The measure rule sets a target price, but it makes no guarantee that price will reach it.
Table 9.10 Trading Tactics
| Trading Tactic | Explanation |
|---|---|
| Measure rule | Compute the formation height from highest high to the horizontal trendline. For upward breakouts, add the height to the highest high in the pattern. For downward breakouts, subtract the height from the value of the horizontal trendline. The result is the target price. More accurate targets use a formation height divided by 2. The bottom portion of the table shows how often the measure rule works. |
| Partial rise or decline | Use a partial rise or decline as an entry signal. A partial rise works 61% of the time and a partial decline works 80% of the time in correctly predicting the breakout direction. |
| Intraformation trade | For tall patterns, buy near the lower trendline and sell near or at the top when price stops rising. |
| Stop location | Use Table 9.7 for help placing a stop. |
| Busted trade | Table 9.9 may help you decide to trade a busted pattern. |
| Description | Up Breakout | Down Breakout |
|---|---|---|
| Percentage reaching half height target | 86% | 68% |
| Percentage reaching full height target | 68% | 40% |
| Percentage reