegan.

Of course there was noguarantee that the uptrendwouldbesopowerful,orthattherewouldbeanytrend.Noone could know what would

follow.This Genworth chart

shows perfectly that the onlythingswecancontrolare:(1)enteringatradeatafavorablespot, (2) setting a stop thatkeeps potential losses withinour risk tolerance, and (3)then turning our attention toother charts, projects, andinterests. The breakout wasreasonably decisive but soonstalled.Unlesswe accept thefact that we have no control

over prices and there isnothingmorewecandootherthan to let the pattern playout,wewill fail in this tradeand in trading. Each bar inthat stall area represents aday. Imagine staring at ourscreen wondering andagonizing over whether andwhen the stockwill continuethe uptrend started by thebreakout – for three weeks.Wecannotdoit.Wecan,butwe’ll be physically and

emotionally spent in a fewdays.Ifwegetexhausted,wedon’t have the mental andphysical strength to staypatient. So we may sell ourshares and watch as apowerful trend leaves usbehind. Then we chase thebreakoutathighriskbecauseour weak emotional statemeans that we lack patienceanddiscipline.Assoonasweenteratahighpricethestockreverses andwe are outwith

a large loss. Our emotionalstate continues to deteriorateand we continue to chasetrying tomakeupour losses.The result is more losses.Thisisaself-destructprocessthatwemustavoid.

Forthesereasons,wemustpursueother interestsbesidestrading. I don’t mean weshould take trading lightly.Tradingisaseriousendeavorthat will challenge ourmental, physical, and

intellectual reserves. Butbeing a serious trader doesnot require us to obsess overevery price tick. Quite theopposite. Proper tradinginvolves a lot of letting goand,quite frankly,notcaringat a certain point. Letting goafter entering a trade andputting in our stop order.Remember that the smallrectangle within whichGenworth’s stock bouncedaroundrepresentsthreeweeks

of our life. How stupid,wasteful, andweakening is itto worry about what a stockwill do? If the stock moveshigher, then fine. If thepattern fails, then our loss islimited to just a fraction ofour trading account and wecan look forward to otheropportunities.

LionsGateEntertainment: 5-monthsymmetricaltriangle

Trading demands patience inmany ways. We waitpatiently for a breakout. Wewaitpatientlyforaresolutionafterabreakout.Patiencealsomeans persistent diligence infollowing a chart for weeksandmonthsandevenyearsasthe price action evolves. Thenext chart shows theimportanceofnotquittingona chart after a decisivebreakoutstalls.

Let’s look at the weekly

chart to get an overall senseofthepattern:

FIGURE35

It is a classical pattern as

elegant, well-formed, andsimple as the very first chartwe looked at. But trading isalso about the details,specifically, advantageousentriesandloss-limitingexits.Anduponcloserexamination,wehadtomeetsuccessfullyacouple of stiff challenges totradethisset-upwell.

The next chart is a dailychart that focuses on the

breakout and the subsequentpriceaction:

FIGURE35.1

The breakout from the 5-

month symmetrical triangle,shownon the left part of thedailychart,wasdecisive.Thestock rose in the followingweek but soon stalled and itlooked as if there may be ahard retest of the upperboundary when pricesdeclined in late September.But there was no hard retestandpricesmadesteadygainsover the next month. Two

months have now passedsince the breakout. Thequarterly earnings reportwasdue soon. Prices declinedsharply in the week leadingup to the earnings release.Then prices jumped 14% onearnings news but there wasstill no resolution to the factthat the stock had beenessentially trading in the14.50to16.50rangesincethebreakout. Indeed, the stockremained in this range for

anothertwomonths.It would have been

understandabletoquitonthispatternandmoveon tootherset-ups. Andwe should lookat set-ups where a breakoutmay be imminent. But thereis also much value tocontinuing to keep up with“old” patterns because arelatively small but powerfulpattern can develop overseveral weeks. Realize theeffectiveness of a brief but

focused look at a patternevery couple of days or so.Here, such continuousdiligenceallowedustospotasmaller symmetrical triangledevelop. The breakout cameon a gap up in price. Wecouldhaveenteredaroundtheclosing price of the breakoutday and set our stopsomewhere below the upperboundary and remain wellbelow our maximum risk.The stock marched higher

fromhere.So in a sense this second

smaller triangle launched the“real” uptrend.Therewasnoway to anticipate thisdevelopment other than tostay patient and continue tomonitorthechart.

Lincoln National Corp.: 15-month reversal symmetricaltriangle

Thissymmetricaltrianglewas

a reversal pattern.Here’s theweeklychart:

FIGURE36

Next is the daily chart

with a focus on the breakoutandretest:

FIGURE36.1

The first breakout failed

whenpricescloseddecisivelybelow the upper boundarywithin a week. Failedbreakouts, disappointing andjarringastheymaybe,donotnecessarily mean that thepattern has also failed. Wewill find thatsomebreakoutssucceed only on their secondoreventhirdattempt.Butwedo need tomove on at somepoint. I will consider trading

asecondbreakoutattemptbutwill almost always move onafterthesecondtry.

Here, the secondbreakoutwas successful. The highervolume and gap up in pricestrongly supported the viewthatthissecondbreakoutwasthe real breakout.What isn’tsocleariswhetherweshouldtrade this breakout. The gapupmeantthatwewouldhavetochasethisbreakouttoenterthe trade. It wasn’t

unreasonable to chase if weboughtasmallerposition.Orwe could have let thisbreakout go on its waywithoutus.Therewillalwaysbe other opportunities,including set-ups where wedon’thavetochaseatall.

Lastly, note that the daybefore the second breakout,thestockclosedmodestlybutclearly above the upperboundary of the symmetricaltriangle. I think that this re-

close above the boundaryofferedagoodchancetobuyshares and set our stop justbelow the retest low. Thepossible downside wasdefinedandlimitedwhiletheupside was potentially muchgreater, which is a conciseandcogentdefinitionofgoodtrading.

Cheniere Energy: 7-monthsymmetricaltriangle

The next example involvesanother tricky breakout. Thefollowingweeklychartshowsa textbook symmetricaltriangle that formed fromMaytoNovember2013:

FIGURE37

Weekly charts are useful

because they give usperspectiveandasenseoftheoverallsituation.Buttheycanhide the gritty details of abreakout, and theparticularitiesof every set-upcanrevealbothobstaclesthatweneedtodealwithoravoidaswell as edges thatwe cantakeadvantageof.

The next chart, a dailychart, reveals a tricky

breakout:

FIGURE37.1

The stock closed above

the upper boundary of thesymmetrical triangle on thelasttradingdayinNovember.While not a decisivebreakout, buying shares herewithastopjustbelowthelowof the day was a reasonableentry with limited risk. Thenextdaythestocktradedabitbelowtheupperboundarybutclosed above it. A moresevere retest came the

following day as the stockclosed below the upperboundary and also triggeredany stop set just below thebreakoutday’slow.Anythingis possible at any point on achart. The stock couldcontinue to decline and thepattern could fail beforeevolving into a completelydifferent set-up. Or it couldattempt another breakout. Ithink the best thing to do inthis situation, if we were

stoppedout,istosimplywaitand see how the chartdevelops. We didn’t have towait longas the stock closedabovetheupperboundarythenext day. Should we buyshares again here? Some ofus, as a matter of principle,may decide to never trademorethanoncethesameset-up. The pattern works thefirsttimeordoesnot.

Ifwearestillinterestedintrading this pattern, what

factors should we consider?The first factor is, asalways,risk management. Does theset-up offer an advantageousentry spot? Here, the answerwasyes.Wecouldbuyshareswhen the stock re-closedabove the pattern boundaryand set our stop just belowthe lowest reach of the hardretest. Our risk was well-defined and likely verylimited.Ifwegotstoppedoutagain, then we could move

on.Volume was another

factor to consider. The nextchart focuses on the priceaction and volume in thebreakoutarea:

FIGURE37.2

The volume on the hard

retest was lower than duringthe initial breakout and thesecond breakout after thehardretest.Itwaspossibletointerpret this volume actionas hinting that there wasgreater enthusiasm andstrength among buyers thansellers.But thiswas just onepossibleinterpretation.Itwasnot and could never be acertainty.

Anotherfactortoconsiderwas that although the stockre-closed above the upperboundary,itdidsobyasmallmargin.

So we had to weigh thevolumeaction,whichseemedto favor theupside, against ahesitant breakout, whichmadeanotherhardretestverypossible.

Iwouldre-enter this tradearound the closing price ofthesecondbreakoutbasedon

the favorable volume actionand, most importantly, thefact that my potential losswas very limited while theupside was much greater. Inthis case, I would have beenrewarded with a 7% pricejump on heavy volume thenext day.Butwe’re far frombeingdonewiththischart.

Nextquestion:isittoolateto enter this trade after the7% jump? We know thatpowerfulbreakoutscanmake

entering trades difficult byforcing us to chase and riskmorethanwewouldlike.Thesituation is sometimes sodifficult and risky that nottrading the breakout is thecorrectdecision.Butweneednotruleoutchasingifwecanchasewhilestayingunderourmaximum risk. Here, buyingapositionthatwasaboutone-third to one-half the size ofournormalpositionmadeourrisk acceptable even if we

placedourstopbelowthelowofthehardretest.

And I think setting ourstop down there was betterthan placing it, say, justbelow the low of the daywhenthestockincreased7%.While the 7% increase onheavy volume seemed toconfirm the pattern andbreakout, there was noguarantee that the stockwould only go up fromhere.Indeed, the stock reversed

immediately after the 7%jump and declined over thenextweek.

While thisdeclinedidnotreachthepatternboundary, itwould have triggered a stopset just below the lowof the7%day.Thestock lostallofits 7% gain and then some.And the stock could declinefartherandstillstayabovetheupperboundary.Prices couldreturnallthewaybacktotheupper boundary before

reversing and launching apowerfuluptrend.

So a reasonable spot toplace our stop-loss order isbelow either the low of thehard retest or the low of theday before the 7% jump.While we could place a stopatahigherprice, itmeantanincreased chance that ourpositionwillget stoppedout.Getting stopped out for asmalllossisnottheproblem.Thedangerinthissituationis

getting caught in a painfuland destructive downwardspiral.We’ll discuss this risknext.

Yoda said something aboutangerandsuffering

We can get caught in anegative spiral if we getangry, frustrated, and greedyafter we get stopped out bythe price decline followingthe 7% jump. If we simply

accept our small loss andmove on, then there is noproblem. But there is aproblem if we get obsessedwithmakingmoneyfromthispattern and we rashly buysharesagain.Thenwesetourstop very close to our entrybecausewewant tokeepthisemotional trade on a shortleashandwecannotbear thethought of losing moremoney. But normal volatilitystops us out again. We get

angry and buy anotherposition. And so on. Ourlosses pile up. The situationbecomeverydangerousifwedecide to simply not place astop-loss order because webelieve the pattern “has towork.” A big loss results ifwe refuse to get out even asthe stock continues to fall.The ultimate danger is if weconvince ourselves that thepattern, despite these earlydifficulties, will work given

its textbook shape andthereforegoallin.

What led us to this self-destruction? Greed and fear.We wanted to make a lot ofmoney right now with thispattern.Wefearedmovingoncould mean never findinganother good set-up. Asridiculous as this fear maylook to us as readers,we areall susceptible to such short-sightedness when we arefearfulandangry.

Contrast this painfulexperience against traderswho are unattached to theoutcome of any single trade.Let’s say some traders chasethe breakout with a smaller-than-usual position and settheir stop just below the lowof thehard retest. If theygetstoppedout,thentheyarenotbotheredmuchaboutlosingasmallfractionoftheirtradingaccount.Theyknowthattheyhave given this trade a fair

chance to work. They moveon to other opportunities.They may not even checkback until weeks or evenmonthslateras theyarebusydoing other things. Had theyfollowed every price move,they would have beenstrongly tempted to sell theirpositionafterthestockerasedall of its gains from the 7%jump.

Finally, note how thingswerefarfromeasyevenifwe

had bought shares the daybeforethe7%jump.Weweresoon sitting on a 7% profit,butthisprofitcushiondidnotmakeweathering the ensuingpricedeclineeasyifwewereanxiously watching the priceaction. All of us aresusceptible to fear andfrustration if we watch ourprofits get chipped away dayafter day.We need to let goafterenteringatrade.

Unfortunately, every

trader is likely to experiencethis negative spiral. And wearemostlikelytofallintothisdiabolical trap when weforget that there will alwaysbemoreprofitableset-ups.Agood way to recover ourcomposure is to open thisbook and see how manyintriguing patterns haveappeared in U.S. stocks injustthepastcoupleofyears.

We should do this now:grab pen and paper and

write “THERE WILLALWAYS BE MOREGREAT SET-UPS” andpost itonthewall.Sayandbelieve these words everyday.

NorthropGrumman:5-monthsymmetricaltriangle

The next chart shows thesituation in NorthropGrumman fromAugust 2012toMarch2013:

FIGURE38

Northrop Grumman made

strong gains up to August2012 then stalled and tradedbetween$65and70foreightmonths. The second half ofthis range-bound price actionturned into a symmetricaltrianglethatlaunchedanotherstronguptrend.

Thenext chart focuses onthebreakout:

FIGURE38.1

Heavy volume

accompanied the decisivebreakout through the upperboundary of the symmetricaltriangle. If we had boughtsharesaroundthecloseofthebreakout day and set a stopjustbelowthelow,wewouldriskabout2%ofourpositionon a pattern that held muchpromise give its size, shape,andbreakout.But,asalways,these positive factors did not

mean that the pattern wasguaranteedtowork.

Indeed, prices hugged theupperboundaryformorethana week after breaking out.Four days after the breakout,prices closed slightly belowthe boundary. Pricescontinued to trade just aboveand below the upperboundary for two more daysbefore breaking out of thiscongestion that included fourhard retests. If we were

checking the price actionoften, then we were muchmore likely to lose ourdisciplineandsellourshares.Then, of course, we wouldhavemissedtheupwardsurgethatstartedjustdayslater.

Again: enter and forget.Repeat.

Lastly, note how the hardretests didn’t get close totriggering a stop placed justbelowthelowofthebreakoutday.

Principal Financial: 9-monthsymmetricaltriangle

The next chart includes anearly look at a veryinterestingandusefulpattern,a H&S top failure pattern. Ilearned this pattern fromPeterL.Brandt.Wewilllookat many more H&S topfailurepatternsinChapter16.These patterns areH&S topsthat start an upward price

move when prices decisivelyclose above the high of therightshoulder.

Figure 39 is a weeklychart that gives us the big-pictureviewoftheset-up:

FIGURE39

This stock had traded

above $50 in 2008 beforelosing90%ofitsvalueduringthe global financial crisis of2007 to 2009. The stockrecovered rapidly from thelows of spring 2009 as itincreased five-fold in sixmonths. Then it tradedbetween $20 and $30 for 3years.Bythemiddleof2012,the stock seemed to beformingagiantH&Stop.The

left shoulder, head, andpossiblerightshoulderofthispotential H&S top wereclearly visible by the middleof 2012. Note how thepossible right shoulderformed a symmetricaltriangle. If this massive 3-year topping pattern wasgoing to become aH&S top,then we would look for thestocktobreakdownfromthissymmetrical-triangle rightshoulder.

The next chart is a dailychart that focuses on thesymmetrical-triangle rightshoulderandthebreakout:

FIGURE39.1

Instead of breaking down

through the lower boundaryof the symmetrical triangle,the stock gapped up throughthe upper boundary. Thestock went on to gain morethan 50% in the followingyear.

We didn’t have tointerpret this multi-year set-upasanH&Stopfailure.Wecouldhave lookedat the set-up as a textbook 8-month

symmetrical triangle thatformed after a multi-yeartradingrange.

ButIhavetworeasonsfordiscussing this set-up as aH&Stopfailure.

First,aswewilldiscussinChapter 16, this pattern canbe very useful and powerful.The more patterns and thusmore possibilities we know,the more productive andcreativewecanbe.

Second, thepossibleH&S

top would have been amassivetoppingpatternhaditbeencompleted.Thefactthata pattern this big failedsuggested that the new trendcould be similarly massive.Some of the most powerfultrendsstartwhenastockgoesintheoppositedirectionfromthe expected direction. Thatsaid,someofuswillprefertolookatthisset-upassimplyasymmetrical triangle. Afterall, the triangle was a large

pattern on its own that couldstart a powerful move.Whatever our preferredinterpretation, our goal is tocontinuously acquireknowledge, includingdifferentperspectives,togainasmuchan edge aspossible.A little edge canmake a bigdifference.

Intermsoftradingtactics,we could buy shares aroundthe closing price of thebreakoutdayandplaceastop

justbelowtheclosingpriceofthedaybeforeratherthanjustbelowthelowofthebreakoutday. In this case,we have tomodify the last day rule forplacing stops because thebreakoutdaydidnothaveanytrading inside the patternboundaryduetothegapupinprice. We could place ourstop a bit lower or evenbelow the low of the daybefore. Our stop placementdepends on our trading style

and risk tolerance. The mostimportant thing is that westaybelowourmaximumriskineverytrade.

Parker Drilling: 2-monthsymmetricaltriangle

Ournextsymmetricaltrianglewas another instance wherevolumehelpedusanalyzethesituation:

FIGURE40

Volume helped us in two

ways.First,thevolumegenerally

declined as the symmetricaltriangle formed. One of therequirements of a textbooksymmetrical triangle isdecreasing volume duringpatternformation.Thatsaid,Ifeel that declining volume isnot an absolute requirementand I have seen manysymmetrical triangles that

work well without a cleartrend of declining volume.But when there is volumeconfirmation, then it can bean important factorsupporting the patterninterpretation.

Second, the fact thebreakoutoccurredonvolumethatwasheavierthananydayduring pattern formationstrongly suggested that thepattern boundary and thebreakout through it had

significance. In fact, thebreakoutday’sheavyvolumewas not exceeded until amonth later when extremelyheavy volume accompaniedtheearningsreport.

The breakout came on an8% price jump. As we haveseen, adecisivebreakoutcanbe both exciting anddaunting.The8%surgemadethe breakout decisive but thetraderiskier.IfIweretotradethis breakout, I would buy a

position that was about onehalf of my normal positionsize at around the breakoutday’s closing price and setmy stop just below thebreakout day’s low. Thistrade would gain about 15%in two weeks. Then I wouldsell my shares before theearnings release. If Iwere togamble on earnings, then Iwouldkeepatmostone-thirdof my original positionknowing that the stock could

drop by double digits inresponse to the earningsreport.Had I stayed in, I gotluckyasthemarket’spositivereactiontotheearningsreportsent the stock higher byalmost20% in thenext threedays. But remember thatgetting lucky isnot the samethingastradingwellbydoingtherightthing.Whilenothingguaranteesaprofitinatrade,doing the right thing overmany trades is the best

strategy for long-termprofitability.

Rite Aid Corp.: 7-weeksymmetricaltriangle

Ournextsymmetricaltriangleformed in Rite Aid after thestockhadgoneupmore than50%intwomonths:

FIGURE41

The breakout came on a

decisive 4.3% gap up. Thenext day the stock went upanother 4.5%. But not manybreakouts go straight in theanticipated direction. Here,the stock declined 5% overthe next three days. And thestock still hadmore room todecline before touching theupper boundary in whatwouldbeanormalretest.So,again, few things are as easy

as they look. The only thingwecandois toentera trade,setastop,andmoveon.

Let’s talk about tradingthisset-up.

First,theforcefulbreakoutmade buying shares andsetting our stop a bit tricky.Buying shares around theclosing price of the breakoutday and setting our stopreasonably far away meantrisking about 4.5% to 5% ofour position. Depending on

our maximum risk andtrading style,wemay decidetobuyasmallerpositionthanusual.Let’s saywedecide tobe cautious, which is alwaysa good approach, and buy apositionthat isabouthalf thesize of our normal positionsize.

Second, where could weplace our stop? Notice thatwe need to modify the lastday rule for placing a stopbecausethegapupmeantthat

there was no trading withinthe pattern during thebreakout day. Some possibleplacesforourstopordersare:(1) just under the pattern’supper boundary, (2) justundertheclosingpriceoftheday before breakout, or (3)justunderthelowpriceofthedaybeforebreakout.

Ahardretestwaslikelytotrigger a stop placed justbelow the upper boundaryandevenastopplacedbelow

the closing price of the daybefore. Simply lowering ourstop placement was not soeasy to do because doing someant risking even a largerportion of our alreadyreducedposition.

This set-up is a greatexample of how a textbookpattern and a decisivebreakout are not necessarilythebest trades.Trading isallabout advantageous entriesand loss-limiting stops. We

must not trade just becausethere is a breakout.Knowingwhen not to trade is animportant skill. The specificsof the Rite Aid set-up andbreakout did not create themost favorable entry pointandstoplevel.Buttheset-upwasn’t so unfavorable as tocall for automaticdisqualification. We haveoptions.First,wecouldpass.Second, we could buy asmaller position and set our

stop somewhere below theupper boundary. And third,wecouldenterapositionandplace our stop somewhereabove the upper boundaryand hope that a hard retestdoes not occur. There is noright answer. Ifwe decide totrade and choose either thesecond or third option, wemust not get obsessed overmakingmoneyonthispatternif we get stopped out. If Iwere stopped out, then I

would move on withouttrying a second time becauseI know there will be manyset-ups and breakouts withmuch more favorable entryandexitpoints.

NxStage Medical: 6-weekreversalsymmetricaltriangle

Ournextsymmetricaltrianglewas a bottoming pattern thatreversed a sharp downtrend.Volume helped us make

senseofthispattern:

FIGURE42

In a textbook bottoming

reversal symmetrical trianglethat launches an uptrend, thefirstmajortouchpointwouldbe with the line that wouldbecome the lower boundary,thesecondtouchwiththelinethatwouldbecome theupperboundary, the third touchwith the lower boundary, thefourth touch again with theupper, and a fifth majorcontact with the lower

boundary. Then the stockwould break out through theupperboundary.InFigure42,wehavefoursolidalternatingtouches with the lower andupper boundaries but wedon’t have the fifth touch onthe lower boundary. Butpatterns don’t have to beperfect to be useful andprofitable. The stock wasclearlycoilingand formingasymmetrical triangle of somekind. Would this triangle

continue the previousdowntrend or reverse thedowntrend and start a newuptrend?

Let’s see if volumeprovidedclues.

First, volume steadilydeclinedaspricescoiled intoatriangle.Thisfactsupportedthe interpretation that ameaningful coil was takingplace.

Second, volume washigher on up days than on

down days. This factsupported the interpretationthat buyers were moreenthusiastic than sellers andthus the bias could be to theupside, though we couldnever be sure. Note howvolume spiked as the stockwent from the first touchpoint on the lower boundaryto the second touch point onthe upper boundary. Volumethen declined as the stockdeclined to the lower

boundary. An even largervolumespikeoccurredas thestockwent up from the thirdtouch point to the fourth.Volume decreased again asthe stock declined from theupper boundary. Note pricesdid not go all theway downtothelowerboundary,whichwouldhavebeenthetextbookfifth touch. Finally, volumeincreased as the stock brokethrough the upper boundary.Apowerfuluptrendfollowed.

So we should be mindful

of the volume accompanyingthe price action withoutfalling into the trap ofthinkingthatitisinfallible.

Somecautionarypoints.The chart does not fully

capture the volatile nature ofthis stock. Large daily pricemoves were common.We’rehappy when we’re on thesame side of a powerful

trend. But we have toremember that sharp trendscanreversequickly.Wehaveto bring to every trade theutmostcautionandprudence:enter a trade only when thereward-to-risk ratio isfavorable, always use stopsthat limit losses, and take atleast some profits atmeasuredpricedtargets.

Also, it was easy to missthe breakout from thisrelatively small 6-week

pattern. If we missed thebreakout, then we must notchase and exceed our riskparameters.Itisfrustratingtowatch a powerful trend takeoff without us. When suchfrustration hits, our job is toremember that there willalwaysbemoreopportunities.

CHAPTER12

ContinuationPennant

(SmallTriangle)

Pennants are small trianglesthat sometimes form after apowerful run or soon after abreakout. We can think ofthem as when stocks take a

breather before startinganotherrun.

CapellaEducation

Figure 43 is a weekly chartthatshowsa9-monthreversalsymmetrical triangle thatformed from July 2012 toApril2013:

FIGURE43

And the following chart,

Figure 43.1, is a daily chartthat focuses on the reversaltriangle in the bottom rightportionofFigure43:

FIGURE43.1

Some of us may object

that this price action is not areversalsymmetricaltriangle.There is something about itthat is ungainly. We mightalsonotethatithasonlyfourtouchpointscompared to thefive touch points of atextbook reversalsymmetrical triangle. Theseare valid objections. Andthere is nothing wrong withmoving on to other charts if

we don’t believe in thepattern or see anythinginteresting. We have tobelieve in and be excitedabout the pattern’spossibilities to trade thepattern well using good riskmanagement. Ifwedon’t seea valid reversal symmetricaltriangle, then how can wetradeit?

Let’s stay on this point. Iam always amazed at howoften I look at another

trader’s “H&S top” or a“descending triangle” and Idon’t see these patterns.Sometimes I see the patternbut they are too looselyformed for my preference.Remember that it is a goodidea to try to trade onlypatterns that can be used astextbook examples. Othertimes I just don’t see anyprice action resembling thenamed pattern. We must nottrade a chart just because

another trader says there is apattern. The temptation totrade another trader’sidentified pattern will bestrong if this trader is an“expert” who appears in themedia. Some well-knowntraders do offer interestinganalyses and insights, but inmy experience only a verysmall portion of the chartinganalysis in the media hasvalue.

Why might this be the

case?First, as mentioned, we

many simply not see, forexample, the H&S top thatanother trader has identified.Such disagreement resultsfromthefactthattradersmayhave different requirementsforclassicalpatterns.Thereisroom for different opinionswheninterpretingcharts.Thatsaid,weshouldtrytostickasclose as possible to Edwards& Magee’s descriptions of

eachof theclassicalpatterns.Edwards & Magee’s classictext has proven to betimeless. We should notdeviate too much from thefundamental principles thattheyhavelaidout.

Second, even if we agreewith another trader that aH&Stopmaybeforming,weare almost certain to havedifferent entry and exitstrategies and also differentrisk tolerances. In short, we

have to do our ownhomework and stay withinour comfort zone. Don’tworry about what others aredoing.Nobodyhas thesinglecorrect method. We need tofocus on doing the rightthings, namely, entering atadvantageous spots andlimiting losses. How weaccomplish these tasks is upto us. Classical chartingoffers traders different waystotradethesamepattern.And

we should welcome thefreedom, flexibility, andchoice.

Let’sreturntotheCapellachart. I would not haveidentified this chart as areversal symmetrical triangleuntil the 18% jump inresponse to the earningsreport. And of course it wasimpossible to anticipate this18% gap up. Further, it wastoo risky to buy sharesimmediately after the

breakout because we had torisktoomuchofourpositionto do so. So does this set-uphaveanyvaluetous?

I think there are twotakeaways.

First, we should be openminded. This reversalsymmetrical triangle did nothave the textbook-specifiedfive major touches with thepatternboundariesandlookedabit“off”tosomeofus.Butpatterns don’t have to be

perfect to be useful.Remember how the reversalsymmetrical triangle inFigure 42 did not have thefifthcontactbutstillservedasa useful and tradableinterpretation of the priceaction.

Second, while we couldnot anticipate nor trade the18% jump, themagnitude ofthis price gap suggested thepossibility of a powerfultrendtocome.Thisbigmove

arguably constituted thedecisive breakout from areversalsymmetricaltriangle.And while the breakout wasuntradeable, the stock couldform another pattern, like asmall continuation pattern,thatmightofferacompellingtradingopportunity.Sofarwehave not committed ourmoney and are simplyappraising differentpossibilities thatmayalertusto a trading opportunity.

There was value tocontinuing to watch thischart.Andwewererewardedwith an opportunity to enterthis trade through acontinuation pennant thatformedwithin3weeksofthe18%jump.

Thenext chart focuses onthepriceactionfollowingtheuntradeablebreakout:

FIGURE43.2

On the right side of the

chart, we see a textbookcontinuation pennant (or, ifyou prefer, a small triangle)forming within a few weeksofthe18%breakout.

Small continuationpatterns can be another andperhaps better opportunity toenteratradeifwemissedtheinitialbreakoutoriftheinitialbreakout was not tradable asinCapella.Smallpatternslike

this pennant can start bigmoves.Here,pricesincreased20%overthenextweek.

There would be anotheropportunitytobuyshares,butnot before our patience wastested.Beforewediscuss yetanother entry opportunity,let’s first note the volumebars.Capellaisavolatileandthinly-traded stock.Wemustuse extra caution whentradingsuchstocks.Thenextchart focuses on the price

action after prices broke outfromthefirstpennant:

FIGURE43.3

Thefirstpennantproduced

a 20% gain in a week. Thenpricespausedand traded inanarrow range for the nextthree weeks. In fact, pricesseemed tobe coiling to formyet another continuationpennant. There seemed to beadecisivebreakout from thissecond continuation pennantbut, the next day, thebreakout lostmomentum andprices closed decisively

below the upper boundary ofthissecondpennanttwodayslater. Prices continued todecline and plunged wellbelow even the lowerboundary of this failedpennant.

Thissecondpennantfaileddecisively. But we had goodreason to trade the breakoutfrom the second pennant.This trade would have beenbased on a clear breakoutfrom a well-shaped classical

chart pattern.Remember thata good trade is not the samething as a profitable trade.Buying shares after a cleanbreakout from the secondpennant was a good tradeevenifthetraderesultedinaloss because the trade had afavorable reward-to-riskpossibility. We werejustifiably, but not overly,disappointed when thepennant failed but we couldconfidentlymoveonknowing

that we limited our losses tojust a small fraction of ourtradingcapital.

Almost as important aslimitingourlossiscontinuingtowatchthechart.Continuedattention did not requirehourlyor evendaily looks atthe chart. A focused glanceevery couple of days wasenough to alert us to thepossible development ofanother bigger continuationpennant. Prices broke out of

this larger pennant whenprices jumped 9% onearnings news. Incidentally,note that it was possible tointerpretthepriceactionfromthe failed second pennant tothe breakout from the largerpennant as a continuationH&S bottom with a down-slopingneckline.Buthowwelabelapriceactionisoflittleimportance compared to theutmost importance ofmanaging our risk on every

trade, and here, it wasdifficult tobuysharesaftera9% jump that required us torisk up to 10% of ourposition.

As we should not hold aposition through the earningsrelease, we should not havebought Capella shares inanticipation of a positivereactiontotheearningsnews.Andbydoingtherightthing,wecorrectly“missed”the9%gain. Should we buy shares

towards the end of thebreakout day? I say nobecause we were out ofposition.Ifweweretobuyaregular position around theclosing price of the breakoutdayandsetourstopusingthelast day rule, thenwewouldberiskingalmost10%ofourposition. I think 10% is toomuch to risk no matter howexciting the set-up andbreakout. We have toremember that the breakout

from the second pennantfailedonly6weeksago.Andthis breakout, too, couldreverse and lead to patternfailure. The problem is notfailed patterns. The problemis the excessive risk I wouldbetakingonifIweretoenterthe trade after the breakout.Buying a smaller position isalways an effective way toreducerisk.

The set-up tested ourresolveandpsycheevenifwe

used a smaller position asthere was hard retest of theupperboundarytheverynextday. Again, placing our stopreasonably far away, ideallybelowthelowofthebreakoutday, was important. If wetried to get awaywith a stopplaced closer to the upperboundary to lose less moneyifwewere stopped out, thenwegotstoppedoutandfaceda difficult situation. Do weenter again and risk getting

stopped out again? I think itisimportantthatifwedecideto enter this trade after thebreakout, we should do itright the first time: use asmaller position and set awideenoughstoptogiveourposition a fair chance tosurvive normal volatility andeven hard retests. If we getstoppedout,wecanmoveonknowing that we gave thetrade a fair chance to workwhile staying below our risk

limit.Of course there was

another option: do not tradethe breakout, even with asmaller position. We don’thave to tradeeverybreakout.As we saw, some breakoutsare untradeable. Much effortand discipline will berequired to stop ourselvesfrom chasing untradeablebreakouts, especially if thestock is soaring and we areleft behind. While this

breakout from the largerpennant was not completelyuntradeable, it also was notthe most favorable set-up.Even if we decided to stayout, we could continue toobserve the chart. Severaldays later we saw pricestrading in a very narrowrangeandmakingaverytightcoil. Could anothercontinuation pennant, thistime a very small one, beforming? This development

stresses the importance ofdiligently going through ourcharts. Simply checking inevery couple of days wouldhave alerted us to this 4-daypennant.

Since breakouts frompennants can be explosive,one way to trade a potentialbreakout from this possiblepennant was to enter a buystop order just above thepreliminary upper boundaryand set a sell stop order

around just below thepreliminary lower boundary.We would risk just over 3%of our position to possiblycatch early a powerfulbreakout from this pennant.Prices jumped 4.6% todecisivelybreakoutfromthethirdpennantinthreemonths.

Ifwedidnotwanttouseabuy-stop order and dealwithits associated risks, then wewere still in a good positionto buy shares after the

breakout. Buying sharesaround the closing price ofthe breakout day meantrisking about 4.6% of ourposition, which is much lessthanthe9%wehadtorisktochase the breakout from thelargepennant. It alwayspaysto continuously follow achart’sevolution.

CHAPTER13

AscendingWedge

The ascending or risingwedge is our next classicalpattern. It has two risingboundaries lines where thelower boundary’s angle ofascent is steeper than theupper boundary’s slope.

Despite its name, anascendingwedge is abearishpattern that indicates a likelydowntrend as prices breakdown through the lowerboundary.

PFL Energia: 10-weekascendingwedge

Our first ascending wedge isfrom PFL Energia, aBrazilianelectricutility:

FIGURE44

Note the generally

declining volume during theformation of the wedge. Aswe noted, volumeconfirmation isnotnecessarybuthelpfulwhenanalyzingapattern.Noticehowthestocktradedandevenclosedabovethe upper boundary of thewedge. Such peeking iscommon in rising wedges.The signal to go short camewhenpricescloseddecisively

below the lower boundary.We could set our stop justabove the high of thebreakdownday. Finally, notethe higher volume as thestock started to break down,which supported thedowntrend interpretation.Everything about this risingwedgewas by the book.Ourbottom line will be muchbetter if we strive to tradeonlysuchtextbookset-ups.

Oriental Financial Group: 3-monthascendingwedge

Our next ascendingwedge isanother textbook pattern.Figure 45 shows the overallset-up leading up to theformationofthewedge:

FIGURE45

Oriental Financial’s stock

had doubled in price in 10months and then started toform this ascending wedge.Remember,a reversalpatternneeds something to reverse.Thenextchartfocusesonthebreakoutarea:

FIGURE45.1

Therewasaretestofsorts

aspricesrecoveredabitafterbreaking down through thelower boundary. But thissemi-retest did not comeclose to challenging a stopplaced above the high of thebreakdownday.

The rising wedges thatformed inCPFLEnergiaandOriental Financial were trulytextbook examples. But notall ascendingwedgeswill be

so elegant and clean. Themost difficult aspect oftrading rising wedges issimilar to other patternswithslanting boundaries likesymmetrical triangles andH&S patterns with slantingnecklines:dealingwithretestson a sloping boundary. Anormal retest in a risingwedge could keep pricesbelowthelowerboundaryyetstill go higher than thebreakout point. Such a retest

can also trigger our stop-lossorder and still stay under thewedge’slowerboundary.Thenext chart shows how apossible retest could stayunder the lower boundarywhilepricesshothigher:

FIGURE45.2

I can think of three ways

todealwithsuchretests.First, we simplymove on

when we are stopped out. Ifthe rising wedge will notbreak down cleanly, thenweare not interested in tradingthepatternagain.

Second, we can attemptone more trade if the stockcloses just under the lowerboundary after stopping usout. If the stock continues

higher and stops us out forthe second time, then wemoveon.

The third option is asomewhat drastic but notunreasonable choice: avoidtrading rising wedges. Afterall, there are plenty oftextbook patterns withhorizontal or nearlyhorizontal boundaries. It isfine to trade, say, onlyrectangles and H&S set-ups.While I would not

categorically eliminatepatterns with slantingboundaries, I think beingselective in general is verygood. We must find ourlikings and strengths andstick to thenanddon’tworryaboutwhatothersaredoing.

CHAPTER14

DescendingWedge

Our next classical chartpattern is the descending orfalling wedge. A descendingwedge has two descendingboundaries, with the upperboundary declining moresteeply than the lower

boundary. It is a bullishpattern that indicates thestock will likely rise afterbreaking out through theupperboundary.

Owens Illinois: 6-weekdescendingwedge

Ourfirstdescendingwedgeisfrom the chart of OwensIllinois. Let’s first get anoverallviewoftheset-up:

FIGURE46

The stock rose almost

50%fromDecember2012 toMarch 2013. Then it pausedand traded in the $24 to $28range for the next 6 weeks.Whileadescendingwedge isdrawnonthechart,itwasnotsoclearinmid-Aprilwhethera descending wedge was themost useful way to interpretthe price action. The moreobviousinterpretationseemed

to be a larger H&S topforming from February toApril2013:

FIGURE46.1

It was not just the price

action strongly suggesting apossibleH&Stop. Itwasnoteasy tobelieve that the stockwould continue to rise aftergainingalmost50%insuchashort period. It was easier tobelieve that the stronguptrendwascomingtoanendthat this possible H&S topwould reverse the uptrend.Ontheotherhand,itwasalsoreasonable to interpret the

price action frommid-Marchto mid-April as a bullishdescendingwedge.

Whatnow?As classical chartists, we

shouldnottrytopredictthefuture. Instead, we shouldstrive to participate intrendslaunchedbyclassicalpatterns.Sothebestthingtodowastocontinuetoobservethechart’sevolution.

The next chart shows onewaytotradethepriceaction:

FIGURE46.2

Ifsomeoneaskedmewhat

I thought about the priceactioninOwensIllinoisfromFebruary to April 2013, Iwould have said that itseemed like a H&S top wasforming.Butmyopinionwasjust that: an opinion. Andother traders had differentopinions. Some of us mayhavepreferredthedescendingwedge interpretation.Whatever our view of the

chart, therewas no reason totake a position unless therewasabreakoutfromtheH&Stopor thedescendingwedge.Sowhile it isfine tohaveanopinion, we must not be socommittedandobsessedwitha particular view as to blindourselves from the actualprice action. We have toremain mentally nimbledespite our biases. The bestway to remain flexible is tobelieve what we see and not

whatwewanttobelieve.Thisiseasiersaidthandone.

If we were so committedtotheH&Stopinterpretation,thenwewouldnothaveseena small pennant developwithinthedescendingwedge.Wealsowouldhavemissedastrongbreakout to theupsidefrom this pennant thatresulted in prices closingabove the upper boundary ofthe descendingwedge.Don’tget me wrong: there was no

guarantee that this pennantanddescendingwedgewouldworkasthepossiblebreakoutcould reverse at anymomentand the chart evolve intosomething completelydifferent. But keeping anopen mind would have atleast alerted us to a possiblycompellingentryopportunity.

On the other hand, if weweresingle-mindedlyfocusedon a bullish descendingwedgeinterpretation,thenwe

were blind to a potentiallypowerful H&S top. If theupside breakout from thewedge reversed and failed,yet we had convincedourselves that the wedgepattern “had to work,” thenwewerevulnerable to takingrisky and foolish actions,suchasrefusingtohonorourstop or even adding to ourlosing position as the stockbroke down through thenecklineoftheH&Stop.

We might object that the3-day pennant is tooinsignificant a developmentto trade on it. I sympathizewith this objection, but Ithink it is also important tolook for small edges. Andtrading well is aboutcontinuouslyexploitingsmalledges. The pennant need notcarry some deep meaning.The breakout from thepennant, ifwechose suchaninterpretation, was simply a

chance to enter this trade onfavorable terms. In exchangefor risking 2.5% of ourposition, we could make farmore if our interpretationworked. If thebreakout fromthe pennant turned out to benothingandwewerestoppedout soon, thenwe suffered aminor loss and we wouldmoveon.

Let’s say that we eitherdid not spot or thinksignificant the breakout from

the pennant and descendingwedge. We wanted a moresignificant signal beforegoing long or short. Wasanother trade setting up?Recallourbriefdescriptionofthe H&S top failure patternabove and then look at thenextchart:

FIGURE46.3

Figure 46.3 shows prices

closing above what wouldhavebeenthehighestpointofthe right shoulder in a H&Stop. This close signaled acompletion of a H&S topfailure pattern and was achance to buy shares. Thefact that the right-shoulderhighlaterservedasasupportlevel confirmed that pricesclosing above the rightshoulder was a meaningful

eventsupportingtheH&Stopfailureinterpretation.

We may be overwhelmedbythemultipleinterpretationsinherent in almost everychart.Wemightbefrustratedat not seeing the alternativeinterpretations until too late.Wemustnotworry.Timeandexperience will improve ourability to spot patterns andkeep an open mind at thesame time. We should takecomfort in the versatility of

chart patterns that allows formultiple interpretations andthus multiple entry points.Havingmorethanonewaytotrade a set-upmeans thatweoften have anotheropportunity to enter a tradeeven if we missed the firstbreakout.

Parker Drilling: 10-weekdescendingwedge

FromFebruarytoApril2013,

Parker Drilling formed thefollowing textbookdescendingwedge:

FIGURE47

While the wedge had

textbook form, it requiredmuch patience in severalwaystotradeitwell.

First, patience anddiscipline were required tostayoutofthistradeuntilthedustsettledfromtheearningsrelease. The stock closedabove the upper boundary ofthe wedge four days beforethe earnings release. It wastempting to enter the trade

then and rationalize thisentirelyunpredictablegambleby thinking, “the stock mustknowthat theearningsreportwill be good since it closedabove theboundary justdaysbefore the earningsannouncement.” This isgroundless and dangerousreasoning.

If the market reactsfavorably to the earningsreport and pushes prices upbeyondour reach, then sobe

it.Wemove on to themanyother set-ups that we cantrade. If the market reactsnegatively to earnings andcrashes the price downthrough the upper and lowerboundariesofthewedge,thenwemoveonknowingthatwedid theright thingbystayingoutregardlessofthemarket’sreactiontoearnings.

Whatis interestingishowoften the market gives usenough time to enter a trade

rather than putting the tradeoutofreachwithanexplosivemove.Here, thedayafter theearnings announcement, thestock traded within the samenarrow range as it did onearnings day. Also, with theimmediate uncertainty of theearnings release out of theway, we had a logical entryand exit strategy. We couldbuysharesaroundtheclosingprice of the day after theearnings release and set our

stop at a reasonable distanceaway that still kept us wellunderourmaximumrisk.Therationale for this trade is thatthe earnings report did notcause prices to undo thebreakout from the pattern.The breakout was still validandwehadanattractiveentrypoint.

That said, the inherenttrickiness in tradingapatternwith slanting boundariesremained. While prices

reactedcalmlytotheearningsreport,pricescouldstillretestthe upper boundary andtriggerourstop-lossorderyetstay above the boundary.Given the inherent difficultyof trading a pattern with aslanting boundary, I wouldmove on if stopped out andnotattemptanothertrade.

Here, the stock jumped9% two days after theearnings release. But thestock did everything but go

straight up. Much patiencewasagainrequired.Thestocktraded within the $4.20 and$4.90 range for the next sixweeks. Six weeks of pricesgoingsidewaysandnowhere.Onlyinhindsightisiteasytosayholdingpatientlywas theright thing to do for a biggain.Wehavehearditbeforeandwemust hear it again: itis impossible to stay patientand give a set-up time towork (or fail) unlesswe turn

our attention to other chartsand other interests. Mygeneral rule is that I try myverybesttogiveatradetimeto work itself out as long asmy position is sitting on anykind of profit or is onlyslightlyinthered.

Patience is perhaps themostimportanttraitofagoodtrader. But, and there isalways an exception, infinitepatience may not be alwaysappropriate. There will be

other set-ups that never lookback after breaking out. Soanother general rule I followis that I may reduce myposition size, say, to half ofmy original position, to freeup capital for other trades ifthe stalling sideways priceaction continues for morethan three weeks and acontinuation pattern does notseem to be forming. If therearetrulypromisingset-upsinother stocks, I may exit my

entireposition.In Parker Drilling, the

month-long sideways actionfollowing the early-Maybreakoutwouldhavetriedmypatience. The sharp declineinto early June would befrustrating for many traders.But difficult moments oftenoffer important clues. Noticehow the early-June declineheld above the $4.10 leveland did not trade or closebelow our possible initial

entry point. Prices stayingabove this crucial supportlevel supported the view thatthe early-May breakout hadcontinuing significance andthat there were buyers whenthe stock returned to thebreakout price. The stockstartedtosurgeaweekafteritsuccessfullystayedabovethislevel. If the stock failed tohold this support level, thennot only would I have beenstopped out but I would not

havetriedtotradethisset-upagain.Ihadgiventhepatternplentyof time towork and acrucial support level hadfailed. It would be time tomoveon.

Stifel Financial: 10-weekdescendingwedge

Our last descending wedgecombined a textbook shapewithatrickybreakout:

FIGURE48

Prices broke out of the

descending wedge five daysbefore the earnings release.Was it worth buying aposition here? We certainlydon’t have to, but if we arelooking for a quick trade, anentry here could beworthwhile because a stockmay runupquite abit in thedays leading up to theearnings report. Pricesincreased by 5% in the four

days between breakout andearnings. If we entered thisquick trade, we should selloursharesbeforetheearningsrelease.

It is always interesting towatch the stock’s reaction tothe earnings report.Sometimesastocktradesasifnothing happened by tradingwith less volatility thannormal. Other times, a stockmakes a huge gap up or gapdown. And sometimes an

earnings release will lead togreat initial volatility thatsettlesdownandclarifies thepicture. In Figure 48, theearnings report led to a gapdown in price. However, thestock reversed the downwardmomentumby theendof theday.Thestockwasstilldown3% for the day, but themomentum seemed to be totheupsideasthestockclosednearthehighoftheday.Hadwegambledbystayinginour

position through earnings, itwas likely thatwegotscaredand sold near the low of thedayorsimplygotstoppedoutforaloss.Ifwedidnottradethrough earnings, and weshouldnothave,thenwenowhad the opportunity to enteron much more favorabletermsandwiththeimmediatevolatility and utterunpredictability of theearningsreportbehindus.Wecould buy shares around the

closing price of the day andplace our stop-loss order justbelowthelow.

Finally, note again thepatience required to ride thebigmoves.Thestockinitiallysurged after the earnings-dayreversal.Thenittradedwithinthe$34and$37rangeforthenext month before breakingthrough.

CHAPTER15

FlagsandChannels

A descending flag looks likea down-slopingparallelogram. Flags that areanywhere from several daysto three to four weeks induration are similar tocontinuation pennants in that

they are often form after bigruns. Breakouts from flagsoften start another strongmove that continues theprevioustrend.

Descending flags usuallyform after a strong move upandareusuallydown-slantingorhorizontalandindicatethepossible continuation of theuptrend. Ascending flagsform after a decline and areusuallyup-slantingorstraightand indicate the possible

continuation of thedowntrend.

Edwards & Mageespecified that true flagsshouldnotformformorethan2-3 weeks. It has been myexperience that small flagsranging from several days totwoweeks are often the besttrades. However, I have alsofound success with muchlarger flags, sometimesmonths in duration. Everyclassicalpatternhascountless

variations.We can study thefollowing charts, learn someofthemanypossibilities,andpick the tradingstyle thatwelike.Which pattern we tradeisfar less important thanthatwe trade each set-up usingprudentriskmanagement.

Clearwater Paper: 7-weekdescendingflag

Our first flag launched abreakout from a yearlong

rectangle.Figure49providesanoverallviewoftheset-up:

FIGURE49

Thenext chart focuses on

thebreakout:

FIGURE49.1

Note the failed breakout

after prices traded just undertheupper-boundaryresistancelevelforamonth.Thisfailuresuggested that there weremany sellers at that level.Somany, in fact, that gatheringmomentum for a month wasnot enough to break throughresistance. Then the stockformed a down-slanting flag.Onepossibleinterpretationofthe price action was that the

stock was again gatheringmomentum to break throughresistance. Here, a decisivebreakout from the flag alsoled to a decisive breakoutfrom the yearlong rectanglepattern.

There are severaltakeawayswiththissetup.

First, a small patternwithin a larger pattern caninitiate the overall breakoutandstartabigmove.

Second, we must not

underestimate old resistanceandsupportlevels.Resistanceand support levels formedmonths, years, and evendecades ago can have forcetoday.Here, theMarch 2013high served as powerfulresistancealmostayearlater.

Third, breakoutssometimessucceedonlyafterseveral attempts, especiallywhen the breakout mustsurmount a longstandingresistanceor support level. If

we have been stopped out acouple of times due to failedbreakouts, then we may behesitanttotryagain.Anditisperfectly fine to move on.There will be many set-upsthatwillbreakoutcleanlyonthe first attempt. Here, therewere six failed breakouts inthetwomonthsleadinguptothe real breakout. Pricestraded above but failed toclose decisively above thepatternboundaryduringthese

failed breakouts. The realbreakout, in contrast, wasunmistakable. So anotherlesson is to wait for theunmistakable breakout(which can still fail). Theadvantage of waiting is thatthesituationclarifies.Whileapowerful breakout can makeenteringthetradetoorisky,inmy experience more oftenthan not charts provide afavorable spot to enter evenafteradecisivebreakout.And

ifitistooriskytochase,thenwe must have the disciplinetomoveon.

CtsCorp.:6-weekdescendingflag

Ournextflagformedafterthestock gained 50% in threemonths. The following chartprovidesabig-pictureviewoftheset-up:

FIGURE50

Next, the close-up of the

patternandbreakout:

FIGURE50.1

Let’s first note that CTS

often had very low daily-trading volume. I always useasmallerpositionwiththinly-tradedstockslikeCTS.Also,the declining volume duringthe formation of the flagsupported the patterninterpretation.

The breakout wasdecisive, but the follow-throughwas not. Thereweretwo retests in the next 10

days.Thefirstretestwasahard

retest thatcame thedayafterbreakoutand led to the stockclosing below the upperboundary.Pricesdidnotclosebelowtheboundarybymuchbutthehardretestwouldhavetriggered a stop-loss orderplaced just below the low ofthe breakout day given thatthe breakout day had verylittle trading within thepattern boundary. In such a

case, it is prudent to set ourstop farther away from theboundary.

The second retest came aweek after the breakout.While it did not touch theupper boundary, itnonethelesswould have beendiscouraging to a trader whowasimpatientlywaitingforastrong uptrend and who wasanxiously watching the priceaction.Asalways,thecorrectthingtodoistoenter,setour

stop,andturnourenergyandattention elsewhere. Had weturned to other charts andprojects and forgotten aboutthistrade,thenwewouldfindthat the stock had brokenthrough the post-breakoutcongestion two weeks laterandmadelargegains.

Patrick Industries: 10-weekdescendingflag

Our next descending flag

formed in another low-volumestock:

FIGURE51

Some classical chartists

mayargue that thispattern isnot a true flag because it istoo long in duration. WenotedthatEdwards&Mageedefined flags as rather smallpatterns that last no longerthantwotothreeweeks.Istilltrade large “flags” because Ithinkofthemasvariationstothestandardsmallflag.Moreimportant than the pattern’slabel is whether we can find

an advantageous entry pointand logical stop-loss point.And I think this largedescending flag provided afavorabletradeset-up.

Thenext chart focuses onthebreakout:

FIGURE51.1

We could buy shares as

soon as prices closed abovethe upper boundary or waitforamoredecisivebreakout,whichcame thenextday.AsPatrick Industries is anotherlow-volume stock,wewoulduse a smaller position tofurther limit risk. Using asmaller position allows us toset our stop at a reasonabledistance from the upperboundary and still remain

belowourmaximumrisk.

Federated Investors: 3-monthdescendingflag

Our next large descendingflag is one of my favorites.Volume declined duringpattern formation andincreasedduringthebreakoutand the strong followthrough:

FIGURE52

Altisource PortfolioSolutions: 5-monthdescendingflag

Ournextflagmightbecalledagiantdescendingflag:

FIGURE53

We have seen how

quarterly earnings reportsaffect our trading. Here, thestock broke out and closedabove theupperboundaryonearnings news. With theimmediate volatility causedby the earnings releasebehindus,wemightconsiderbuying shares around theclosing price. Because thestock was up 7% on thebreakout day, we would

likely buy a smaller positionto stay within our riskparameter.Another reason tobuy a smaller position is thefact that Altisource Portfoliois a relatively volatile low-volume stock. We mustalways use extra cautionwhen trading a thinly-tradedstock.Wemaybetemptedtousea largepositionor rashlygo all-in with thin stocksbecause we think about howfast they can move and

producebigprofits.But fast-moving stocks don’t alwaysmove in our favor. Fastmovesgoinbothdirections.

Bytheway, thegiantflagismy own label. Edwards&Magee would likely identifyFigure 53 as a descendingchannel. Theywrote that thebreaking of a channel line isnot a trade signal as it maysignal only a change in thetechnicalsituationratherthanadefinitechangeinthetrend.

They argued that tradersshould wait until a classicalpattern forms after thebreaking of a channel line. IagreemostlywithEdwards&Magee’s analysis andprescription. Channels bydefinition have slantingboundaries and thus aresubject to all the additionaldifficulties associated withtrading patterns with non-horizontal boundaries. Also,large channels, despite my

labeling them “giant flags,”reflect an entirely differentprice action compared to thecompact flags that Edwards& Mage had in mind. Flagsare relatively brief restperiods within a narrowtrading range. They usuallyformafterastockhasmadeastrong run. In contrast,channels,orgiantflags,covera much larger trading rangeanddonotformafterastrongrun.

I will at least considertrading channel breaksbecause I have seen fastmoves come from them. AslongasImanagemyriskandstaywithinmy comfort zoneon every trade, I amcomfortable trading patternsinaway that the foundersofclassical charting may nothaveenvisioned.Itisfineforustodevelopourowntradingstylethatstillfollowsmostofthe fundamental rules of

classical charting. I considertrading giant flags as arelativelyminor extension ofclassical charting principles.Classical charting offers uschoices.Aswelearnandgainexperience, we will developour own trading style. Weshould take advantage of thefact that classical chartingprinciples are flexible andallowforpersonalization.

WhileIamopentotradingbreakouts from channels, I

would much prefer to tradebreakouts from flags. I havefound it more difficult totrade channel breakoutscompared to flag breakouts.Thus,Imoveonifthereisnoimmediate and decisivefollow through after thebreakout from the channel.Patience is vital in trading,but I give less leeway tocertain set-ups. Channels aresuchinstances.

Cray Inc.: 4-monthdescendingflag

Here’s another giantdescendingflag:

FIGURE54

The breakout day from

this4-monthchannel inCrayInc.wasan ideal spot tobuyshares. While the stockclearly closed above thechannel’s upper boundary, itdidnotdosobysuchalargemargin as to make enteringthe trade too risky. Indeed,the stock was up a modest1.1%onthebreakoutdayandthus allowed us to risk nomorethan2%ofourposition

if we chose to buy sharesaround the closing price ofthe breakout day and set ourstopjustbelowthelowprice.Itturnedoutthatthebreakoutdaywas not just a good daybut perhaps the last day tobuy shares as the stockjumped almost 10% the nextday.

Isit toolatetobuysharesafter the 10% jump? I thinkreasonable minds can differ.Some will argue that the

initial “breakout” was notdecisive enough, that this10% gain was the realbreakout and the better tradesignal.Otherswill argue thatrisking close to 12% of ourposition, even a reducedposition, in a single trade issimply too much. I wouldhavepassedon this trade if Ihad not bought shares at theinitial breakout. Again,reasonable minds will differ.If we decide to buy shares

after the 10% jump, thenwemust significantly reduce ourpositionsizetostayunderourmaximumrisk.

Cray made strong gainsafter the breakout,culminatingina39%gainonearningsnews.Beforewesay“see, that’s why it’s worthgambling on earningsreleases,” we have toremember that the large gaincouldjustaseasilyhavebeenahugeloss.

Olin Corp.: 7-monthdescendingflag

As in Figure 54, our nextdescending giant flag patternfeatured a modest but clearbreakout followed by stronggains:

FIGURE55

Therewasa retestaweek

after breakout but the retestdidnotthreatenastopplacedbelowthebreakoutday’slow.

Hilltop Holdings: 5-monthdescendingflag

We have another textbookchannel:

FIGURE56

The breakout was very

decisive – up almost 5% onthe day. This strong gainmeant that some of us,depending on our risktolerance,wouldhaveboughtasmallerpositiontotradethebreakout. I would have usedmy regular position sizebecause I thought the set-upand breakout were verypromising. First, the upperboundary had clearly been

acting as a strong resistancelevelasitrejectedatleastfiveattempts to break above it.Second, the breakout wasdecisive on volume that wasmuchhigherthanonpreviousdays. Third, because theearnings report led to thebreakout,enteringaround theclosing price of the day andafter earnings had beenreleased meant that we didnot have to deal with theimmediate volatility of

earnings news. Lastly, thebreakout from the channelalsomeantabreakoutfromasmallH&Sbottomwithinthechannel.Iammoreconfident,thoughnevercertain, aboutatrade when a smaller patternlaunches a breakout from alargerpattern.

Buying shares around theclosing price of the breakoutdayandplacingastopbelowthe low price meant riskingabout 5% of our position.

Five percent may be theupper limit of our maximumrisk for a single trade. Wemay feel more comfortablebuying a smaller-than-usualposition.AsIsaid,Igivelessleewaywhen trading channelbreakouts. If they don’t startworking immediately, thenI’moutandlookingforotherset-ups. Whether or not wedecide to trade channelbreakouts,we can benefit bylooking for smaller patterns

that can launch breakoutsfromlargerpatterns.

Companhia SiderurgicaNacional: 4-monthdescendingflag

The lastgiant flagwe’ll lookat is a set-up that I thinkEdwards&Magee would beinterested inbecause ithadatextbookclassicalpatternthatformed after the breaking ofthe channel boundary. The

next chart shows SID, aBrazilian steel maker,forminganintriguingdouble-patternset-up:

FIGURE57

The eventual H&S

bottom’s left shoulder andhalfoftheheadformedinsidethe channel. The rest of theH&S bottom formed afterprices broke above the upperboundary of the channel.Prices first closed above theneckline of the H&S bottomby the smallest of margins.After this hesitant breakout,prices seemed to gainmomentum in the next two

daystopossiblystartastrongrun. Instead, three days afterthe indecisive breakout,prices plunged but did notclosebelowtheneckline inadifficultretest.

Onthebreakoutday,therewas very little trading belowtheneckline.Strictlyapplyingthe last day rule meantplacing a stop just below thebreakout day low, very closeto the neckline and likely tobe triggered by a hard retest

or even normal volatility. Infact, the hard retest heretriggered such a stop-lossorder. So the specificities ofthis set-up and breakoutcalled for modifying the lastday rule to place our stoplower,say,somewherebelowthe closing price of the daybeforethebreakout.Doingsostill meant that we wererisking only about 3% to3.5%ofourposition to tradeaverypromisingpattern.The

next chart zooms in on theretestarea:

FIGURE57.1

Let’ssaywewerestopped

outbythehardretest.Shouldwe consider re-entering thetrade?Ithinkso.Whilepricesplungedbelowthenecklineatthe beginning of the tradingsession, they decisivelyclosed above the neckline attheendoftheretestday.Thatprices closed above theneckline suggested thepossibility that the patternandbreakoutwere stillvalid.

It is important to understandthat prices staying above theneckline did not guaranteeanything as prices couldplunge the next day. But theimportant thing was that thisdevelopment provided alogical entry and exit set-up.We could buy shares aroundtheclosingpriceof theretestday and set our stop belowthe lowest reach of the hardretest. Again, there was noguarantee that another retest

would not go farther belowthefirstretest.Butenteringatthis spot meant that our riskwas defined and likelylimited while the possibleupsidewasgreater.Thestockmade strong gains in theweeks and months followingthehardretest.

CHAPTER16

H&STopFailure

As we started to discuss inChapter11,aH&StopfailurepatterniswhenastockformsapossibleH&Stopbutratherthan breaking down throughthenecklineitinsteadgoesupand closes above the high of

therightshoulder.Adecisivecloseabovetherightshouldercan provide a buyingopportunity.

Avago Technologies: 3-monthH&Stopfailure

Let’s first get a big-pictureview of our next set-up. Thenext chart is a weekly chartthat shows AvagoTechnologies doubling inpricefromthespringof2010

tothespringof2011andthenpausing and trading betweenthe$30and$40rangeforthenexttwoyears:

FIGURE58

Avago Technologies

formed a giant 14-monthsymmetrical triangle duringthesecondhalfof thisrange-boundperiod.Let’snowlookatthedailychartthatfocuseson the breakout from thesymmetricaltriangle:

FIGURE58.1

Aswehavelearned,some

breakouts are so powerfulthat they are untradeable, atleast until another tradablepattern, such as acontinuation pennant, forms.Here, the quarterly earningsreportledtoanunpredictable10%jumpandbreakoutfromthe giant symmetricaltriangle. It was a decisivebreakout, but it was not, inmy opinion, a tradable

breakout. I would not havebought shares even after thevolatility surrounding theearnings release had passedbecause entering after thebreakout meant risking closeto10%ofmyposition.Asofnow, the set-up andbreakoutdid not provide a favorableentryspot.And,asweknow,we should not buy sharesbefore the earnings releaseandhopethatthemarketwillreact positively to the

earnings news. This 10%increase could have been a10%, 20%, or larger crash.Nobody knows how themarketwill react toearnings.We must wait and see howthe chart plays out after theearningsreport.

Two weeks after thebreakout, a retest challengedbut did not penetrate theupper boundary. Then stocktraded between $35 and $40for the next two months.

Therewasno follow throughaftertheexplosivebreakout.Ihave seen this scenario oftenand it is another reason whywemustbeverycarefulifwedecidetochaseabreakout.Ifwe had bought a full-sizeposition around the closingprice of the breakout day,then we were likely tobecome very frustrated asprices stalled. We weresusceptible to anxiouslywatching every price tick

because we did not want tolose 10%of our position.Asit is impossible to remainrelaxed and detached whilewatching a stock’s everymove for days or weeks (letalonemonths),wegettiredofwaiting and sell, likely for asignificantloss.

So if we are going togambleandchase,weshoulduse a significantly smallerposition and place our stop-loss order at a reasonable

distance away from upperboundary and then forgetaboutthetrade.Noamountofwishing, hoping, and screen-gazing will make the tradework. Prices will take theirtime to do whatever theywanttodo.

Whether we decided towait or buy a small position,we would have found threemonthsafterthebreakoutthatnot only had prices failed tobreak out of the congestion

but also that a H&S topseemed to be forming.Whatwashappening?Howcouldareversalpatternformsosoonafter what seemed like adecisive breakout from agiant 14-month symmetricaltriangle? Of course patternscan fail anytime. And thisonce-promising set-up wasnow not only frustrating butalso potentially verydangerousforthosewhowereunwilling to accept the

possibility that the patternmightfail.

Thenweremember:everyH&StopcanbecomeaH&Stopfailure.Everypatterncanfail. A promising ascendingtriangle can fail and pricesplunge down through therisinglowerboundaryinsteadof breaking through thehorizontal upper boundary.An upside breakout from arectangle can reverse andprices can shoot down

through the upper boundaryand then even the lowerboundary.And so on. I havefound H&S top and bottomfailures to be particularlyusefultradingtools.

Moretradingopportunitiesresult from knowing andbeing open to differentpossibilities. Charting isabout possibilities. If theH&S top worked and pricesbroke down through theneckline and then the upper

boundary of the giantsymmetricaltriangle,thenwewould conclude that theinitialbreakoutwasnolongervalid and that the giantsymmetricaltrianglefailed.Ifwe had bought shares afterthe10%jump,thenwewouldbe stopped out for amanageableloss.Whetherwebought shares or not, wewouldmoveon.

Here, the H&S top failedand became a H&S top

failure pattern when pricesclosed above the highestpoint of the right shoulder.Anearningsreportsledtothecompletion of the H&S topfailurepatternjustasitledtothe breakout from the giantsymmetrical triangle threemonthsago.Ifwehadboughtsharesafterthebreakoutfromthesymmetricaltriangle,thenwe would have sold ourshares before the latestearningsreporttowatchfrom

the sidelines. Once the dustsettled from the earningsrelease, we found that theH&S top failure patterncompletedandcreatedagoodopportunity to re-enter thetrade. And of course it wasalso a good opportunity tobuy shares for the first time.We could buy shares aroundthe closing price of thebreakout and place a stopsomewhere below the lowand risk less than 1% of our

positionforapromisingchartdevelopment.But, as always,patience was required. Thestocktradedinaverynarrowrange just above the rightshoulder for two weeksbefore making a powerfulrun.

Aclue that suggested thata H&S top failure patterncould develop was when theprice decline in mid-August2013 stayed above thesupport level established by

the retest in mid-June. AH&S top pattern was stillpossible, but so was a H&Stopfailurepattern.Tradingisall about being open todifferent possibilities andtrading according to theactualpriceactionratherthanour wishes or biases. Thischart was undeniablyinteresting: the 3-monthcongestion after the breakoutfromthesymmetricaltriangletook the form of a 3-month

H&S top failure pattern,which finally launched thepost-breakoutfollowthrough.

Whatever our initialapproach to this set-up,patience was the vitalingredient for trading itwell.We had to be patient whilethegiantsymmetricaltriangledeveloped and launched abreakout.Weneededpatiencenot to chase the initialbreakout. If we chased thebreakout with a small

position, then we neededpatienceanddiscipline togetout before the next earningsreport. Andwe needed to bepatient after we entered thetrade upon the H&S topfailure.Bepatient.

CraneCo.:10-weekH&Stopfailure

Let’s again start with anoverallviewofthesituation:

FIGURE59

Crane Co. made a

powerful run from 2012 into2013 and then seemed to bepossiblyformingasignificantH&Stoppattern.

Thenext chart focuses onthis possible H&S toppattern:

FIGURE59.1

BythemiddleofAprilwe

saw a well-formed possibleleftshoulderandheadaswellas a horizontal neckline. BylateAprilwealsohadahalf-formed potential rightshoulder.Wewerejustifiedinsuspecting a possible H&Stop that might reverse thepreviousuptrend.Butwealsoshould have kept an openmind and remembered thateveryH&Stopcouldbecome

aH&Stopfailure.Wehadtostaymentally flexible and bewilling to accept the actualpriceaction.Suchrulesseemcommonsensicalbutareoftendifficult to follow. Thus, wemay have been jolted whenprices closed above thepossiblerightshoulderwithagapup inprice.Notallpricegaps are significant. Forexample, some thinly-tradedstockshavepricegapsalmostdaily. Here, however, the

price gap seemed verysignificant because itoccurred in a stock that hadjust a few price gaps in thelast four months and it wasthe gap up that vaulted thestockabovetherightshoulderhigh. Thus, this gap up wasvery possibly a breakout gapthat completed the H&S topfailure pattern rather thansimplyarandompriceaction.

This interpretation wassupported by subsequent

developments. First, pricesmade steady gains over thenext three weeks. Second,prices stayed comfortablyabove theright-shoulderhighwhen prices decline into lateJune. It was now reasonableto conclude that the right-shoulder high had been asignificant resistance levelbefore the gap-up breakoutandthatnowithadbecomeasupport level. Previousresistance often becomes

support, and prior supportresistance. We’ll furtherdiscusssupportandresistanceinChapter21.

Facebook,Inc:10-weekH&Stopfailure

The next set-up combined aH&S top failure with anoverlapping H&S pattern,another pattern that I learnedfromPeterL.Brandt:

FIGURE60

Aftermakingastrongrun,

Facebook formed aH&S topthat seemed ready to pushprices down. A decisivebreakdown through theneckline seemed to completethe pattern and would havejustified shorting shares. Butthe decline lasted only a dayas prices reversedimmediately and closedabovethenecklinewithintwodays. Prices continued to go

up,pausedat the levelof theright shoulder high, declineda bit, then burst through theright shoulder resistancelevel. The stock hadcompleted a continuationH&S bottom. Note how therightshoulderoftheH&Stopconstituted the left shoulderand part of the head of theH&Sbottom.PeterL.BrandtcallsthisanoverlappingH&Spattern.

This price reversal need

not alarmus.Yes,wewouldhavelostmoneyifweshortedFacebook shares upon thecompletion of the H&S toppattern. But our loss wasnothing more than a minoroneifweusedprudentmoneymanagement.We could havechanneled our milddisappointment to findingotherset-ups.Andagoodset-up could be found on thesame chart less than twoweekslater.Intheprocessof

forming a H&S top failurepattern, the chart alsoproduced an overlappingH&S pattern, which was asmallpatternthatwaseasytomiss. We cannot and do nothave to find every tradablepattern.Evenifwecould,wecannot and should not tradeevery one. Beginners,especially, should not worryabout missing patterns. Wewillgetbetter.

KindredHealthcare: 6-monthH&Stopfailure

Thenextset-upshowswhyitissoimportantyetsometimesso difficult to believe whatwe see rather than what wewanttobelieve.

ThefollowingchartshowsKindred Healthcare doublinginpricefromsummer2012tosummer 2013 and thenforming a possible H&S topfromMaytoNovember2013:

FIGURE61

The next chart focuss on

the possible H&S top thatseemed poised to reverse thepowerfuluptrend:

FIGURE61.1

A well-defined H&S top

was my first, second, andthird impression. Thesymmetryoftheleftandrightshoulders in duration, size,and shape was textbook. Ialso noticed that the head ofthis 5-month H&S top wasitselfasuccessfulH&Stop.Iamalwaysfascinatedbysucha pattern within a pattern. Itwas easy and comfortable tobecommittedtotheH&Stop

interpretation. And it is fineto have an opinion. What isdangerousandcostly is tobesoattachedtothatopinionasto blind us from the actualprice action. If we thoughtthata textbookH&Stopwasforming, then we had to re-evaluate the situation whenprices decisively closedabovetherightshoulderhigh.This level was also theneckline of the small H&Stop that formed the head of

our beloved H&S topinterpretation. Itwasalso thehigh of the left shoulder. Adecisive close above thissignificant level signaled theneed to re-think ourinterpretation and tradingstrategy. If we hadpreemptively entered a shortposition,thenweshouldhavecovered our position. If wewere still waiting for thestock to break down throughthenecklineof theH&S top,

then we should considerbuyingsharesinstead.

Experienced tradersunderstand the importanceofmentalflexibility.Ithelpsthem overcome their biasesand accept and trade theactual price action.Nimbleness allows them torecognize that thedisappointing failure of apotentiallytextbookH&Stopcouldmeanaprofitabletrendin theotherdirection.Mental

flexibility allows us to takeadvantage of a rapidlychangingsituation.

ExtraSpaceStorage:6-monthH&Stopfailure

The next set-up alsomade iteasy to believe that a trendreversal “had to happen.”First the big-picture view ofthesituation:

FIGURE62

After doubling in price

over 15months, Extra SpaceStorageseemedtobeforminga large H&S top that couldreversetheuptrend.

Thenext chart focuses onthe possible H&S top thatwasforming:

FIGURE62.1

Pricesdidnotbreakdown

through the neckline of theH&S top. Instead, thepossiblerightshoulderofthisseemingH&Stopturnedintoa smaller continuation H&Sbottom that launched anotherupswing. This set-up mayalsobecalledanoverlappingH&Spattern.

CHAPTER17

DoubleBottom

Amongtheclassicalpatterns,the double bottom (anddoubletop)patternisperhapsthe most carelessly talkedabout price action. ButEdwards & Magee laid outquite specific requirements

for the double bottom andtop, and true double bottomsandtopsarerare.

One requirement is thatthe twobottomsbeat least amonth apart. Another is thatthepriceincreasebetweenthefirst and second bottomsshould be about 20%.Edwards & Magee said thatthetimerequirement,thatthebottoms be at least a monthapart, ismore important thantheheightoftheriseandthat

most true double bottomshave bottoms that are two tothreemonthsapart.Theyalsosaid that the greater the timebetween the two lows (orhighs for a double top), theless important therequirement for a significantpriceincrease(ordecreaseforadoubletop).

These requirements arenot absolute and Edwards &Magee recognized that thereare many examples that

deviate from the textbookrequirements. That said, weshould try to adhere to thetextbook requirements fordouble bottoms and tops asmuch as possible given thatthey are prone to muchmisuse and mislabel. Mypersonal requirement fordouble bottoms and tops isthatthetwolowsorpeaksbeatleasttwomonthsapart.

NutriSystem:7-monthdouble

bottom

Our only double bottom isone of my favoriate patternsfromthelastcoupleofyears.It formed in NutriSystemfromNovember2012toJune2013:

FIGURE63

Thetwobottomsoccurred

five months apart, fulfillingthekeyrequirementspecifiedby Edwards & Magee. Theprice rise between thebottoms was almost 30%,meeting another requirementfor a legitimate doublebottom. The breakout wasdecisiveandwasfollowedthenextdaybyagapup.

There were two mainchallenges to trading this

patternwell.First,thewait:fivemonths

betweenthetwobottomsandanother twomonths until thebreakout.Adoublebottombydefinition does not formovernight.Somepatterns,likeflags, last only three or fourdays before starting apowerful run. In contrast,double bottoms reflect anextended process duringwhich a stock’s long-termdowntrendreversesasbuyers

slowly accumulate sharesfrom tired and sometimesdemoralizedsellerswhohaveseenthestocklosealotofitsvalue over an extendedperiod.Again,patienceis thetrader’sbestfriend.

Second, diligence.We donothave tocheckeveryhourthe progress of a potentialdouble bottom. The skillsrequired are long-termdiscipline and diligence:cyclingthroughourstocklist

regularly over weeks andmonths as we look for goodset-upswhilekeepingtrackofinteresting developmentssuch as a potential doublebottomforming.Wewill talkmore about our day-to-dayroutineinChapter28.

And ifwemissed the set-up and breakout? Let it go.There will always be otheropportunities.

CHAPTER18

HornBottom

A horn bottom is anotherinteresting and useful thoughrare pattern. Edwards &Mageedidnotmentionhornsin their book but RichardSchabacker did in his. AndPeter L. Brandt in hisDiary

of aProfessionalCommodityTrader specifies therequirements of a hornbottom:amajorlowfollowedby two higher lowsintervened by two higherhighs.

Sina Corp.: 7-month hornbottom

The following chart is aweekly chart that shows theoverall set-up for our first

hornbottom:

FIGURE64

Thestockwentupmore7-

fold from the financial crisislowin thespring2009 to thespring of 2011, going fromlessthan$20asharetoabove$140a share.Then it formeda 5-month reversalsymmetrical triangle and lostmore than 70% of its valueover the next 20months andwas trading at about $40 ashareinDecember2012.

Thenext chart focuses on

the horn bottom that formedaftertheDecember2012low:

FIGURE64.1

Wehaveamajorlow(#1),

followed by a peak (#2) anddecline to a higher low (#3),and rally to a higher peak(#4) andanotherdecline to ayet another higher low (#5).A key requirement is thatthere must be some overlapbetween the decline from #2to#3andthedeclinefrom#4to #5. The pattern completedwith a breakout above thesecondpeak(#4).

Ihavefoundhornbottomsto be useful analytical andtrading tools despite theirrelative rarity.When a stockis trading in a sort of rangebut its bottoms and peaks donot line up exactly as in arectangle, I know that ahornpattern is an alternative andperhaps better interpretation.Wemust keep an openmindwhen analyzing the priceaction, and being aware ofdifferentpossibilitieshelpsus

staymentallyflexible.

Gollinhas AereasInteligentes: 2-month hornbottom

Our next horn bottom wasmuch smaller than our firstbut still produced a powerfultrend.Thenextchartgivesusthebig-pictureview:

FIGURE65

The stock was trading

above $7.50 per share in theearly months of 2013 beforecrashing to less than $2.75persharebyearlyJuly.

The next chart zooms inonthehornbottompattern:

FIGURE65.1

Notehowthishornbottom

fulfilled the patternrequirements. Just asimportant was the fact thatthis horn bottom formedwhere and when it wassupposed to: after a long,dishearteningpricedecline.Ahorn bottom is a reversalpattern.Andreversalpatternsneed something to reverse,such as this long pricedecline.

CHAPTER19

Diamond

The diamond is our nextpattern. Diamonds can becontinuation or reversalpatterns. This versatilitymakessensesincethesecondhalfofadiamondpatternisasymmetrical triangle, and a

symmetrical triangle can beeither a continuation orreversalpattern.

Figure 66 provides theoverall set-up surrounding a6-month continuationdiamond pattern in SusserHoldings:

FIGURE66

Notethetwo-yearreversal

symmetrical triangle in thebottom left of Figure 66 thatlaunchedabiguptrend.Afterthe stock gained more than300% over the next twoyears, it paused and formedthe following diamondpattern:

FIGURE66.1

The next chart zooms in

onthebreakoutarea:

FIGURE66.2

The upper boundary had

five solid touches beforepricesfinallyclosedaboveit.Buying shares around theclosing price of the breakoutday and placing a stop justbelow the lowmeant riskingabout 4% of our position.There was no immediatefollowthroughastherewasahard retest the day after thebreakout and prices tradednear the boundary for a full

week.Patience,asusual,wasrequired.

Whynot justcall this set-up a symmetrical triangle?We can. After all, wewouldtrade a breakout from adiamond in the sameway aswe would trade a breakoutfromasymmetricaltriangle.Istill think there is a goodreasonforchartingthisset-upas a 6-month diamond ratherthan a 3-month symmetricaltriangle. The longer the

consolidation or congestionperiod, the more likely it isthatthebreakoutandensuingtrend will have stayingpower. A pattern’s size isnever a guarantee that apattern will work well orwork at all. But it is animportant factor to considerwhenwearechoosingamongdifferentset-ups.I’drathertieup my money in a largerpattern with a largermeasuredprice target than in

asmallerpattern.Diamond patterns are

relatively rare. We will lookat another textbook diamondpatterninChapter29.

CHAPTER20

SecondandThirdEffort

Sometimesastockbreaksoutonly after several failedattempts.Let’s takea lookatthe following ascendingtrianglethatformedinUnitedCommunityBanks:

FIGURE67

It is a small but relatively

well-defined ascendingtriangle. I think the first“failed”breakoutwas just anout-of-linemovement. So farwe have seen so manytextbookpatternswithpreciseboundaries that it is easy tothink that prices must staywithinthelineswedraw.Butthis example reminds us thatpatterns are not perfect. Andthey don’t need to be to be

usefultradingtools.Wemustallow a certain amount ofleewayaswedrawpatternstomake sense of the priceaction. Still, it is remarkablehow often prices seem torespectourlines.

The stock tried to breakout twoweeks after the one-dayout-of-linemovementbutwas turnedback.This failurecould have been somewhatalarming to traders expectinganupsidebreakoutgiventhat

the breakout failed on heavyvolume. If a breakout couldnot be achieved on heavyvolume, then perhaps thepattern was destined to notwork. Such worrying ispointless as no one knowswhat prices will do. If thepattern fails, then so be it.The first failed breakoutshows why it can beadvantageous to wait beforeentering a trade. Mostbreakouts, even decisive

ones, give traders time toenter at a favorable spottowards the end of thebreakout day. The realbreakout here, on the secondattempt(orthirdattemptifwetreat the out-of-linemovement as a failedbreakout), was decisive andbuying shares around theclosing price and placing astopjustbelowthelowmeantrisking about 2.8% of ourposition.

Stay patient and wait forthepatterntoproveitself.

CHAPTER21

SupportandResistance

If I had describe the essenceof good trading using thefewestwordspossible, then Iwould say “limit losses.” If Iweregivenuptofivewords,Iwould add “support and

resistance.”Theboundaries,horizontal

or slanting, of all of thepatternswehaveanalyzedaresupport and resistance levels.Breakoutsgothroughsupportand resistance. Retests re-challenge support andresistance. Patterns failwhenexisting support andresistance levels fail. Chartsevolvewhennewsupportandresistance levels form. Andprior resistance often

becomes support while priorsupportbecomesresistance.

Ifinditamazinghowwellsupport and resistance levelsperform their function. Theydon’t work every time, butoften enough to makeclassical charting possibleandworthwhile.Ialsofinditfascinating how support andresistance levels establishedyears ago continue to worktoday.

The following examples

show just how resilientsupportandresistancecanbe.

ChicagoBridge&Iron

The next chart is a weeklychart that shows the overallsituation:

FIGURE68

Note the pre-financial

crisishighandhowthestocklost more than 90% of itsvalueoverthenextyear.Thestock recovered remarkablyover the next four years andapproached the pre-financialcrisishigh.

Aswe see inFigure68.1,thestocktriedtocloseabovethe old high reached morethan five years ago. Butheavysellingturnedbackthe

stock. Was the remarkableuptrend over or would thestockmakeanotherattempttobreakabovetheoldhigh?

FIGURE68.1

The old-high-turned-

resistance rejected anotherbreakouttrytwomonthsafterthe first attempt. And notradablepatternseemedtobeforming on the chart. Butafter another month, we sawthat a possible symmetricaltriangle was forming.Wouldthetrianglereversethe4-yearuptrend or launch anotheruptrend?

Let’s discuss how our

emotionsandprejudices, thatis, being human, can affectour analysis and trading ofthis set-up. We now knowthat this symmetrical trianglelaunched another upleg tocontinue this incredible run.But let’s try to get anhonestsenseofwhatourbiaswouldhavebeenifwewerelookingat this chart as it wasdeveloping. I’ll tell you mybias. Very simply, I wantedthe symmetrical triangle to

reverse the 4-year uptrendand start a downtrend. IwantedabreakdownsomuchthatIconvincedmyselfthatatrend reversal must happenbecauseitwastherightthingto happen. It was a case ofbelieving what “had tohappen”ratherthantheactualpriceaction.

Why did Iwant the trendtoreverse?

To be fair to myself, thestock did have an incredible

run. Surely, I thought, thestock is too tired to startanother uptrend. It failedtwice, after all, to breakabove the all-time highestablish five years ago.Going down would create anice symmetry: two nicepeaks5yearsapart thatwereboth followedbymomentousprice declines. And, finally,haven’t those lucky investorsandtradersinChicagoBridge& Iron have had enough

gains?Let’s examine this

ridiculous yet, if you willallow,veryhumansentiment.Money we did not make isnotmoneywe lost.Wewillmiss many set-ups thatbecome big winners, but wedon’t lose money when wemiss a trade. And nobodyknewduringunsettleddaysofthe2007-2009financialcrisisthat Chicago Bridge & Ironwould gain so much in the

next 5 years. So why mightwe, and I’ll shift to “we”from“I”becauseIdon’twantto be too harsh on myself,feel this way? Answer mustbeenvy,no?Wewantedthat14-foldgain.Nevermindthatalmost everyone was tooscared to go anywhere nearthe stock market during thefinancial crisis. Never mindthat the company could havegonebankruptandwipedoutshareholders.Nevermindthat

we might not have had theinvesting or trading skillsthentotakeadvantageofthis“opportunity.” Wishing wewerepartofthishugegainislike wishing we boughtMicrosoft shares in 1986when the company wentpublic. In short, it is a sillyand juvenile wallowing infantasy.

We must always try toprevent our emotions fromblinding us from the actual

price action. But we arehuman, and thus we have aremarkable ability to ignorereality. I did not believe myeyes when the textbooksymmetrical triangleproduced a decisive breakoutto theupsidewith immediatefollow through. So I did notbuy the breakout. I watchedthe stock go up and up andwaited for the stock to crashbecause it “had to”godown.Myhope is that thisexample

of my strenuous ignorancewillmotivateotherstoalwaysbe on guard against theiremotions. Believe what yousee, not what you want tobelieve.

Another lesson is thatsometimesa stockwillbreakout of a classical patternbefore breaking through along-term resistance orsupport level. I compare it toan airplane slowly buildingupspeedtogathertheenergy

and momentum to getairborne. We saw such abuild-up in the flag patternformed by Clearwater PaperCorp., discussed in Chapter15, that launched a breakoutthrough multi-monthresistance.

Johnson&Johnson

Here’s another example ofstock gathering momentumfor a breakout. First, let’s

look at the weekly chart toget an overall sense of thesituation:

FIGURE69

Thenext chart focuses on

the 2-month symmetricaltriangle that formed justunder the resistance level ontherightsideofFigure69:

FIGURE69.1

Note the textbook

symmetrical triangle andbreakout. But how to dealwith the looming earningsrelease? If we had boughtshares around the closingprice of the breakout day,thenweweresittingonabouta3%profitthedaybeforetheearnings report. We shouldexitourpositionforamodestprofit andmove on. BecauseJohnson & Johnson is a

relatively stable stock with astrong financial positionbased on a rock-solidbusiness,wecouldarguethatthere is a stronger case forholding a small positionthrough earnings. Even anegative market reaction toearnings probably won’tcrash the stock by much.However, while Johnson &Johnson is a solid company,wemust still be prudent andnotgambleonearnings.

In any event, the lessonhere is not how to tradethrough earnings. Our policytowards earnings remains thesame: do not trade throughearnings,and,ifwedo,wedoso with a drastically scaled-down position that will nothurt us much if the stockcrashesonearnings.The realtakeaway is to look forpatterns that may form nearpowerful resistance andsupportlevels.

SeagateTechnology

Ourfinalchartofthischaptershows again the importanceandubiquitousnessofsupportand resistance, and howprevious support can becomeresistanceandviceversa:

FIGURE70

Support and resistance

levelsdon’talwayswork,buttheyworkwell enough to bemore than mere coincidenceand to serve as a foundationof classical charting andprudent trading. And whentheydon’twork,ourstop-lossorders will exit us from thetradeforaminorloss.

Trying to find the perfecttrading system, one thatguarantees that most trades

will make money, can beirresistible, especially whenwe are on a losing streak.That is the wrong approachandalmostcertainlywillleadtobiggerlosses.Returningtothe basics, such as neverchasing a breakout andfocusing on support andresistance,isthemostfruitfulthing to do when we aresuffering through a losingstreak.Wehavetorememberandacceptthefactthatlosing

streaksarepartoftrading.Alltraders experience them. Butthebesttraderstradeinawaythat even 20, 30, or morelosses inarowwillnotdraintheir trading account bymuch.

CHAPTER22

PatternwithinaPattern

We have already looked atmany pattern-within-patternset-ups. I think they are sointerestingandusefulthatweshould devote a separatechaptertothem.

Boeing

The next chart is a weeklychart that shows a 15-monthcontinuation H&S bottom inBoeing:

FIGURE71

Boeingmade stronggains

fromthesecondhalfof2011to early2012.Then it stalledfor14monthsas itcouldnotbreakabovethe$78level.Byearly2013, it seemedBoeinghad been forming anintriguing continuation H&Sbottom with an abbreviatedrightshoulder.

The next chart is a dailychart that focuses on rightportion of this possible

continuationH&Sbottom:

FIGURE71.1

The right shoulder of this

continuation H&S bottomdeveloped in the form a 2-month symmetrical triangle.Wehad several opportunitiesto enter this trade.We couldbuy shares as soon as thestock closed above the upperboundary of the symmetricaltriangle. Or, we could havewaited until the stockdecisively broke above thehorizontal neckline of the

continuation H&S bottom.Wecouldhaveenteredevenaday after the breakoutthroughtheneckline.

Weshouldalwayslookforsmallerpatternsthatcanstartthe breakout from a largerpattern. Patterns like thissymmetrical-triangle rightshoulder can help usunderstand the overall priceaction and even provide anearlier opportunity to enterthe trade. We have to keep

our minds open with acreative mindset to takeadvantage of these additionalclues.

One of the best ways tostaymentallyflexibleistobealways drawing differenttrendlines and boundaries toseethevariouswaystomakesenseofthepriceaction.Justas it is crucial towrite downour ideas or risk forgettingthem and lose the chance todevelop them later, drawing

pattern boundaries using ourcharting program helps usunderstand the price actionand also helps us spot andkeep track of emergingpatterns. This monitoring-function is very important.While the initial boundarieswedrawwilloftenneedtoberedrawn as patterns evolve,they can also work from thebeginning.Weare less likelyto miss breakouts from themore modest-sized patterns,

like this two-monthsymmetrical triangle, if wehavealreadyframedthepriceactionwithourdrawings.

SabraHealthcare

Here’sournextpatternwithinapattern.First,let’sgetabig-pictureview:

FIGURE72

Aftermakingstronggains

throughout 2012, SabraHealthcaretookabreakfromits strong uptrend and tradedin a relatively tight rangefromNovember toDecember2012.Thisrange-boundpriceactionproducedanascendingtriangle and a smallersymmetrical triangle withinit.

The next chart zooms inonthepatterns:

FIGURE72.1

The breakout from the

small symmetrical triangleled to the breakout from thelargerascendingtriangle.Thefirst breakout did notguarantee that the ascendingtriangle would work. Thebreakout couldhave reversedand the chart could havecontinued to evolve intosomething else entirely. Thebreakout from the smallsymmetrical triangle had no

inherent meaning, did notrepresent some universaltruth, and did not guaranteeanything. It is merely onepossible interpretation of theprice action to help us findadvantageous entry and exitpoints.Wecouldhaveboughtshares on the day of thebreakout from thesymmetrical triangle on theexpectation that a breakoutfrom the larger ascendingtrianglewouldfollow. In this

case, that possibility cametrue and we were rewardedfor our interpretation of theprice action. If the firstbreakout turned out to be ameaninglesspricegapandthepattern failed, then we wereoutwithasmallloss.Butweshould not be toodisappointed becausewe hadmade a worthwhile bet. Wemoveon.

Note that we had anotherchance to buy shares even if

wemissed both breakouts. Ifwepatiently refused tochasethe missed breakouts andmonitored the chart over thenextcoupleofworks,wesawa 2-week ascending triangledevelop. The breakout fromthis small continuationpattern provided anotherfavorable entry spot. Thelesson: there will always bemoreopportunities.

GoodyearTire&Rubber

Ournextexamplewasnottheprettiestpatternbutitcanstillteach us important lessons.Figure 73 is a weekly chartshowingtheoverallset-up:

FIGURE73

The next chart is a daily

chart that focuses on the lastfivemonthsof this16-monthsymmetricaltriangle:

FIGURE73.1

A 5-week symmetrical

triangleformedinsidethe16-month symmetrical triangle.Adecisivebreakoutfromthissmall triangle led to abreakout from the largertriangle.

Note the big advantagegiven to traders who boughtshares upon the breakoutfromthesmall triangle.Theyrisked around 3.5% of theirposition and would enjoy

larger profits given theirearlier entry. In contrast, wehad to risk about 7% of ourposition when buying sharesafter the breakout from thelarger triangle. Quite simply,in this set-up, if we missedthe breakout from the smalltriangle, then we had to riskmore, work harder, and bemore patient to trade thepatternwell.Someofusmayhesitate risking 7% of ourposition. Thus, we may

decidetonottradethisset-up.Of course we can use asmaller position, and that’swhatIwouldhavedonehadImissedthefirstbreakout.

Once we decided on thesizeofourposition, thenourworkwasjustbeginning.

Let’s say we boughtshares upon the breakoutfrom the larger triangle andset our stop just below thebreakout day’s low. A hardretestoccurredfourdayslater

when the stock penetrateddeep below the upperboundary but did not closebelow it. Another retestoccurred two week later butthis retest did not penetratetheupperboundary.Themostchallenging retest occurredanothertwoweekslaterwhenthe stock again traded deepinto the pattern. The lowestreach of this hard retest was13.89. The low of thebreakout from the

symmetrical triangle was13.91.Ifwehadsetourstop-loss order at 13.90, a pennybelowthebreakoutday’slow,then we got stopped out. Iusually give a bit moreleewaytomystop-lossorder,say, in the range of two tofive cents. But it’s possiblethat I could have used just apenny-buffergiventhatIwasalreadyrisking7%ormoreofmyposition.

Let’s say that this third

retest stopped us out. Wenotice that the stock seemedtojustbarelycloseabovetheupperboundaryatday’send.Whattodonow?

Here are some of ourchoices:

First,wecanmoveon.Webet on a good set-up andbreakout andwe got stoppedout by a deep retest. Wemove on because we knowthere are many morepromising set-ups. Those of

uswholiketokeeptradesona short leash will like thisoption.Wesimplymoveonifwe get stopped out andalmost never re-enter a tradeaftergettingstoppedout.

Second,wecanbuysharesaround the closing price ofthe third retest and set ourstop just below that day’slow.Wearegivingthis tradeanother shot on the rationalethat this third retest could bethe low point of this post-

breakout congestion becausethestockclosedabove,albeitonly slightly, the upperboundary of the symmetricaltriangle. Another attemptmeant risking 2.4% of ourposition, a very manageableloss, especially if we werestopped out on a smaller-than-usualposition.

Another option is to waitand look foranother tradableclassicalpatterntodevelop.

Within a few days of the

thirdretestwesawthatitwaspossible to interpret thisentire post-breakoutcongestion as a descendingflag.Wecanbuysharesuponbreakout from thisdescendingflag.

Likeallcharts,thereisnosingle correct way to tradethis set-up. Besides the factthatbuyingthebreakoutfromthe smaller triangle workedbest and imposed the leaststressonus,ourpersonalities

and trading styles willdetermine how, or, evenwhether, to trade this set-up.Managing risk is our topduty. We shouldn’t beafraid to pass on a chartjust because the set-up isintriguing.Therewillalwaysbe other promising trades. Ifwe decided to trade this set-up, then several significanttechnical developments (apattern within a pattern,decisivebreakouts,andprices

that did not close below theupper boundary despite hardretests) suggested that itcould be worthwhile todevote extra attention to thisset-up.

CheniereEnergy

Our next example features acontinuation H&S bottomwithin a larger symmetricaltriangle:

FIGURE74

The symmetrical triangle

had textbook form, and thesmaller continuation H&Sbottom also had goodstructure. The breakout fromthe H&S bottom coincidedwith the breakout from thesymmetrical triangle. Buyingshares around the closingpriceofthebreakoutdayandplacing a stop-loss order justbelow the lowmeant riskingjustabove4%forapromising

doublebreakout.Thevolumespike on breakout increasedthe likelihood that thebreakoutwouldwork. In thiscase, the smaller pattern didnot provide an early entryopportunity.

TeslaMotors

Ournextexampleremindsusof the thornier aspects oftrading. We must rememberthatadecisivebreakout from

a promising pattern does notnecessarily provide anadvantageous tradeopportunity. Let’s again seewhy.

Thenextchartisaweeklychart that shows Teslabreaking out of amassive 2-yearascendingtriangle:

FIGURE75

The next chart is a daily

chartfocusingonthelastpartofthisascendingtriangle:

FIGURE75.1

A 7-week symmetrical

triangle formed at the veryendoftheascendingtriangle.WesawinChapter21howastock can form a classicalpatternjustbelowapowerfulresistancelevelinpreparationfor a possible breakout. Thehorizontal upper boundary ofthis giant ascending trianglewas also a multi-yearresistance level that,unsurprisingly,wasnoteasily

overcome. Traders wereunderstandably excited whenthey spotted this symmetricaltriangledevelopingjustunderresistance. An upsidebreakout from this smallsymmetrical triangle couldlaunch a breakout from thelarger ascending triangle andperhapsevenprovideanearlyopportunitytobuyshares.

The breakout wasdecisive. So decisive,jumping 16%, that buying

sharesafter thebreakoutwasproblematic.Whatshouldwedo? Here are some of ouroptions:

First,wecoulddecidenotto buy shares unless pricescamebackdown.Wewaitfora retest that will provide anentrythatwillallowustoriskless of our position. Nomatterhowpromisingtheset-up and how potentiallyexplosive the uptrend, wedon’t have to trade if we

decide that the nature of thebreakoutmakes the trade toorisky.Here,theretestbroughtdown prices exactly to theupper boundary. Previousresistance was now support.We were given a chance tobuy shares at a spot with amuchmorefavorablereward-to-risk ratio. Of coursewaitingforaretestthatmightnothavehappenedmeantriskmissing the trade entirely.But it is perfectly okay to

missatrade.Whatisbadisbeing obsessed about notmissing a trade. So if therehad been no retest, then wemove on. Never hastily andrecklesslychasingabreakout,and thus sometimes“missing” a breakout, is thepricewemusthappilypay tonot squander our capital onsuboptimalset-ups.

Second, we could buy asmall position that keeps ourpotential loss within our

normal risk parameters. Ifthere is no retest and thestock surges higher, then wemake money. If there is aretest,thenwemightconsideradding to our small position,stillmakingsuretostayunderourmaximumrisk.

Wealwayshaveachoice.We never have to chasebreakouts. And sometimeswaitingmeanswegetabetterdeal.

CHAPTER23

PatternFailuresandMutations

When we look back at thecharts we have analyzed, wemay justifiably be impressedwith classical charting’susefulness as a trading tool.So useful and intriguing that

we may also be tempted tothinkofclassicalchartingasamathematical certainty orscience. We must avoid thismistake.Classical charting isnot an exact science. It doesnot and cannot predict orguarantee anything. Nothingrelatedtoinvestingortradingis certain, except risk. Themore fervent the claim ofcertainty, the more skepticalwe must be. We must alsohave a healthy dose of

skepticism with experts’opinions, claims, andpredictions. Alwaysrememberthatwedon’thaveto do anything with ourmoney just becausesomebody says we should.Nobody, including theexperts, knows much aboutfuture economic and stockmarket performance.Consider the followinginstance.

Theglobal financial crisis

startingin2007wasthemostserious economic challengesincetheGreatDepressionofthe 1930s. Yet financialwriterTimHarfordpointsoutthat economists as a groupfailed to forecast thiseconomicdisaster. In fact, aslate as September 2008, theexpertconsensuswasthatnotasinglecountryamongthe77being examined would be inrecession in2009.Forty-ninecountrieswere in a recession

in2009.Americasuffered itsdeepest economic downturnsince the Great Depressionand many argue that we arestillfarfromfullrecovery.

Thelessonisthatwemustnot blindly follow others,even our mentors. Tradingoffers great freedom butalso demands muchresponsibility. We must doourownthinking.Inadditionto treating expertpronouncements with due

caution, we must apply thesame care and prudentskepticism to our trading.There are no guarantees intrading.Patternsfailoften.

Toemphasizethefactthatpatterns are prone to changeand failure and we shouldnever rely on classicalcharting as a preciseforecastingtool, this chapterwill focusonset-ups thatdidnot work. Looking at thefollowing failed patternswill

remind us why we mustalways use stop-loss ordersand diversify our trades.Indeed,a trader’sassumptiononevery tradeshouldbe thatit will fail. No amount ofwishing and fantasizing willmake a trade profitable. Wecan only control where weenterandhowmuchwe risk.And by risking only a smallfractionofourcapitaloneachtrade, we can trade for thelongrun.

TexasIndustries

Figure 76 shows a H&S topwith a slightly up-slopingneckline:

FIGURE76

We also have a decisive

breakdown through theneckline.The stock traded ina narrow range for twomonths and then gapped up13.5% in early December. Ifweshortedthisstockafterthebreakdown through theneckline, we lost 15% ormore of our position whenprice surgedupandwewerestoppedout.

Severaltakeawayshere.

First, we must alwaysdiversify our trades. A stockcan crashor jump for anyornoreason.Pricegapshappen.The 13.5% spike here wasunrelated to an earningsreport. Prices just jumped.Thus,wemust never bet ourentire stake on one trade orevenseveraltrades.

Second,wecanlosemorethan we had planned. If weshorted this stock after thebreakdown through the

necklineandplacedabuy-to-cover stop-loss order justabove the high of thebreakout day, we meant toriskabout5%ofourposition.But reality can have otherplans, andour losswas threetimes greater than what wewerewillingtorisk.

Third, it is okay tooccasionally lose more thanwe had allowed for due toprice gaps and unexpectednews. No amount of careful

riskmanagementcanaccountfor unpredictable price gaps.Butwe can andmust alwaysdiversify our trades so that ahuge unfavorable pricemoveremains a very manageableloss.

Fourth, one could arguethatvolumedidnotsupportaH&S top interpretation. Thetextbookspecifiesveryheavyvolume at the left shoulderpeak and head. This possibleH&S top did not have such

climaticvolumeat thepeaks.Thatsaid,volumeisonlyonefactor in my analysis, and Iwould have shorted thebreakdown through theneckline given the pattern’sgood form and meaningfuldecline through a significantsupportlevel.

Fifth,afterbreakingdownthrough the neckline, thestock traded in a narrowrange for 10 weeks. Is thattoo long towait for a follow

through after the initialbreakout? Hard to say.Patience is a vital tradingskill.And some set-ups needtime to work. Some tradersuse a time-stop along with apricestop.Theyexitthetradeeven if their stop-loss orderhas not been triggered if thestock does not start workingintheirfavorwithinacertainperiod.

Lastly, we should staynimbleandbeopentotrading

intheoppositedirectionfromthe anticipated breakout.After the H&S top failed inTexas Industries, the chartcould evolve and produceanothertradablepattern,suchas aH&S top failurepattern.But we will miss such anopportunity if we arepreoccupied with beingdisappointed with the failureof the H&S top. Powerfultrends in the other directionoften come from failed

breakouts. That said, it isunderstandableiftraderswhosuffered a 15% loss on theirshortpositionsimplywant tomove on to otheropportunities. Mentalflexibility is important, butmore important is clearingour minds and moving onfrom a loss. If we dwell onthe “unfairness” of the pricejumpinTexasIndustries thatresulted in our losing muchmore than we had carefully

allotted for, then we willdwell on making our moneyback from this chart. Thestock,afterall,“owes”us.Sowe start tradingeven if thereis no compelling set-up andwe lose more money. Thestock now owes us moremoney so we keep tradingand lose more money. Thedestructive cycle continuesandwe suffermore financialand psychological pain. Aswe know,many life lessons

applytotrading.Movingonafter a setback is one ofthem.

BasicEnergyServices

Ournextexamplecombinesapattern failure and a patternevolution.Figure77 shows afailed breakout from asymmetricaltriangle:

FIGURE77

In addition to its good

shape, this symmetricaltriangle inBasicEnergy alsohad a small pennant thatformed just below the upperboundarythatmightlaunchapowerful breakout from thelarger triangle – the alwaysinteresting pattern within apattern. The breakout fromthe pennant was initiallypowerful. But the upwardmomentum died quickly and

the stock decisively closedbelow the upper boundary ofthe triangle three days later,whichwasonedaybeforetheearnings release. The stockdropped 11% on earningsnews. The bullish breakoutfromthesymmetricaltrianglefailedcompletely.

Sowasthatit?Shouldwemove on?Yes, for now.Butwe would also periodicallycheck in on Basic Energy aspart of our regular cycling

throughofourcharts.Beforeexamininghowthe

chartevolvedinthefollowingmonths, let’s discuss onemore thing about thissymmetrical triangleinterpretation. Was there ameaningfulbreakoutfromthesymmetrical triangle? Wehave discussed how sometraders do not consider abreakout from a symmetricaltriangleoranypatternwithaslanting boundary to be an

entry signal unless thebreakout decisively closesabove a significant highwithin thepattern (fora longtrade such as here) or closesbelowasignificantlow(forashorttrade).

The following chartillustratesthispoint:

FIGURE78

As we discussed, I don’t

think there is a single bestway to trade breakouts frompatterns with slantingboundaries. Determiningwhat constitutes an entrysignalwilldependonourrisktolerance, personality, andtrading style. I would havebought shares upon thebreakout from thesymmetrical triangle butexited my position when the

breakout could not quicklyclose above the horizontalresistance level. The nextquarterly earnings reportwasto be released in three daysand itwasbetter to exitwithlittle or no loss or even asmall profit rather than hopethat the stock quicklyovercome a strong resistancelevel andmake ameaningfulruninamerethreedays.

Now, let’s discuss thechart’s evolution after the

failure of the symmetricaltriangle. Two months later,we saw that the chart wasforming a possibledescendingwedge:

FIGURE78.1

Inadditiontothewedge,a

possible descending flagwasforminginsidethedescendingwedge. As we know that asmall pattern can launch abreakout from the largerpattern, we would carefullywatchthischart.

The flag produced adecisive breakout. I stillwouldnothaveboughtsharesbecause the next earningsreport was due four days

later.Iwouldbuysharesaftertheearningsreleaseandaftera decisive breakout from thedescending wedge, whichoccurredonOctober29.IfwehadboughtsharesonOctober29, we were up by almost34%byNovember8.Agreatgainevenifweboughtonlyasmall position. And the sizeof the descending wedgeindicated that even largergainswerepossible.

Very few breakouts go

straight up or down. Andevery set-up presents uniquechallenges.Here, sittingona34% profit, should wecontinue to hold? I wouldn’tblame anyone for taking atleast partial profits at thispoint.

Let’ssaythatwedecidetotake profits on one-third ofourpositionandholdtherest.Over the next month wewatched the profits in ourremaining position evaporate

asthestockdeclinedandtriedto retest the upper boundaryofthedescendingwedge.

This retest showsperfectly why tradingchallenges so much ourmental and physicalstrength. We know thatretestsarenormaland thatallbreakoutsare subject topauses and even outrightfailure. We also know thatallwecandoistoenteratafavorablespot,setourstop,

and move aside. Butknowing our limitations isone thing. Accepting themtoachievecalmandmentalclarity is much moredifficult. We could suspectthat this price declineindicated that thepatternandbreakout were about to fail.Many of us are likely to sellour remaining shares infrustration at the earlyDecember lows, after all ofour profits have disappeared,

aswedon’twant to loseanymoremoney. Sowe sell andstop paying attention to thischart. We hate the chartbecause it didn’t go straightup. We don’t care whetherthe retest is over or how thechart may evolve in thecomingweeks.

But consider the attitudeof experienced traders whobought the breakout onOctober 29 and used the lastday rule to set their stop-loss

order just below the low ofthe breakout day. The pricedecline into early Decemberdid not come close totriggering their stops. Thedecline turned out to be arelativelyweakretestthatdidnot even threaten touchingthe upper boundary of thedescendingwedge.Ofcoursenoonecouldknowhowsharpthe retest would be. Allanyone could do is enter, settheir stop, and move on to

other charts and projects.They could have beenstopped out and lose all theprofitstheyweresittingoninearly November plus somemore. There is no way topreclude this possibility.Patterns can fail no matterhowdecisive the breakout orbeautiful the set-up. Ourprofits can evaporate in daysor even seconds. The soonerwe accept this reality oftrading, the quicker we can

start to trade in a calm anddetachedmanner focusingondoing the right things ratherthan making money. Here,the early-December lowsturned out to be the lowestpoint of the retest.The stockwent on to form and breakoutofa2-monthcontinuationsymmetricaltriangle.

The formation of thistextbooksymmetricaltriangleshows again why we mustregularlyreviewourcharts.A

quick and focused viewcoupleoftimesaweekwouldhavealertedustotheformingof a possible symmetricaltriangle. This triangle gaveanother chance to buy sharesifwehadmissedthebreakoutfrom the descending flag ordescending wedge or if wesold our position in earlyNovember. Also, thosepatiently holding since theflag breakout could add totheir position and move up

their stops to the breakoutfrom the symmetricaltriangle. We still had to bepatientevenafterthedecisivebreakout from the textbookcontinuation symmetricaltriangle.Thestocktradedinanarrow range for 3 weeksbeforesurginghigher.

Weshouldnotworryifwefeelabitoverwhelmedbythemany evolutions that theBasic Energy chart wentthrough. We do not have to

catch every or even mostintriguing charts. We justneedtotradewellacoupleofset-ups.Andifweloseonthefew set-ups that we catch,thenweknow that therewillalways be more set-ups tocome.

AltriaGroup

Our next example is a 3-month H&S top that formedinsidean18-monthascending

wedge:

FIGURE79

Both patterns had good

structure. Especiallyinterestingwashow theheadof the H&S top stayed justbelow the upper boundary ofthe rising wedge. The stockbroke down decisivelythrough the H&S top’sneckline. The next day thestock plunged as the marketreacted negatively to thequarterly earnings report. Intwo more days, the stock

decisively closed below thelower boundary of theascending wedge. Tradershad good reason to considershortingsharesatthispoint.

The stock declined a bitmore before pausing andsurging higher to do a hardretest of the lower boundary.The stock traded around thelowerboundaryofthewedgefor several weeks beforesurging higher. It closedabove the neckline of the

H&S top and eventuallybroke above the upperboundary of the ascendingwedge.

A promising set-up thatfailed decisively. Why studyfailed set-ups? To remindourselves that many, if notmost, patterns will fail. Wehave looked at many idealset-upswith clean breakouts.Andmany of our trades willbeliketheseset-upsandworkwell. But many will not.

Many will test us beforeworking or failing.Wemusttry our best to remain abovethe volatility and focus ontradingwellratherthantryingtomakemoney.Thebestwaytofocusondoingwhat’srightistoenteratafavorablespot,set our stop, and move on.We have no control overwhether a trade works. Wecan only manage our risk.These are blindinglyobvious statements but we

tend to forget these truthswhen we bet real money.Experienced traders havelearned to maintain a calmstateofmindnomatterwhathappens in the markets. Thebest way to try to staydetached from the gyrationsof themarkets is to riskonlyasmallportionofouraccountonanyindividualtrade.Ifwedo this, even our worst casescenariowillbemanageable.

I think this failed

ascending wedge asks animportant question: shouldwehavetradeditatall?Wastheset-uppromisingtobeginwith? This question makesclearthatknowingwhennottotradeisjustasimportantashowwetrade.

Let’s examine the set-upagain.TheH&Stophadgoodshape and the breakdownthrough the neckline wasdecisive. But how tradablewas this breakdown? We

would have been prudent tonot trade it given that thequarterly earnings reportwasreleased the day after thestock closed below theneckline. And as the stockcontinued to decline in thedays following the earningsreport, it did not offer afavorablespottoshortshares.We essentially “missed” thebreakout, by choice, becauseofthependingearningsnews.Entering now, so far below

the neckline, meant riskingtoomuch.

Didwehaveabetter spottoshortsharesafterthestockclosed below the lowerboundary of the ascendingwedge? Perhaps, but we hadto remember the additionaldifficulty trading patternswithslantingboundaries.Dueto the rising lowerboundary,a retest here meant that thestock could stay under thelower boundary of the

ascending wedge and stilltriggerourstoporder.Ahardretest did happen and wouldhave stopped out our shortposition.

Shorting shares upon thebreakdownthrough the lowerboundary of the ascendingwedgewouldnothavebeenabad trade. My point is thatthis set-up was not so idealafter all, especially since wedid not have a goodopportunity to enter earlier

via the breakdown from theH&Stop.Andbecauseofthedrawbacks of this set-up, itwould have been more thanreasonable to simply pass onthis trade no matter howinterestingthepattern-within-a-pattern set-up. Remember,notallbreakoutsaretradable.We should trade only themost desirable among thetradablebreakouts.Themoreexperience I gain in themarkets, the more I find

myself passing on patternsthat I would have traded inthepast. Ihave learned tobemore patient (don’t get mewrong – it is a constantstruggle) because experiencehas taught me that therealways be more and betterset-ups. Such knowledgehelps me remain calm andpatientmoreoftenthannot.

CHAPTER24

DoNotGambleonEarningsReports

As we have discussed manytimessofar,weshouldavoidtrading through earningsreports. I almost always exitmy entire position in a stockthat is about to release its

quarterly earnings report.Only rarely, and only if I’msittingonaprofit,willIkeepa small position through anearningsrelease.

I avoid trading earningsreports even though I knowthat exiting my position canmean“missing”hugegainsifthemarketreactspositivelytothe earnings news. Thefollowingexample shows thekinds of gains we might“miss” ifwe always exit our

position before earningsannouncements:

FIGURE80

So then why should we

not hold positions throughearnings reports? We knowthe answer. Because stockscancrashonearningsnewsaswell:

FIGURE81

We analyzed this CETV

chart in Chapter 11. It isfoolish to risk a significantportion of our capital on ablind luck of the draw. Suchoutright gambling is simplyunnecessary. We studyclassical charting because itallows us to take calculatedrisks at only advantageousspots. And we saw entrypoints with highly favorablereward-to-risk possibilities

where we must risk onlyabout 2-3% of our position.Steadily building our capitalis the goal. Overnightsuccesses are based onextremelyrareluck,andsuchluck is often based onreckless gambles that wipedoutallexceptthefewthatwehear about as overnightsuccesses.

We are human, andtherefore we are impatientandgreedy.Wewantmoney,

preferablyalotofit,todayorat the latest tomorrow. Weare not going to get it. Weknow that there is no easyroadtosuccessanywhere;wejust don’t want to believe it.We should play the longgame while steadily gainingexperience and capital. Istrongly believe that tradingis all about longevity. Byprotecting our capital againstlargelosses,wecantradeforthe long run. And long-term

survival greatly increases thechance that we will make itsimplybyvirtueofthealmostinevitablecoming togetherofacquired wisdom andfavorablemarketconditions.

Sometimesthemarketwillhaveveryfewchartsthatlookpromising. But there willalways be periods when themarket throws us many fatpitchestochoosefrom.Theseideal pitches and the largepotentialprofitsaretheresult

of impatient traders whospent their capital chasingpoor set-ups and treacherouscurveballs.Now they are toospent, financially andmentally, to take measuredswingsat the fatpitches.Butwe can take advantage if wehave carefully preserved ourfinancial and mental capitalthrough patience anddiscipline.

CHAPTER25

BeingOutofPosition:

NotTradingNoMatterHow

PromisingtheSet-UpandBreakout

We know that not all

breakouts are tradable. Wesaw some breakouts that areso powerful that it was toorisky to enter after thebreakout. I call this situationbeing out of position.Whenwe are out of position, weshould not chase, no matterhow tempting and promisingthe pattern. If we recklesslychase, thenwemustmitigatethepotentialdamagebyusinga much smaller position toavoid getting caught in a

negative feedback loop ofchasing, losing money,chasing, and losing moremoney.

FlirSystems

The next chart shows FlirSystems breaking out of awell-defined symmetricaltriangle:

FIGURE82

Note the first time prices

closed above the upperboundary.Whilethestockdidnot close above the upperboundary of the symmetricaltriangle by a largemargin, itdid so clearly, at least tomyeyes. I would have boughtshares at this point. The factthat this breakout wasthrough a boundary withthree good toucheswould bea factor in my buying.

Perhaps the most importantfactor was that I would beriskingonly about2%ofmyposition to buy shares at thispoint. The potential upsidewasgreatwhilethedownsidewasverymanageable.

Others will disagree withmyanalysis.Someofuswillprefer a more decisivebreakout that closed abovethe prior significant high.Because there was no suchbreakthrough here, we may

have decided to wait for astronger breakoutconfirmation.Thatdecisionisa very reasonable oneregardless of what happenednext.

The next day the stockjumpedmore than 6%. Ifwedidn’t enter the day before,shouldwebuysharesnow?

My opinion is that if wedid not buy shares at theinitial breakout, then weshould not chase this jump

unless prices came backdown and retested the upperboundary of the triangle toprovide us a much morefavorableentryspot.Enteringafter the 6% jump meanthaving to risk up to 8-9%ofourpositionandIthinkthatistoomuch.

Prices did come backdown but not enough formeto enter this trade. Enteringnow meant buying shareswhen I was clearly out of

position. I still could chasewithamuchsmallerpositionbut I prefer not to.And I tryto never chase a breakoutusing a full position becausethe consequence is almostalways emotional andfinancialpain.

But let’s say that wechased using our regular-sizepositionafterthe6%jump.Ifthe stock continued to surgehigher,thenwegotluckyandmade a large profit. But

rememberthatmakingmoneyisverydifferent fromtradingwell and doing the rightthing.Anybodycangetluckyoccasionally. More often weare not so lucky. The stockcouldhavereversedjustafterweboughtsharesanddeclineall the way down to thepattern boundary in aperfectlynormal retest.Here,there was a retest thatdeclined halfway to theboundary. If we did not set

our stop low enough afterchasingthe6%jump,thenwewouldhavebeenstoppedoutand would watch as pricessurgedhigherwithoutus.Wewould be frustrated andangry, and we may chaseagain. When we again buyshares, the stock may pauseand reverse yet again to stopusout.Itisapainfulcycleoffinancial loss and mentalpain. It gets increasinglydifficult tomoveonfromthe

crushing combination ofdamagedpride(whycouldn’tImakemoneyonthistrade?),greed (I thought Iwas goingto be rich soon?), andfrustration (only if I didn’tmiss the breakout or did thisordidthat…).

Asmuchasweknowthatwe should not to chase astock if we missed thebreakout or we are out ofposition, we will still chasesometimes.AndIdon’t think

welearnuntilwehavechasedand suffered financially andmentally.I’msurethereareafew traders out there whohave never chased a trade.But chances are we are notone of them. I certainly wasnot.

GamestopCorp.

Let’s examine another trickybreakout:

FIGURE83

GamestopCorp. formed a

well-defined 3-monthsymmetrical triangle fromDecember 2012 to March2013.OnMarch26,thestockclosed above the upperboundary. But I would nothave bought shares becausethe next quarterly earningsreportwastobereleasedtwodays later. I would wait andsee where prices settle aftertheearningsreport.Thestock

jumped6%onearningsnews.How shouldwe trade this

breakout? Shouldwe trade itatall?

Buying shares around theclosing price of the 6% daywouldmeanenteringataspotwherethereward-to-riskratiois unfavorable.Wewould berisking about 8% of ourpositionifweweretousethelast day rule to place ourstop-loss order. Only inhindsight do we know that

there was no difficult retestand the stock gained morethan 100% in the next sixmonths. The decisivebreakout could have faileddecisively and produced aquick 8% loss on ourposition.

If we were to enter thistrade after the 6% jump, Ithink we should buy asmaller-than-normal positionsothatan8%loss(rememberthat it isalwayspossible that

we lose more if there is adownward price gap) on ourpositionstillkeepsourlosstoless than 1% of our totalcapital. Even if we use asmaller position, we are stillchasing. And when I chase,my rule is to not attemptanother trade if Iget stoppedout. I have found thatchasing, even with a smallerposition, always createsnegative emotions. I getanxiousaboutthetraderather

than staying detached anddoing other things. Anxietythrows off our mental gameand increases the likelihoodthat we will do the wrongthings, such as not honoringour stops or chasing againand entering at increasinglyunfavorableandriskierspots.

So,weshoulddoourbestnot tochase. Ifwechase,weshould do so with a smallposition.Andwemustmoveonifwearestoppedout.

ShoreTel,Inc.

Here’s another breakout that,depending on our risktolerance and trading style,mayhavebeenuntradeable:

FIGURE84

We have a textbook

symmetrical triangle with adecisive breakout on the dayof the quarterly earningsrelease. The breakout wasstrong: up more than 7% onthe day. Entering around theclosing price of the breakoutdaymeant riskingmore than7%ofourposition.Ifwehadbought shares earlier duringthebreakoutdaywhenpriceswerehigher,wewere risking

morethan10%.Ifwedidnotwanttoriskaround10%ofanormal-size or even smallerposition, then we could waitand observe. Doing nothingisalwaysanoption.Aquickand focused glance once adaywould inform us of newchart developments that maycreateamorefavorableentryspot.

The next day, we saw aretest that dropped the stock2.2%. If we chose to buy

shares now, we would berisking less than 5% ratherthan more than 7% of ourposition, a big difference.Let’s saywedecided towaitfor an even more favorableentry spot. Or, wemay havesimply missed this decline.Perhapstherewouldbeahardretestthatdropspricesalltheway down to the upperboundary of the symmetricaltriangle. There was no hardretest, but instead of being

disappointed, we would bewise to continue to monitorthe chart. And our diligencewouldalertustoapossible2-week continuation pennantdeveloping just above thepattern boundary. A decisivebreakout from this pennantgaveusanotherchancetobuyshareswhileriskingjustover5%ofourposition.

In addition to providing amorefavorablereward-to-riskpossibility than the initial

breakout, this pennant hadanother favorable attribute:greater likelihood ofproducing an immediatefollow through. I have foundthat breakouts from smallpennants and flags have ahigh success rate. I wouldbuy shares on the day of thebreakout from the pennantandsetmystopusingthelastday rule. If the breakoutwasto reverse and the pennantfail, then I would simply

moveon.Ihavefoundthatitis easier to move on aftergetting stopped out of aposition I entered at anadvantageous spot comparedto after getting stopped outfrom chasing an unfavorabletrade.Why?Ithinkthereisasignificant satisfactionknowing that I lost a verymanageable amount of mycapital to make a bet with afavorable reward-to-riskpossibility.It isabouttrading

correctly regardless of theoutcome. If a promisingpennant fails, I accept it, andI think about how I focusedon doing the right things,such as waiting for a morefavorableentryspot.Tradingwell is so much about ourmentalstate.A losingtradecan increaseourconfidenceif we know that we tradedthe set-up well. We lookforward to applying ourknowledgeandexercisingour

discipline on the nextpromising set-up. We knowthat have no control overwhetherournexttradewillbeprofitable.Butwe alsoknowthatwehavefullcontroloverhowwe trade and that if wetrade correctly then even alosing streak will keep ourlossessmall.

CHAPTER26

TakingProfits

Sofarwehavefocused,withvery good reason, on how toentertradesatfavorablespotsand how to place stop-lossorderstolimitpossiblelosses.We canmakemoney only ifwe have money to bet on

promisingset-ups.Preservingour trading capital requiresstrict money management. Itis far better to miss abreakout and not makemoneythantochaseandlosemoney. Focusing on limitinglosses is proper andproductive.

Once we understand thefoundational importance ofprotectingourtradingcapital,wealsoneed to learnhow totake profits. We discussed

how to estimate the possibleprice target of a patternbreakout by projecting up ordowntheheightofthepatternatitswidestfromthepointofbreakout. This projection iscalled the measured pricetarget. It is only a generalguideline. Breakouts canreverse and fail any time.Orapatternbreakoutmayfailtoreach the measured pricetarget even though itmade astrong run and produced a

significant profit. Or pricesmaycontinue tosurgehigheror lower well past the pricetargets. We should not bedisappointed in the lack ofcertainty. Looking forguarantees in the financialmarkets is asking forconfusion, frustration, andpain.

Instead, we can use theveryunscientificnatureofthemeasured price target “rule”tohelpmanageriskandmake

money. I almost always takeprofits on my entire positionifapricetargetishit.Also,Ioften take profits on part ofmypositionifabreakouthasreached the halfway mark tothe price target. Sometimes Iwill do so with the intentionof adding to my position ifthere is a retest and pricesreturn to the patternboundary. Because patternscanfailanytime,Idon’tminderring on the side of having

taken profits “too soon.” Itend to take profits whenthere are profits to be taken,especially at or around thepricetarget.

Thatsaid,Idon’tthinkweshould exit a position themoment it is sitting on aprofit. Ironically, takingprofitstooquicklycanleadtoadestructivecycle.

If we seem to be exitingmany positions with only atinyprofit,thenwearelikely

watching our screens toomuch. We are watchingnervously every price tickandgettingscaredeverytimethe price action isunfavorable.Wecannottradewell and do the right thingswithsuchananxiousstateofmind. We will be mentallyexhausted and lackingdiscipline,whichleadtolargelosses.

If we have done ourhomework, identified a

promising breakout, andentered at a favorable spotwith a very manageablepossible loss,weshouldgiveour position time to work(make significant progresstowardthepricetarget)orfail(trigger our stop). If we areunabletoletgoafterenteringa trade, if we cannot standtakingevenasmallloss,thenwe must not trade stocks orany financial instrument.There is absolutely nothing

wrongwith deciding that wehave no interest in trading.We all have differentinterests, personalities, andaptitudes.Andwedon’thaveto prove anything to anyone,especially in the markets. Ifwe are not willing to takemany small losses as theregular and expected partof trading, then we arealmostguaranteed to sufferlarge losses. Let’s see howthisdisastercanhappen.

Saythatweboughtsharesafter a strong breakout. Weare sittingonaniceprofit asprices surge higher. Thenprices reverseandourprofitshave almost entirelydisappeared. We think aboutexitingwith a small gain butwe “want to make back ourprofits thatwehadonlydaysago.” But prices continue todecline and we are nowsittingonaloss.Asmallloss,but we are annoyed. We

“want our money back.” Sowe wait and stay in ourposition even when pricescontinuetodeclineandreachourstop-losslevel.Insteadofallowing our stop-loss orderto takeusoutofourpositionfor a still minor loss, wecancelourstop-lossorderandstay in. Prices are nowcrashing. We still don’t getout because we want to getout when we are respectablyclose to breaking even. The

stockcontinuestodeclineandour losses grow. Weeventually exit with a hugeloss.

And things don’tnecessarilygetbetter.Weareembarrassed.Andangry.Themarket owes us. Sowe tradeill-defined patterns and poorset-ups. We continue to losemoney.Wearenowonwhatcan only be called the cycleofpainandgreed.Thereisawayoffthissatanictreadmill.

Exit our positions, step awayfrom our screen, and take abreakforseveraldaysorevenweeks.Musterthecouragetothink about why we madethese mistakes. Reflect onhowwecan improve.Affirmthatwecandobetter.Realizethattherewillalwaysbemoreopportunities. Calm down.Forgive ourselves. Focus ondoingtherightthings.Returntothebasics.

Too dramatic?

Unfortunately, no. I think allofuswill(must?)takeatleastone ride on this treadmill ofpain. It seems sometimesexperiencing pain is the onlywaywelearn.

To avoid this destructivecycle, I try to stay in a tradeuntil it is resolved either bypriceshittingorhavingmadesignificant progress to thepricetargetorgettingstoppedout. Meanwhile, I try toignoremy positions and stay

away from the screens asmuch as possible duringmarket hours. I remindmyself that I am bigger thanmy positions. We are biggerthan the small losseswewilltake.Wearealsobiggerthanthe large profits we couldmake.As in life, self-respectisnecessarybeforesuccessintrading.

MechelSteelGroup

Mechel Steel formed atextbook ascending trianglefrom June to September2013:

FIGURE85

Thebreakoutwasdecisive

and the follow throughimmediate. The price targetwas hit two days after thebreakout. At this point, Iwould have taken profits onat least two-thirds of myposition. Why not sell theentireposition? I should, andI usually do. But there isalwaysthetemptationtokeepmy position to make moremoney if the uptrend

continues.Also, the breakoutand price target wereachieved in three days whiletheascendingtriangleformedfor three months. There issomething unsatisfactoryabout diligently tracking apattern for months and evenyears and then see the pricetarget reached in less than aweek. We want more. Wewant to ride themoney trainfor at least severalweeks. Inaddition, a continuation

pattern might form after thepricetargetishitsowe’lljuststaywithourpositioninsteadofriskmissingafastbreakoutfromapennantorflag.

But there are also goodreasonstoexitoncethepricetarget is hit. The measuredprice target is just apossibility, and prices couldhavestoppedwellshortofthetarget. Also, an immediatefollow through after abreakout is a good thing as

we don’t have to deal withretests.This3-daytrektothepricetargetmaynotseemlikemuchofamoveon thechartbut that is an almost 18%gain.Itisabiggaininsuchashort time and it will buildour capital. Finally, we gainconfidence in our ability totradewhilemanagingrisk.

So what to do when thepricetarget ishit?Iseethreeoptions.

First, get out completely

andmoveon.Second, take profits on

most of our position and letthe remainder ride. If thestockcontinues to surge thenfinebutwewon’t add toourposition unless there is acompelling continuationpattern that provides anadvantageous entry spot. Ifprices reverse and we getstopped out on the positionwekept,thenthat’sitandwemoveon.

Third, keep our entireposition evenwhen the pricetargetishit.Butwe’redoneifwe get stopped out at ouroriginalstop-losslevel.

Ialmostalwayschoosethefirst or second option and Ithink most of us should aswell. If we choose the thirdoption and get stopped outafter prices reverse, then wehavetorememberthatwehadpreparedforthisloss.Trynotto think of the evaporated

profits as money we lost.Instead, focus on havingentered at a favorable spotand consider taking profitsearliernexttime.

Here,sellingoursharesatthe price target turned outwell. Of course we had noway of knowing the optimalstrategy. The stock pausedafter hitting the price targetand traded in anarrow rangefor 7 days. Itwas reasonableto think that a possible

continuation pennant or flagwasforming.Butinsteadofafast uptrendoutof apennantor flag,pricesdropped to theupper boundary of theascendingtriangle.

Some scenarios toconsider:

Ifwe sold our position attheprice targetormissed thebreakout, then it was worthconsidering whether weshould buy a position whenprices returned to the upper

boundary.Idonotusuallyre-enter a position on a chartwhere prices have hit themeasured target and thenreturnedtothebreakoutlevel.Myreasoningisthatthechartpattern that launched thesuccessful move has servedits purpose. But support andresistance levels are oftenenduring. The upperboundary of the ascendingtriangle was resistance priorto breakout and it may now

be effective support. So wemaydecide tobuyapositionjust above the upperboundary of the ascendingtrianglewitharelativelytightstop. If we get stopped out,then we move on. If theboundary holds up againstretestsandpushespricesbackup,thenfine.

As we see in Figure 85,the upper boundary held assupport over four days ofretests. But the stock closed

belowtheupperboundaryonthe fifth day and thendecisively closed deep insidethe pattern over the nextseveral days. If we hadbought shares during theretests, we were stopped outwith a small loss. At thispoint, for a while at least, Iwas no longer interested intrading this chart. Theascendingtrianglehadserveditspurposebyhittingitspricetarget and then also became

invalid when the upperboundary failed as a supportlevel. There was no tradableclassicalpatternon thechart.Of course Mechel Steel’schart will continue to evolveand perhaps form anothertradable classical pattern, butthat possibility was probablymonthsaway.

Let’s discuss anotherscenariofromthischart.Let’ssayweheldontoourpositioneven when the price target

was met. We were countingon a continuation flag orpennant forming and ridinganother powerful uptrend.Instead,pricesdeclinedtotheupper boundary. We weredisappointedwhenourprofitsdisappearedbutwehopedfortheupperboundarytoholdassupport and push prices up.Then we were stopped outwhen the upper boundaryfailed to hold as support.What we must do now is

move on knowing that wetooka reasonable riskbynotsellingat theprice targetandcounting on a continuationflag or pennant to develop.Wemust also remember thatwe lost only a very smallslice of our trading account.Indeed, we expected to losethis modest sum when weentered this tradeandsetourstop. Again, we must notcount the profits thatdisappeared as a loss. But

what is absolutely the worstthingwecandoistore-enterthis trade to get our moneyback. By early October, thischart is “broken.” There issimplynotradablepattern.Inmid-November, the stockdropped 30% in one daybefore closing the day down23%.

The overall lesson is thatwe must accept the fact thatthere is no trading methodthat maximizes our profit in

all situations. The wisedecisionistoadoptastrategythat manages our risk in allmarket conditions. It meanssometimessellingatthepricetarget and then watching thestock explode higher. Itmeans sometimes watchingprices trigger our stop andthenimmediatelyturnaroundand take off without us. Wemust accept thesedisappointments withmaturity and calm because

weunderstandthatprotectingour capital, not makingmoney,isourpriority.

CHAPTER27

WhyWeMustDiversifyOurTrades

As we gain experience andhavesomewinningtrades,wecan get overconfident andforget that the reasonwe arefindingsuccessisbecausewehave been focused on the

fundamentals, namely,limiting losses andmanagingrisk.Overconfidencecanleadtotakingalargepositioninasinglestock.Whygoforonlysteady gains when we canmakealotononetrade?Thefollowing chart shows whywemustalwaysdiversifyourtrades,especiallywhenthingsare going well and we aremost vulnerable tooverconfidence,andneverbetitallonasingleposition:

FIGURE86

In July 2013, NQMobile

broke out of a giantdescending flag or channelthat had been forming forover four months. Pricesnearly tripled over the nextthree months. The breakoutand follow through were sostrongthatthestockhadonlyacoupleofdowndaysduringthe month following thebreakout. If we had takenprofits on two-thirds of our

position in, say, late July orearlyAugust, and decided tohold onto the rest, we sawNQ Mobile form a textbookuptrendchannel fromAugustto October 2013 thatcontinued to push priceshigher.Wearehuman,sowemay regret getting out “soearly” instead of focusing onhowwekeptaportionofouroriginal position. At thispoint, there is one thing thatwe must not do: buy more

shares, and, driven by thefrustration over sellingearlier, perhaps go all in onthis stock. We should notdismiss this possibility. Weare very capable of buyingshares at the September orOctober highs even thoughtherewas no tradable patternwith an advantageous entryspot. The only classicaltrading principle that couldguide us in September andOctober was the rising

channel, but it, like allpatterns, had multiplepossible interpretations. Abullish rising channel couldjust as easily be seen as abearish giant rising flag.Whatever our interpretation,ouroverallconclusionshouldhave been that there was nofavorable entry spot with acompelling reward-to-riskpossibility.Therefore, Idon’tthink we had a compellingreason to add to our position

or start a new position atthesepricelevels.Ifanything,we should have beenconsidering selling ourremainingposition.

Then in late October, thestock dropped 47% in oneday.Eventhisdisasterdidnothurt us if we took partialprofits in JulyorAugust anddid not recklessly add to ourremaining position or initiatea new position in August,September,orOctober. Ifwe

tookprofits,westillearnedasmall or even significantprofit. But if we chased andbought shares anytime fromAugust to October, then welost nearly half of ourposition or account if wewentallin.

This crash was unrelatedtoanearningsreport.Andthecausedoesnotmatterbecausesuchunpredictableeventscanhappenanytime toanystock.We simply have no control

over unexpected news thatcrashes a stock. We cancontrol howmuchwebet ona stock. I usually commit atmost no more than 7-8% ofmy account to a singleposition. By alwaysdiversifying our trades andenteringonlywhen there isacompelling opportunity, wecan reduce our risk to verymanageable levels andsurviveevenmarketcrashes.

Onemore thing about the

August to October priceaction. Some people willprefer to interpret it as apowerful uptrend within awell-defined rising channel.Otherswill like tosee itasagiant bearish flag. As wediscussed,itisfinetohaveanopinion but we must bementally flexible and honestenough to at least recognizethat there is an alternativeinterpretation.Ifweonlysawa powerful uptrend within a

textbook rising channel andignored all contraryinterpretations, thenwewereclosing our eyes to risk, andsuch willful blindness isalwayscostly.Ifwepreferredthe bullish rising channelview and bought sharestowardthelowerboundaryofthe channel, but we alsorecognized the opposite andpotentially dangerous bearishrising flag possibility, thenweweremuchmorelikelyto

use an appropriate positionsize thatwouldhave reducedour losses to a manageableamount.

CHAPTER28

TheTrader’sRoutine:

ContinuousPatienceandDiligence

Winnershavesystems.

ScottAdams

Weneednot,indeed,must

not, spend 13 hours a daystaring at charts. However,wemust be diligent in doingour homework by regularlymonitoring our charts. Aquick, focused, and efficientglanceatacharteveryseveraldaystoeverycoupleofweekswill allow us to identify,monitor, and trade manyinteresting classical patterns.

Someexceptionsarethefast-forming and fast-movingsmall flagsandpennants thatcan last as few as three daysor so. But since many flagsand pennants form afterbreaking out of much largerpatternsthatareeasiertospotandtrack,wecancreatealistof stocks that justify morefrequent, such as daily,check-ins. We cannot andshould not try to catch andtrade every classical pattern

that forms in the markets.Several promising patternsareenough.

Since most patterns takemany weeks and months toform, I would describe theskillandattitudeneededtobeagood traderasoneof long-term patience and diligence.Let’s saywehave about 700to 800 stocks on our watchlistandweusuallytakeabouta week or two to reviewthem. If we spot an

interestingchart,wecansaveit in one of several folderscategorizedbytheurgencyofthe set-up. For example, wecan have a folder for chartsthat have already formed anidentifiable classical patternand may be close to abreakout. Another folder canbe for patterns where thebreakout does not seemimminent.Yet another foldercanbeforset-upsthatmaybein the process of forming a

classical pattern but no clearpattern can be identified yet.Andanotherfoldercanbeforcharts that have potential,suchas those thatshowclearresistanceand support levels.Sowe can cycle throughourstock list about every twoweeks while checking in onour urgent folders moreregularly and perhaps evendaily.

Let’s seehow this tradingprocess might work in real

life using the following set-ups.

MatrixServiceCo.

FIGURE87

It is late February 2013.

We start to go through ourstock list and see nothinginteresting about the chart ofMatrixServiceCo.

We cycle through our listover two weeks and comeback to Matrix Service inmid-March. Again, nothingnoteworthy.WecomebacktoitinearlyAprilandstilldon’tsee any identifiable classicalpattern.

Butby lateApril it seemsthat prices are coiling andforming a possiblesymmetrical triangle.We putthis chart inoneofourmoreurgent folders and review iteveryday.

There is a decisivebreakout in earlyMay and astrong follow through intomid-May. Let’s say webought shares around theclosing price of the breakoutday and set our stop-loss

orderjustbelowthelow.Weare happy about the strongfollowthroughbutwetrynottogettooexcitedandinsteadwemove on and continue tocycle through our stock list.TwoweekslaterinearlyJunewe see that the stock hasdeclinedfromtheMayhighs.We consider this declinenormal as no stock goesstraightupandweknowthatwe have to expect retests.Another two weeks later, in

themiddleofJune,pricesareessentiallyunchanged.

But there are somewhatdisappointing developmentswhen we come back to thechart in late June. The stockhas dropped further and isnowtradingataboutthelevelwherewewouldhaveplacedour stop-loss order. If ourstop-lossorderwastriggered,thenwewereoutwithasmallloss.No big deal. Therewasnothing to get angry about.

Small losses are part oftrading.Atthispoint,wehadno urgent interest in thischart. But that did not meanwe would ignore this chartforever. We would reviewthis chart every couple ofweeks as part of our regularsearchfortradeset-ups.

In mid-July, we saw thatthe stock had bounced upnicely from the lows of lateJune. But, and this point iscrucial, we do nothing

because therewas nothing todo:wedidnot seea tradableclassical pattern with acompellingentryopportunity.So we continue to cyclethrough our stock list. InearlyAugustwesawthatthisstock was trading in a rangeand was perhaps forming adescending triangle since thehighs of mid-May. We putthis stock in our folder formedium-urgency set-ups andcheckineveryseveraldaysor

so. By mid-August adescending triangle did seemto be forming and animminentdownwardbreakoutseemed possible. We movethis chart into our folder forthe most urgent set-ups andcheck it daily. Still,wemustnot get fixated on a singlepossibility and instead wemust keep our minds openand flexible. We know thatpatterns can fail and evolveintoaverydifferentlook.

ItisnowlateAugust.Itisstill possible that adescending triangle informing.Butweseeanother,perhaps more compelling,possibility: a symmetricaltriangle. The strongest cluethatasymmetricalratherthana descending triangle wasformingwas the rising lowerboundary of a possiblesymmetrical triangle. Thisrising lower boundary wasnot evident in the middle of

August but had six or sevensolid price touches by lateAugust and even more byearly September. Sincesymmetrical triangles canbreak up or down, wecontinue to stay mentallynimble. We check the chartdailyandcatchthebreakoutafew days later.We decide tobuysharesaroundtheclosingpriceofthebreakoutdayandset our stop just below thelow. Then we move on and

continue our routine ofcyclingthroughourstocklistwhile also checking morefrequently our more urgentset-ups.

This multi-month routinewedescribedis theideal,butit is still a reasonable andreachable goal for us. It iswithin our power to doeverything that wasdescribed.

Let’s discuss aninteresting event from this

pattern.Whenpricesdeclinedto the breakout level in lateJune, did the pattern fail? Isay no. It is true that pricesreturnedtothebreakoutlevelwithout reaching themeasured price target. But,again, the target is only apossibility and the breakoutdid launch a significantuptrend. And prices couldstillreachthepricetarget.

Was there are any reasonto expect the late-June lows

to hold and possibly reversethedowntrend?Noticehowifwe extend a horizontal linefrom the apex of the triangle(the pointed end), that levelheld as support during thelate-June lows. Prices brieflytraded a bit below the apexlevelbutdidnotclosebelowit. Edwards & Magee wrotemore than 50 years ago thatthe apex level of asymmetricaltrianglecanbeasupport level. Here, this

principleworked as the apexlevelsupportedprices for thenext twomonthsandwasthebasis of a textbook andpowerful symmetricaltriangle.

Should we trade bouncesoff of apex-based support? Iwill consider trading anypatternorsituation thathasaclearly defined and favorablereward-to-risk scenario. Forexample, here I can buyshares around the apex

support level and place mystopjustbelowarecentlow.Iam risking a fraction of apercent of my position on aclearly-defined situation: Icanmake significant gains ifsupport holds and prices goup while I will lose a smallfraction of my position ifsupport fails (barring a bigdownward price gap). Aswith any trade, a favorableentry spot is key. If an apexlevel serves as powerful

support and quickly reversesadowntrend,thenthebounceoff supportmaybe so strongas to force me to chase therebound and enter at a spotwhere I must risk more thanprudent.

Lastly, let’s return to thetopic of this chapter, and,reallythisbook:patienceanddiligence.Almosttwomonthspassed from the breakoutfrom the first symmetricaltriangle to the retest of the

apex-level support in lateJune. And it was another 10weeksuntilthebreakoutfromthe second symmetricaltriangle. We neededdiscipline to regularly checkthe chart to spot importantdevelopments. We neededpatience to give the patterntime to evolve knowing thatthere was no guarantee thatthe chart would form atradable pattern despite ourvigilance overmanymonths.

There are also the inevitableboredom and anxietyassociated with suchpermanent uncertainty. Onlyin hindsight does it seem“obvious” that a symmetricaltriangle was forming. Onlynowdoes it seem like itwaseasy to wait the almost fourmonthsittookforthesecondsymmetrical triangle to form.Wemust not think that idealset-ups will presentthemselves to us whenever

we feel like looking at somecharts. Taking advantage ofcompelling set-ups requiresfollowing a regular anddiligent routine over manymonths,andtheprocessmustnever stop ifwe are to tradewelloverthelongrun.

In short, I think it isimpossible tobea successfulclassical chartist over thelong-run without beingsubstantially at peace withourselves before we start to

trade. We simply will nothavethepatience,composure,andcalmtodiligentlyapplyasystematic trading processover many weeks, months,and years if we are lookingfor personal validation andquickrichesinthemarkets.Idon’t mean that being atpeace will spare us from asteep and challenginglearning curve. I am sayingwewill bemuchmore likelytosurvivethedifficulttrading

periods that we willexperience if we commitourselves to being gratefuland reflective regardless ofourtradingresults.

RylandGroup

Our next chart is anotherexample of the necessity andrewardsofdiligentlyapplyinga systematic trading processovermonthsandyears:

FIGURE88

In early July, we did not

see anything interesting onRylandGroup’schart.Sowemoveon.A fewweeks later,we see somethingnoteworthy. In late July, wesee prices were turned backright around a highestablished several weeksago. We draw a horizontalline justabove the twopeaksto signify a possiblysignificant resistance level. If

this level does turnout to bean important resistance, thena breakout through this zonewillbeimportantandperhapsa trading opportunity. Fornow,wedonotseeaclassicalpattern so we just wait forfurther chart development.But we know that patternscan form quickly and howseemingly meaningless priceactioncanbethebeginningofa textbookpattern, soweputthis chart in our medium-

urgency folder for morefrequentcheck-ins,say,every3 to4daysvs.every7-to-10days.

Twomoreweekspassandit is early August, and wedon’t see anythinginteresting. But there issomething interesting inanother two weeks. Ourpreliminary horizontal lineindicating a possibleresistance level has againturned back prices. Two

touches can be justcoincidence, but three ormore touches on a potentialpattern boundary arenoteworthy. And there wasanother development: apossible rising lowerboundarywith4or5touches.Wenowput thischart inoururgentfolderfordailyreview.If an ascending triangle wasforming and if the lowerboundary had already beenestablished, then a breakout

could happen soon. Buteverything is only apossibility before the patterncompletion and breakout.Prices could plunge belowour preliminary lowerboundaryand thechartcouldcontinue to evolve forweeksor months into nothing. Wewillcheckthechartdailybutwe will not do anythingunless there is an actionabledevelopment that provides acompellingtrade.

On the last dayof tradingin August, the stock made astrong upward move andclosed just under the upperboundary of this potentialascending triangle. Abreakout could be imminent.Orthechartcouldcontinuetoevolve for a while. So wewatch rather than jump in.The next day stock brokethroughandcloseddecisivelyabove the upper boundary.The stock was up 2.35% on

thedaysobuyingaround theclosing price and setting astop just below the breakoutdaylowmeantriskingaveryreasonable amount of ourposition for a promisingpattern and breakout. Thenwe immediately face achallenge.The followingdayprices decline by 1.24% and,perhaps more ominously,closeslightlybelowtheupperboundary.

Should we sell our

position?Werewetrickedbythe “breakout” that was infact a nasty bull trap or justan insignificant out-of-lineprice movement? It waspossiblethatthebreakoutwasa false move. It was alsopossible that the 1.24%decline was a normal hardretest. Nobody could know.Myopinionisthatweshouldstayinourpositionuntilthereisaresolutionto thetrade.Ifprices continued to decline,

thenwewerestoppedoutforaminorlossandwemoveontootherset-ups.If the1.24%decline turns out to be anormal retest after whichpricesincrease,thenfine.

Such composure is ourgoal. It isnot thatwe shouldnot care. That is impossible.We should care. We shouldtakegreatcaretoenteronlyatcompelling spots. But wehave no control over prices.Obsessingafterweenteronly

causes anxiety and can undothe patient work we did toidentify and enter acompelling set-up. If we didour homework beforeenteringatrade,thenwehaveto learn to let go. Since wewill use strict moneymanagement and risk only afraction of our tradingaccount on any single trade,wearenotbotheredtoomuchabout the prospect of gettingstopped out. We can stay

detachedandgivethepatterntimetowork.

Here, we did ourhomework before enteringand bought shares after aclearbreakoutthatprovidedacompelling entry spot. Wedidallwecanandthuswedonot obsess over theoutcome.Severaldayslaterwesawthatthe pattern survived the hardretest and launched a strongfollow through that reachedthe price target. We sell our

shares foraniceprofit at themeasured price target. Andfor now, we move on fromthischart.Wewillreviewthechart as part of our regularcycling through of our stocklist rather than checking itdaily. We don’t see anycompelling set-ups on thischartforthenexttwomonths.

We know that continuouspatience and diligence arenecessary to identifypromising patterns so we

continue to review the chartevery couple ofweeks or so.By late November we see adescending resistance linethat could possibly form theboundary of a tradablepattern.We put this chart inour folder for more frequentreviews and check in everyseveral days. By earlyDecember we see anascending support line thatcould be the lower boundaryof a possible symmetrical

triangle. Now we move thischart into our urgent folderfordaily review tomaximizeour chances of catching apotential breakout. Severaldays laterpricesbreakoutofthe 5-week symmetricaltriangle. After a hard retest,pricesmovedquicklyup.

Wewillneverknowwhenor whether the charts we aremonitoring will produce atradablepattern.But theonlywaywewill spot compelling

setupsanddecisivebreakoutsistoalwaysdoourhomeworkby cycling through our stocklist, drawing and redrawingpossible boundaries, andstaying patient. There is noother way. If we arebeginners and just started tolook at charts, we may notfind a tradable pattern forweeks or even months. Themarketisnotrequiredtogiveus a welcome basket full ofcompelling chart set-ups just

becausewe decided to trade.We have to be patient. Wemustnotbesoeager to tradeand make money that wewaste our capital by tradingweak set-ups and non-patterns.

Lastly, a five-weeksymmetrical triangle is arelatively small pattern. Itwas easy tomiss this patternevenifweexaminedthepriceaction daily in lateNovember.Manypatternsare

much easier to spot whenframed by boundaries.Therefore, we should alwaystirelessly draw and redrawpreliminary patternboundaries for an evolvingchart.Boundariesframeandfocus our view and help usspot and track meaningfulpricedevelopments.

XeriumTechnologies

Our next chart is a great

example of the rewards ofpatienceandhowturningourattention elsewhere afterentering a trade is often thebest and only thing we cando:

FIGURE89

A 14-week symmetrical

triangle. We did not seeanything resembling aclassical pattern from July toearlySeptember.OnlybylateSeptemberdidweseearisingsupport level from the mid-August low. With four solidtouches, this ascendingboundary was potentiallysignificant and thus we putthischartinourfolderforset-ups requiring more frequent

review. In early October, wesaw that the rising supportline successfully supportedtwo more price touches. Wecontinue to check in everyseveraldaysandstaypatient.In late October, we see thatthe rising support line hasearned another price touchand that a possible upperboundary of a potentialsymmetricaltrianglehasbeenestablished. The patternseems to be maturing so we

check it daily. We shouldalways find out as soon aspossible the release date ofthe next quarterly earningsreport.We find thatXeriumTechnologiesisduetoreleaseits earnings report in about aweek,inearlyNovember.Wewait and watch. Pricesdecisivelybreakoutfromthesymmetrical triangle onearnings news. The breakoutispowerful:up8.78%fortheday.

Given this powerfulbreakout, we can decide tobuy a smaller position.Another and more importantreason is that Xerium is averythinstock.Allstocksaresubject to fast moves andlarge price gaps, but verylow-volume stocks are morevulnerable.Infact,weshouldgenerally avoid trading suchlow-volumestocksunlesswedo so with a significantlyreduced position and only if

there is a compelling reasonto trade. Here, the breakoutwas decisive and on heavyvolume and closed above asignificant prior high. Thatsaid, risk management, notmaking money, must be ourfocus and priority so weshould use a much smallerposition or avoid trading thiskindofset-up.

Wedecide to buy a smallposition, set our stop justbelowthelowofthebreakout

day, and move on. We havedoneallwecanforthischart.Wecontinuetocyclethroughour stock list to spotpromising set-ups on othercharts. While suchdetachmentiseasiersaidthandone, it must be our goal ifwe are to achieve long-termsuccess. We do ourhomework before we enter atrade. Afterwards, we shouldbe indifferent toward ourpositions.

Acarefreeattitudefocusedonothertasksafterenteringaposition will always bebeneficial, as it was here.After breaking out, pricestraded in anarrow range justabove the pattern boundaryforamonth.Also,thereweretwo hard retests that tradedbelow the upper boundary ofthe symmetrical triangle.Prices broke above thetrading range a month afterbreakout. Then prices traded

in another narrow range fortwo weeks before starting asustained uptrend. So pricesessentially went nowhere forsix weeks after a decisivebreakout. If we had watchedeverypricetickorevenifwechecked the post-breakoutprogressonlyeverydayorso,we were almost certain tolose patience and sell ourposition.

Aswediscussed,therearereasonable arguments against

waiting six weeks for abreakout to reach aresolution. Here, only inhindsight dowe know that apowerful uptrend started sixweeks after breakout. Sometraders look for trades towork almost immediately intheirfavor.Otherwise,eveniftheir position is sitting on asmall profit, they will exittheir position and move onbecause theirvaluablecapitaland time can be deployed in

other set-ups. Others givemore time for a pattern towork.

I think there arereasonableargumentsinfavorof moving on after a coupleof weeks of waiting. Weshould consider thesearguments and adopt them ifthey fit our personality andtrading style. But even ifwedecide togiveour trades lessleeway, we still must avoidfollowing too closely the

price action after we entertrades becausemicromanaging trades is thepathtoadestructivenegativefeedback loop.Micromanagement is so badprecisely because itsometimesworksandrewardsusforourbadbehavior.

Forexample,let’ssaythatwe bought a position inXerium Technologies afterthe breakout. We anxiouslywatch the post-breakout

action as prices, rather thansurging up, are hugging theupper boundary of thesymmetrical triangle. Whenthere is a hard retest inmid-November, we have hadenough. We sell our shares.Thenlet’sassumethatprices,instead of eventually surgingupwards in mid-December,continued to decline and thatthe pattern failed. We werefeeling brilliant instead ofmerely lucky for

“anticipating” the patternfailure.Wetellourselvesthatwe knew the pattern wasbound to fail. Besideshumorousanddangerousself-deception, what have wegained?True,we saved a bitof money by selling at ahigher price than we wouldhave had our stop-loss orderbeen triggered at the lowerprice. But because ourposition sizewas appropriateto begin with, selling at the

stop-loss price would stillhavemeantaverysmallloss.The only “reward” was thatwewererewardedforourbadtradingbehavior.

In fact, the money we“saved” is inconsequentialcompared to what we havelost. We spent our mostvaluable possessions, timeandenergy,obsessingaboutthe price action, which wehavezerocontrolover.Whydo we act as if prices will

obeyourwishes ifwewatchthem closely? Having spentour energy on a futile task,we are more tired than weneed to be. And fatiguemakes it much more likelythat we will trade badly andmake mistakes. Fatiguemeansmore anxiety and lesspatience.We find it difficultto stay patient and calm.Instead, we are prone tochasing breakouts andentering where there is no

compelling trade. Worse,whatif,insteadofthepatternfailingasinourhypothetical,we sold our position a weekbefore prices finally surgedupwards? We might kickourselves for being soimpatient. So we chase thebreakout,perhapswitha too-big position. When pricesinevitably pause and decline,wegetstoppedoutforalargeloss. We are angry andanxious to make back our

moneythemarket“owes”us.Sowechase again andagainwith larger positions and thelosses mount. It is thefamiliar cycle of great painandfrustration.

The way to avoid thisnegative loop is simple: wemust be bigger than ourtrading results. And we are.Stop obsessing over a tradeandletgo.BelikeHanSolo:cool, calm, and nonchalant.The foundation of such

detachment is riskmanagement: trading onlycompelling set-ups andriskingonlya fractionofourtradingaccountonanygiventrade,weareindifferenttotheoutcome.

TRWAutomotiveHoldings

Our next set-up emphasizesagain the need for and thebenefits of sustaineddiligence.

First,theweeklychart:

FIGURE90

A 14-month symmetrical

triangleformedaftera2-yearrally from the 2009 lows.Beforewe examine the dailychart, let’s talk about anybiaseswemayhavehadwiththis set-up. I’ll tell youwhatmybiaswas.Ithoughtsurelythis possible symmetricaltriangle will be a reversalpattern. I hadadifficult timeacceptingeventhepossibilitythat the stock could continue

to go up after rising 43-foldfrom March 2009 to March2011.

But, of course, pricescould continue to go up.There is somethingirresistible about picking thetops and bottoms of a pricemove. With TRW havingrisen so much over severalyears, we liked the idea ofshortingsharesatpossiblythevery end of a multi-yearuptrend. We missed the

gigantic uptrend from thedepths of the 2007-2009financial crisis, but we surewon’tmissthecrashfromthetop.Thisisexactlythewrongmindset.Ifwearesofocusedonaparticularresult,thenwewill fight the trend and losemoney and miss a profitabletrade. We must continuouslyfightourbiasesandwishestokeep our eyes open andaccepttheactualpriceaction.

Let’s return to analyzing

the chart of TRW. We sawnothingresemblingaclassicalpatternduringthefirstyearofthe construction of thissymmetricaltriangle.Onlybycontinuously checking thechart as part of our regularbrowsingprocess,andalsobyoccasionally checking theweekly chart to get a big-picture view of the priceaction, could we spot thispattern. And despite thepattern’s large size andwell-

formedshape,itwasnoteasytospotit.Partofthereasonisthat the six significant highsandlowsthattouchtheupperand lower boundaries arespread over 14 months.Again, constantly drawingand redrawing preliminarypattern boundaries madespotting and tracking thepattern much easierbecause boundaries frameand focus our view of theprice action. They also alert

us to the need to redraw ourpreliminarylineswhenpricesovershoot them. And theyalso confirm the significanceof a boundary by stayingwithinthem.

Now let’s focus on thebreakoutusingadailychart:

FIGURE90.1

ByearlyAugust2013,we

sawthatapossiblesignificantlow had been established inlateJulyandthatthispossiblesymmetricaltrianglenowhadat least four solid touchesframing it.As a continuationsymmetrical triangle canlaunch a breakout after fourtouches, we know that apossible breakout couldhappen soon. So we put thischart in one of our more

urgent folders for morefrequent check-ins. In mid-August, prices touched theupper boundary but wasturnedback.Thispriceactionwassignificantbecauseitwasthefourthtouchontheupperboundary and it alsosupported the interpretationthat our upper boundary wasa meaningful boundary andresistance. Perhaps priceswould make another attemptat overcoming and closing

above the upper boundary.Or, prices could fail tobreakabove the upper boundaryand instead drop through thelowerboundaryandcompletea reversal symmetricaltriangle. Or the chart couldevolve into somethingentirely different. These areall possibilities that we haveto be open to while we waitfor a compelling reason toenterthisset-up.

By late August and early

September,wesawapossible3-week symmetrical triangleforming just under the upperboundary. This small patternhad the potential to launch apowerful upward breakout ora downtrend. The situationwas resolved when pricesdecisively shot up from thesmall triangle and the larger14-month triangle onSeptember 6. Prices went up4.5%onthebreakoutdayandsowecouldenteraround the

closingpriceandsetourstopjust below the day’s low.Prices moved higher for aweek before pausing andreversing for a hard retestwherepricestradedbelowtheupper boundary. Dependingonwhereweplacedoutstop-loss order, this hard retestcouldhavetriggeredourstop.

Let’ssaywewerestoppedout and disappointed, butwecontinued to focus andevaluate the chart. We

thoughtitwassignificantthatduringtheretestpricestradedbut did not close below theboundary. This fact,combined with the initialdecisive breakout from asignificant pattern, suggestedthat we should continue tomonitorthisset-up.

In fact, some of us maydecide to re-enter very soonafter being stopped out. Wecould enter around theclosing price of the hard

retest day and set our stopjust below the low. Therationaleforthissecondtradeis that the upper patternboundary kept prices fromclosingbelow it and thus thepattern and breakout werestill valid. We also had aclearly defined and, in myopinion, favorable reward-to-riskscenario.Iftheretestwasover, then prices wouldrebound. If prices continuedto decline, then we got

stoppedoutfora likely1.4%lossonoursecondentry.

If we saw no compellingreason to re-enter so soonafter the hard retest, thenwecould wait and continue tomonitor the chart. We sawprices jump almost 8% threedaysafterthehardretest.Didwemakeamistakebystayingout?No.Waiting for amorecompelling entry spot was areasonable decision. Mostimportantly, we absolutely

must not chase. If prices hadcontinued to streak up afterthe8%jump,thenwehavetoaccept it and let it go. Let itgo. We did not do anythingwrong. And, let’s say ittogether:therewillalwaysbeother and more compellingset-upstotrade.

As it happened, pricesstalled again at around theprevious significant high andgenerallydeclinedasthenextquarterly earnings report

approached.Ifwehadboughtshares after the hard retest,then we should sell ourshares. If we had not re-enteredthistradeaftergettingstopped out, then we wouldwait until the earnings reportis released and see how thechart looks afterwards. Theearnings announcement inlateOctober caused prices torise modestly but there wasno reason to buy shares.There was no continuation

pattern that presented a goodentryspot.

So far we had the initialbreakout from the giantsymmetrical triangle, whichwas tradable, a hard retest,which likely stopped us outand could be seen as arelatively attractive re-entrypoint, and range-boundtrading before and after theearnings report. Since wenow had no compellingpattern to trade, we would

wait and continue to watchthechart.

One thingwenoticedwasthat the post-earnings rise inearly November was turnedbackatexactlythepriorhighreachedinearlyOctober.Wehad a potentially significantresistance level that couldform the boundary of aclassical pattern yet to beformed. Prices declined intomid-November beforereversing and going up.

Prices turnedup justaboveapreliminary rising supportboundary we had drawn andthereforeweconcludethatanascending triangle waspossibly forming. We checkdaily thechartandseepricesbreaking out decisively fromthe ascending triangle in lateNovember. Now we had aclear breakout from atextbookclassicalpatternandacompellingreasontoenteratrade at a spot with a

favorablereward-to-riskratio.What were the key

ingredients to spotting andtrading this entry signal?Consistent patience anddiligence.The breakout fromthe 7-week continuationascending triangle camealmost threemonthsafter theinitial and exciting breakoutfrom the 14-monthsymmetrical triangle. Whenthe initial breakout fizzledand stopped us out,wewere

disappointed and inclined toforgetthischartandmoveon.And it is important not todwell pointlessly on whythere was no powerful andimmediate follow through.But an even better approachis to have the courage,patience, and diligence toperiodicallycheckbacktoseeif the chart was evolving toform another tradeopportunity. Why courage?We all get discouraged,

especially when a promisingset-up does not work in ourfavor.Ournatural inclinationistotrashthechartandneverlook at it again. Instead, wecould periodically glance atthe chart to spot interestingpriceaction.

Trading well is neveraboutforcingmeaningontoachart. We can never makethings happen by beinganxious and impatient. Wecan only participate in price

moves launched by classicalpatterns. And we needcontinuous diligence andpatience to spot compellingset-ups.

GeneralDynamics

Let’s finish this chapterwithone of my favorite chartsfromthepastcoupleofyears.Here is a weekly chart of a27-month symmetricaltriangle:

FIGURE91

A perfect giant

symmetrical triangle. It istempting to think that all wehadtodotomakemoneywasbuy shares at the breakout.But remember that we arelooking at this pattern inhindsight. Trading in realtimeischallenging,evenwithagiantpatternstaringatus.

What was required totradethisset-upwell?Again,we needed patience and

diligence to spot, track, andtrade this symmetricaltriangle.Ofcoursewewouldnotlookdailyatthischartfortwenty-seven months. Therewasnothingtomakesenseofwhen the pattern started toforminearly2011.Evenwellinto2012,wewouldnothaveknownwhat, if any, classicalpattern was forming. It wasonly in late 2012 and early2013 thatwe saw that priceswere coiling and forming a

symmetricaltriangle.Whilewe did not have to

check this chart every day,westillhadtomonitoritonaregular basis, say everyseveral weeks or so. Andeven such intermittentvigilance is not so easy forthose of us, especiallybeginners, who are not usedto systematically goingthroughourchartsevenwhennothinginterestingortradableseems to be developing.

Continuous diligence can beburdensome for experiencedtraders too. We could besingle-mindedlyandunwiselyfocused on a potentiallyexplosive set-up or a post-breakout action whileignoring our basic job asclassical chartists: to look atcharts.

Thatsaid,missingthisset-up was not a disaster. Wemayseethischartforthefirsttime only after the breakout.

Or we may have beenviewing this chart every twoweeksorso,but,becausewedidnotdrawanypreliminaryboundaries that framed theprice action,we did not spotthe coiling triangle. Orperhaps we were busyfocused on other compellingset-upsandbreakouts.Or,wemay get lucky and spot thisset-upforthefirsttimejustasit is nearing a breakout. Mypoint is that we must accept

the fact that we will missmany setups, including giantpatterns such as thissymmetrical triangle.We arenot perfect, and we don’tneed to be. In fact, we mustnot pursue perfection giventhe inherently highlyimperfect nature of charttrading, including thenecessity of taking manysmall losses. We find someandwemisssome.Andevenwhenwemissabreakout,the

set-up will often give ussecond and third chances toenter through retests orcontinuationpatterns.

Let’snowlookatthedailychart to focus on thebreakout:

FIGURE92

Prices closed above the

upper boundary on earningsnews. With the immediatevolatility of the earningsrelease out of the way, wecould buy shares around theclosingpriceandsetourstopjust below the breakout daylow. We had a goodopportunity tobuyshares forthenextseveraldaysaspricesdidnot immediately jumpupandforceustoriskmorethan

prudent. Then pricesgradually increased for thenext 3 weeks and the stockwas up about 10% sincebreakout. Everything wasgoing well: clean breakout,good follow-through, and nodifficultretest.Thencamethechallenges. In late May,prices stalled and started totrade in a narrow range.Everytime prices seemedready to make a run, theywould reverse and decline

before turning up againbeforestallingyetagain.

Thissituationcapturesoneof the dilemmas and mentalchallenges of trading: wehave a 10% profit on ourposition and we want moregiven the decisiveness of thebreakout from a massivetextbookpattern, butwe alsodon’t want to lose the profitwearesittingon.Itiseasytosay now that we should justwaitpatiently,thatweshould

do other things and checkback in several weeks to seewhat happened. If we gotstopped out, then so be it.Only in hindsight do weknow that prices eventuallybroke out from this tradingrange and went higher andhigher. Don’t get mewrong:we should direct our energyelsewhere after entering atrade.Buttherealityisthatitis difficult to be so detachedfrom a trade given our

emotions.Oneway to achieve some

detachment is to take profitson a portion of our position,say, one-third or so, and lettherestridethepriceaction.Ilike this option. Itacknowledges our emotions.It also accounts for thepossibility that the breakoutcan fail and prices crashdown through the patternboundary.Still, I think it isaworthy goal to try to stay

with our full position until aresolution.Afterall,weknowthat if prices decline and weget stopped out, we willsuffer a small loss that wasaccounted for and evenexpected in exchange formakingaworthwhilebetonacompellingbreakout.

The choice is ours. Wemust choose a trading styleafter considering ourpersonality, capacity fordetachment, and preferences.

No single trading strategywillproducethebestoutcomein all scenarios. Instead, wemust choose a trading stylethat suits our temperamentand gives us the best chanceforlong-termsuccess.

Let’sreturntotheGeneralDynamicschart.Let’sassumethatwewemissed the initialbreakout. We weredisappointed but it is amistake to banish a chart tothe trash bin out of

frustration. Instead, we willrevisitthischartaspartofourregularcyclingthroughofourstock list. Perhaps in aweekor two there will be a retestthat brings prices back downto the pattern’s upperboundary and create anotherentryopportunity.Orperhapsa continuation pattern willform and provide a goodentryspot.

Twoweeks pass and it isearlyMay.Pricesaresteadily

climbing. There is no reasonforus toenterandchase.Bylate May prices seems to betrading in a narrow range.Prices are still trading in arange in the middle of June.We notice that the price dipinto early June was reversedat the exact level where apricedeclineinmid-Maywasreversed. We now have apotentiallysignificantsupportlevel and we draw ahorizontalline.Ifpricesclose

decisivelybelowthissupport,then we know that a hardretestorevenapatternfailureis a possibility. Anotherpossibilityisthatthissupportcan form the lowerboundaryof a continuation pattern thatpushes prices higher. Theseare simply possibilities fornowandwecontinue towaitandobservebecausewehavenoreasontoenterthetrade.

Twomoreweekspassandnow it is late June. We see

that our preliminary supportlevel bounced another pricedip in mid-June. We alsonotice that a possibleresistance level turned backtwobreakoutattemptsinJuneand so we draw an upperboundary.Wenowhavewell-established support andresistance boundaries.Was arectangle forming? If so,would itbeacontinuationorreversal rectangle? No needto rush to judgment. We’ll

wait and observe and enteronly ifwehave a clear pricesignalandacompellingentryspot.

ItisnowearlyJuly.Pricesaremakinganotherruntoourupperborder.Thistimepricesclose above the resistance.Wehaveaclearbreakoutandan attractive reward-to-riskscenario. We buy sharesaround the closing price ofthe breakout day and set ourstopjustbelowthelow.Then

wemove on and continue tocyclethroughourcharts.

Whatifwealsomissedthebreakout from thiscontinuationrectangle?

Disappointed, and that’sunderstandable. But weshould never despair andnever chase. We won’t anddon’t have to catch everypattern and breakout. Andnew patterns are forming allthetime.Weneedtocontinueto look at charts to find new

set-ups. So we calmly moveon and look at the GeneralDynamics chart five or sixtimesinthenextthreemonthsas we cycle through ourcharts. We don’t see anypatternsdeveloping.Theonlything that jolts us is thesteady rise in prices that wemissed. Again, it is okay tobe mildly disappointed butwemustcontrolouremotionsand never chase. Beratingourselves over missed

trades is completelyunnecessary as there willalwaysbemoreset-ups.Weshould use our modestdisappointment asmotivationtobepatientanddo our homework. Nobodysaid consistently tradingwellwouldbeeasy.

Four months pass sincethe breakout from thecontinuation rectangle and itis now early November. Wenotice that prices coiling and

forming a possiblesymmetrical triangle. Wedraw preliminary boundariesto help us monitor thisdevelopment.Andweputthischart inoururgent folder forregular,perhapsdaily,check-ins. A week passes and weseethat thepricefluctuationshave continued to narrow: asymmetrical triangle wasdefinitely a possibility. Wealso notice thatwe can drawthe possible boundaries of a

larger symmetrical trianglethat engulfs the smallertriangle: the alwaysinteresting pattern-within-a-pattern phenomenon. Wemonitor daily this chart andsee a breakout from thesmaller symmetrical triangleon November 14, 2013. Wedecide to buy shares aroundthe closing price of thisbreakoutandsetourstop-lossorder justbelowthelow.Weare risking just above 1% of

our position to enter thisintriguing breakout, whichmayalsolaunchthebreakoutfrom the larger symmetricaltriangle. Indeed, thenextdayprices decisively close abovethe upper boundary of thelargertriangle.Buyingsharesaround the closing price ofthis second breakout stillmeant risking just 2%of ourposition.

We have to continue tocycle through our charts and

hunt forset-ups inallmarketconditions. Long-termdiligence is just as importantwhen we are on a winningstreak. We will grow and,more fundamentally,preserve, our capital only ifwecontinuetotradewell,andwe can tradewell only ifweare continuously spottingfavorable set-ups. If, instead,we get confident and neglecttodoourhomework,wewillbetonweaksetups.Ourgains

will quickly become largelosses and lead us to adestructive cycle of financialloss, frustration, pain, andmoreloss.

CHAPTER29

TradingtheMarketIndexes,

andALessoninStubbornness

As traders, we look atindividualset-ups.Wewouldnot buy the shares of a

company at a random spotjust because the market isexploding higher.Norwouldwe short the shares of acompany just because themarketisdeclining.However,most stocks move with theoverall market. That meanswe should trade mostly longset-upsinarisingmarketandmostly short set-ups in adecliningmarket.

Soifwefindacompellingupside breakout from a

textbook classical patternamid a declining overallmarket,wemaytradethisset-upbut do so as an exceptiontotheoveralldecliningtrend.Edwards&Magee stress theimportance of tradingmostlyinthedirectionof theoverallmarket and how short tradesin a rising market and longtrades in a declining marketshould be undertaken sparelyand only as partial insuranceagainst thebulkofour trades

beinginthesamedirectionastheoverallmarket.Long-termtrends do not usually reverseovernight. Trends continuelonger than traders andinvestors expect. Remember,classical chartists seek toparticipate in, rather thanpredictoranticipate,thepricetrendsthatstartfrompatterns.

There are times when thedirection of the overallmarketandthepriceactionofindividual charts give a

mixed signal. For example,wemay find that the overallmarket as measured by themajor market averages iseithertradinginarangeorina general uptrend while wesee many short set-ups onindividual charts. Whatshould we do? The mostimportantruleistorememberthat we do not have to doanything. There is no rulerequiring us to trade for anyreason. I have learned that

trading as few times aspossible often pays off thebest, even when there aresome promising set-ups andbreakouts. Sitting still andwatching andwaiting for themost compelling set-upswherethereward-to-riskratiois overwhelmingly in ourfavorisperhapsthebestwayto ensure longevity andprofitability in the markets.Andnobodypreventsusfromwaiting for these fat pitches

…except ourselves.Wewillalways be our own worstenemy.

Individualchartsareproneto false break outs in achoppy market. When themajor market indices aretradinginarange,Ioftenseebreakouts from textbookpatterns reverse quickly andlead to pattern failure. Thenthese formerly-ideal patternswilloftenevolveintonothingor a different classical

pattern. Therefore, I try totradeas littleaspossible inarange-bound market. If I dotrade in a sidewaysmarket, Itend to trade only the majormarket indices using ETFssuch as the QQQ (Nasdaq100), SPY (S&P 500), IWM(Russell 2000), and DIA(Dow Jones IndustrialAverage).Regardless of howoftenwetradetheindices,wemust pay close attention tothem as most stocks will

move with themmost of thetime.

Let’s see how we couldhavetradedtheindicesinthefirsthalfof2014.

QQQ: Continuation diamondpattern

While Ididnot trade itwell,this set-up was one of myfavorite patterns of 2014because it reaffirmed thevalue of classical charting.

Let’s first get a big-pictureviewofthesituation:

FIGURE93

A textbook diamond

pattern. Looking at it now,thepatternseemssoobvious.Itmayalsoseemobviousthatit would continue the multi-year uptrend. Surely everytrader who was paying evenmodest attention must havemade money on this set-up,yes? That’s what I wouldthink too if I saw this chartforthefirsttimemonthsafterthe pattern had launched a

breakoutandreacheditspricetarget.

But remember that wehave trade in real time andnot in hindsight. If I soundcondescending, then pleaseknow that condescension isnotmyintent.Myintentionisto warn us that thesehindsight judgments aremisleading and simplywrong. Again, we trade inrealtime,andinrealtimethemarketwas very choppy and

imposinggreatfrustrationandlosseson traders.Theperfectboundaries we see nowincluded much volatility anduncertainty. I am not sayingthat we needed to decoderandom price movements orget lucky predicting thefuture to trade this set-upwell.Toputitbluntly,allwehadtodowaswaitandallowthe chart to declare its likelyintention. And waiting iswhat is so difficult for all of

us. Much patience anddiscipline were required toobserve the evolution of thechart over several months.Then, just as important, weneeded courage and nerve toenterthetradeuponbreakout.

Let’s start in earlyDecember of 2013. Here istheQQQchartfromlate2013onwards:

FIGURE93.1

Thestockmarkethadbeen

on an incredible runthroughout 2013 and itseemed nothing would derailits historic rise. There wassome choppiness inDecember but the QQQ wasstill up for the month. TheQQQ continued to risethrough mid-January beforesuffering a 6% drop into theFebruarylow.ThentheQQQreversedandwentupfortwo

weeks straight. Prices stalledin early March beforedeclining into theearlyAprillows.

So the market wasvolatile, but the market isalways volatile. Pricessometimes go up andsometimes go down. Amidthe ever-present uncertainty,was there a way to makesenseofthispriceaction?Wewill find that returning to themost basic fundamentals of

classical charting, and wecannot get more basic thansupport and resistance, willalways be productive andenlightening. Notice that theFebruary and April lowstradedbutdidnotclosebelowthe support level dating backto November 2013. In fact,pricesbouncedstronglyoffofthissupport.

Another way to help usframe the price action is toalways draw preliminary and

possible boundaries. Noticethat a rising resistance linefrom December 2013 toMarch 2014 has about 10solid touches. Just asintriguing was how adeclining support line fromDecember 2013 to the April2014 low got three solidtouches. And there was alsothe fact that a decliningresistance line from theMarch 2014 highs also hadmultiplesolidtouches.Wasit

possible that a diamondpattern was forming? If so,would itbeacontinuationorareversaldiamondpattern?

So far we have notdiscussedwhetherthesepricedevelopments presented anytrading opportunities. As aclassical chartist, we tradedecisive breakouts fromclassical patterns. We mightalso trade standalone supportand resistance levels if theyalsopresentaclearlydefined

and favorable reward-to-riskscenario.Here,wecouldhavetraded the bounce off of thesupport level dating back toNovember2013.

What about the possiblediamond that was forming?Wasthereacompellingearlyentry point for the possiblediamondpattern?

I thought there wereintriguing developments thatsuggested,tomeatleast,thatthis possible diamond would

be a reversal pattern thatwould start a significantdeclineinthemarkets.

First, there was a well-formedmini-diamondpatternthatformedattheverytopofthepossiblelargerdiamond.

Second, there was also apossiblehorntopthatformedsoon after the breakdownfrom the mini-diamond. Ilooked at the mini diamondand horn top as promisingearly entry points before a

possible breakdown from thediamond.Apotentialpattern-within-a-pattern is alwaysinteresting,andnowIthoughtIwaslookingatanevenmoreintriguing two smallerpatterns within a largerpattern that could start apowerfuldowntrend.

So I had an opinion andalsotradedonwhatIthoughtwere compelling entryopportunities. Having anopinionandtradingonlogical

entry points are notproblematic. What isproblematic is being soattached to any one possiblescenario. And I made thismistake. I was so excitedabout this multiple-patternset-up starting a bigdowntrend that I closed mymindtoalternativeoutcomes.For my multiple-patternscenario to become reality,the mini-diamond and horntop patterns had to be the

catalysts of a significantdowntrendandnothingless.Iso wanted the chart to playoutaccordingtomyopinion.

By being so stubborn andinflexible, I was of courseignoring an alternativescenario: that the mini-diamond and horn top couldboth work by producingmodest price declinesreflectingtheirsmallsizesbutthat afterwards prices maystillbreaktotheupsideoutof

thepossiblediamondpattern.And the chart offered ampleclues that anupsidebreakoutwasarealpossibilitywhenanascending triangle seemed tobe forming in the lastpartofthispossiblediamondpattern.You may be asking why Ifailed to see this ascendingtriangle.My answer is that Idid see it. But seeingsomething and accepting itare different things. If Imaysay so, I think we have a

large capacity to ignorereality and instead believewhatwewanttobelieve.AndIwantedmyoriginalopinion,that the diamondwould be areversal pattern, to becomereality.

SostrongwasmybiasthatIcameupwithmanyexcusesto justify not changing mymindandbuyingshareswhenpricesbrokeouttotheupsidefrom both the ascendingtriangle and the continuation

diamond.Whywas I so stubborn? I

wanted themultiple-patterns-within-a-pattern scenario towork and not waste thetextbook mini-diamond andhorntopthathadformed.Butthe reality is that the smalltopping patterns did work.What also worked was theascending triangle thatformed immediately afterthesesmalltoppingpatterns.Iwas too close-minded to

accept the possibility thatthey were part of theconstructionandevolutionofthe continuation diamondpattern.

A trading principle thatI have found to be veryvaluable is that tradersshould wait until a patternproves itself. That is, weshould not jump toconclusions and predict.Instead, we should simplyparticipate in the trend.

There was nothing deceitfulabout the breakout from thediamond pattern. We hadplenty of time to buy shareswhile risking a veryreasonable amount of ourposition. All we had to dowaswait,observe,andletthechart declare its intention.This is why early entries,even based on logical entrypoints, must be used withcare: they can make usinflexibleandleadustomiss

therealbreakout.Itiscrucialtoalwayshaveanopenmindand consider oppositescenarios,especiallywhenwehaveenteredinanticipation.

It would not be anoverstatement to say that theskills needed to successfullytrade this breakout from thecontinuation diamond werethe ability to draw lines andtounderstandthedirectionofthe breakout. Drawing andknowing up from down.We

learned to do these things inkindergarten but along theway we also learned how toover think and pursuepersonalglory.

SPY

Now let’s see how the othermajor stock indices weredoing.Themajorindexeswillalmost alwaysmove togethersowewould expect theSPYETF that tracks theS&P500

index to be in an uptrend inthis period as well. Andindeed SPY was trending upfromMaytoJuly2014:

FIGURE94

DIA

Let’s now look at the DIAETF that tracks the DowJonesIndustrialAverage:

FIGURE95

DIA was also in an

uptrend from May to July2014.

SPY vs. DIA: which shouldwetrade?

The stock market was risingduringthistimeandthethreeETFstrackingthethreemajorindices all reflected thisuptrend. Does that mean wecould have used any one of

the three ETFs to trade thistrend? Remember that wewouldnotbuyanystockatarandompricejustbecausetheoverall market is rising. Wewould look to enter only iftherewasacompellingset-upwith a clearly-defined andfavorable reward-to-riskpossibility. The diamondpatternandthebreakoutfromit provided a favorable entryspot in QQQ. Was there awell-defined pattern on

SPY’s chart that provided acompelling entry point?Yes,in the formof a continuationH&S bottom as shown onFigure96:

FIGURE96

What about DIA: did its

chart produce a classicalpattern?No,inmyopinion,itdid not. SowhileQQQwentupafterformingatextbook5-month continuation diamondand SPYwent up after a 2.5month continuation H&Sbottom,DIA simplywent upwithout forming a tradablepattern.This absence doesn’tnegate the fact thatDIAwasgoingup.Butfromaclassical

chartist’s perspective, thatomission meant we did nothave a compelling trade ontheDIAchart.

Thereisasayingthatit ishard to make money in arising market. Even thestrongest bull markets haveperiods of declining prices.Investors who buy risingstocks just before themarketbegins adecline areprone toselling justbefore themarketresumes its uptrend. Patience

is still very much necessaryeven and especially in aragingbullmarket.

Traders are even morevulnerabletolosingmoneyinabullmarket.Arisingmarketlullstradersintothinkingthatmaking money is easy andtheydonothavetobecarefulin choosing chart set-ups. Sothey start to enter early andmake anticipatory trades andhopethatarisingmarketwillforgive their haste. The

results are large losses, andevenmore damaging,mentalpain and loss of confidence.The frustration of losingmoney in a bull market is auniquely painful experience.Ourbestdefenseistobeevenmore patient and carefulwhen trading during a bullmarket.We have to continuetodoourhomeworkandtradeonly the best set-ups. Biglosses are guaranteed themoment we get

overconfident.The fact that most stocks

movewiththeoverallmarketmostofthetimeleadsustoavital implication: we shouldsavemostofourfinancialandmentalcapitalfortimeswhenthe market is trendingstrongly.Iftheoverallmarketistradinginarange,thenitislikely that there will berelatively few decisivebreakouts from individualcharts. Individual stocks will

also likely be range-boundand perhaps methodicallyconstructing but not yetbreaking out of classicalpatterns.Andthereisahigherlikelihood that individualbreakoutsmay turnout tobefalse breakouts that lead tofurtherchartevolutionbeforethe real move. Of coursethere will be individual set-ups that break out andstrongly trendevenwhen theoverall market is stuck in a

range and we should alwaysmake tradingdecisionsbasedoneachset-up.But I think itisbettertodeploythebulkofour trading capital when themajor indices are breakingout of trading ranges andpossibly startinga run.Thus,we need to look closely atSPY, QQQ, and DIA tounderstand what the overallmarketisdoing.

Looking back at my firstcouple of years of trading, I

realize that concentratingmyfocus and capital to trendingperiods would have been thesinglebestthingIcouldhavedone todramatically improvemytradingresults.Iwouldbeup 20% to 30% when themarketwas trending but losemuch of it or more duringrange-bound periods when Igot stopped out trade aftertrade. Instead of steppingback and realizing that themarket was choppy and not

trending, I would tradeincreasingly unfavorable set-ups trying to recover mylosses. More losses led tomore frustration and morechasingofbadset-upsandyetmorelosses.Ihadenteredthecycle of pain, and I couldblameonlymyself.

Weneed not fall into thistrap. By observing themajorindices and having thedisciplinetowaitfortrendingperiods, we can reduce our

losses and increase thelikelihood that we keep ourprofits.TimeandtimeagainIam struck by how much oftrading comes down topatience. If we get only onethingoutofthisbook,Ihopewe learn that themarketwillgive patient traders manycompelling set-ups at somepoint.Thetrickis thatwedonotknowwhenthattimewillbe. But the set-ups will bethere. We need patience.

Surely the market candemandpatience inexchangefor giving us the opportunityto learn about ourselves,exercise discipline, andperhaps even make somemoney.

CHAPTER30

50-dayand200-daySimpleMoving

Averages

Iuseonlytwoindicators: the50-day and 200-day simplemoving averages. I use themas supplemental but notcontrolling references. These

twomoving averages are theonlyvisualdatadisplayedonmy screen other than priceandvolume.Agoodchartingprogram will allow us todisplay the moving averageof our choice. Ask customersupport if you need helpsetting up moving averagesonyourcharts.

Why these two movingaverages instead of, say, the10-day or 100-day or anyotherperiod?The50-dayand

the200-daymovingaveragesaresomeofthemostreferredto indicators among tradersand investors. I have foundthe 50-day and 200-dayaverages to be effectivesupport and resistance levelsoften enough to warrantobservation but not be thefinal determinant of mytrading. Prices and breakoutsare still the most importantfactors in my tradingdecisions.Asatrader,Iama

chartpurist.Others may feel that

different moving averages,say, the30-day and100-day,arebettersecondaryreferencepoints.

We have to be cautious,though, when choosing andusing moving averages. Justasthereisnosingleentryandexitstrategythatwillproducethe best outcome in everysituation, there is nomovingaverage that will always be

the ideal reference point forevery chart. Because we candisplay any moving averagewewish,thedangeristhatwechoose the moving averagethat confirms our wishes or“explains” thepriceaction inourfavor.

How not to use movingaverages

Let’s say that we have abreakout from a descending

triangle.Thelowerhorizontalboundary is at the $17.50level. Prices decline to $17then reverse and the patternfails. We ask why the pricebounced up from the $17level insteadofcontinuing togo down. We don’t see anyprevioussupportorresistancelevelsat$17.The50-dayand200-daymovingaveragesarenowherenearthepriceaction.Sowestartchartingdifferentmoving averages to fit the

price action. After trying the10-day, 13-day, 17-day, andetc.,wefindthatthe“35-day”moving average was justunder $17. So we concludethat the 35-day movingaverage formed a supportlevelandwasthereasonwhypricesfailedtodeclinefartherand the pattern failed and,worse, resolve to buy shareswhenprices return to the35-daymovingaverage.

Such tweaking of the

moving average to “explain”thepriceactioninhindsightisvery misleading anddangerous. We have stoppedbeing disciplined classicalchartiststradingonlydecisivebreakouts from textbookpatterns and instead havestarted to trade randomly.There is likely no reasonother than coincidence whyprices reversed at the $17level and the 35-daymovingaverage happened to be at

thatlevelaswell.

How moving averages canhelp

Let’s look at an examplewhere the 50-day and 200-day moving averagesfunctioned as powerfulresistance. The followingchart shows a possible H&SbottomthatformedinMechelSteelGroupfromFebruarytoJune2014:

FIGURE97

A decisive breakout in

earlyJuneseemedtoconfirmthe pattern. We notice,though, that the breakoutstopped just under the 200-day. Prices then traded in anarrow range for severaldays. It was possible thatpriceswereformingabullishflag or pennant that wouldpropelthemthroughthe200-dayresistance.Instead,pricesquickly reversed after briefly

trading above the 200-dayand closed decisively belowthe neckline of the H&Sbottom.Prices failed tocloseabove thenecklineagainandthe pattern failed over thenextseveraldays.

In my view, the keyquestion is not whether weshould buy shares given thefactthatthebreakoutfailedtoclose above the 200-day, butwhether there was acompelling entry opportunity

after thebreakout– thebasicand most important questionwemustaskforeveryset-up.That the breakout stoppedjust under the 200-day is aninteresting but a secondaryconcern for me. Whether Ienter this trade will dependon whether there was anadvantageousentry spot afterthe breakout, and here therewas none. Why? Thebreakout, despite beingstopped by the 200-day, was

powerful: up 13.2% on theday. Iwouldnothaveusedabuy-stoporderinanticipationof a possible breakoutbecause MTL is a relativelylow-volume and high-volatility stock. That meantthat I would have to decidewhether to buy shares afterthe powerful surge. And itwas clear that I was out ofposition after the breakout: Ididnotwanttoriskmorethan13%ofevenasmallposition

totradethisbreakout.Would I have bought

shares if the breakout wasmoremodest,say,risingonly3-4% on the breakout dayinstead of more than 13%?Yes,becauseIsawadecisivebreakout from a promisingpattern despite the fact thatthepotentialresistanceofthe200-daywasoverhead.Itradebreakouts from classicalpatterns and not movingaverages. I have found that

even when the 50-day and200-day averages function aseffective support orresistance, they only rarelyaffect my entry and exitplans. In contrast, anupcoming earnings releasewillalwayschangeorhaltourtrading. If one of thesemoving averages overlaps apattern boundary, then wemay conclude that theboundary’s resistance orsupport potential may be

stronger than otherwise. Butthis possibility does notsignificantly affect mytrading since we are lookingfor a decisive breakoutthrough the pattern boundarywhether or not the 50-day or200-day is nearby. Abreakout through a keyboundary and the 50-day or200-day makes the breakoutmore credible. But our tradedecisionstillrestsonwhetherwe have a favorable entry

spot.

PARTIII

CONCLUSION

CHAPTER31

LifeandTrading

Nothingcanbringyoupeacebutyourself.

Nothingcanbringyoupeacebutthetriumphofprinciples.RalphWaldoEmerson

Aswe said at the beginning,trading is speculating. Withits lure of quick profits,speculation seems uniquelywellequippedtobringouttheworst in ourselves. But wesimply cannot succeed intrading with a get-rich-quickmentality or any short cut.Tradingwellmeansdoingourhomework, being patient,limitingrisk,movingonaftersetbacks, pursuing diverse

interests, living life, andrecognizing thatour livesarebigger than trading. Againand again. Informed andprudent trading, far fromrequiring a gambler’slifestyle, is based on acontinuous affirmation ofworthyvalues.

Remember thatwedonothavetoproveanythinginthemarketstoanyone.Wedonothave to trade to secure ourfinancial future. Thrift and

living within our means arealwaysavailableandeffectiveways to build a solidfoundation for ourselves. Ifwechoosetotrade,weshoulddo so with discipline andcaution, always rememberingthatprotectingourcapital,notmaking money, is ourpriority. If we apply thesetruths to our trading,wewillfind that trading can be asource of wisdom, self-discovery, and yes, even

excitement.Iplantopublishabookof

instructive and recent chartpatterns on a regular basis. Iam sure there will be manyinteresting classical patternsto choose from for the nextvolume of this book. Someare forming now, some willform later, and some arebreaking out as I write theselastsentences.

Thepatternswillbethere.We must bring the patience,

discipline,andperspective.I wish you the best.

Farewellfornow.

CHAPTER32

SuggestedReading

Here are some books that Ienjoyed and offerfundamental knowledge ontrading, investing, and thefinancialmarkets.We shouldtake time to learn beforecommitting our time, energy,

andmoneytothemarket.

“TechnicalAnalysisofStockTrends” by Robert D.Edwards&JohnMagee

I use the 5th edition (1966)formydailyreference.Ialsohave the 4th (1957) edition.The 4th edition is essentiallythe same as the 5th, but thecharts in the 4th are not asclearlydrawnasthechartsin

the 5th. I bought my pre-owned 5th edition fromAmazon.

“Technical Analysis andStock Market Profits” byRichard Schabacker(HarrimanHouse2005)

While Edwards & Mageedeservepraisefortheirwork,they acknowledgeSchabacker as the original

founder of classical charting.You don’t need to buy bothSchabacker and Edwards &Magee. Either book willsuffice.

“Market Wizards: InterviewswithTopTraders”byJackD.Schwager(Wiley2012)

Informative and funinterviews with prominenttraders.Thebookisnotabout

specific trading strategies.Thevalueofthisbookcomesfrom learning timelessprinciples (e.g., cut yourlosses quickly) and theimportance of the mentalgame.

“A Random Walk DownWall Street” by Burton G.Malkiel(W.W.Norton2003)

A good introduction to the

stockmarket.Malkiel arguesthat chart traders andfundamentalinvestors’effortsto beat themarket are futile.Instead,heurgeseveryone touse low-cost index funds toinvestinthestockmarket.

Traders must be open toopposing ideas and differentpossibilities, and this book isas far from classical chartingas you can get. If you agreewith the message of thisbook, then you should not

trade.

“The Intelligent Investor” byBenjamin Graham (Collins2006)

A book on picking stocksusing the value investingapproach. Ironically, one ofthe main messages of thebook is that we should justinvestinlow-costindexfundsrather than pick individual

stocks.Thebookisultimatelya cautionary tale about thestock market. Before wedecide to trade or invest, weshould learn what we are upagainst.

ABOUTTHEAUTHOR

Brian studied at theUniversity of California atBerkeleyandatHarvardLawSchool. He is a student ofeconomic history and thefinancial markets. As aHarvard Law School Post-Graduate Research Fellow,Brian researched the

relationship between equityreturns and national politics.He has authored articles oneconomic issues inpublications such as theHarvard Journal onLegislation.

Brian is a writer, investor,trader,andtradingcoach.

You can follow Brian atportfoliocareerist.blogspot.comand on Twitter:

@PortfolioBrian.

Brian can also be reached atbrian.b.kim@gmail.com.

DISCLAIMER

Everythinginthisbookisforinformational, educational,and entertainment purposesonly and is not to beconsidered professionaladvice of any kind. Allstatements and opinions inthisbookarenotmeanttobea solicitation orrecommendation to buy, sell,

or hold securities. Tradingandinvestinginvolveriskandmay result in financial loss.All trading and investmentdecisions youmake are yourown.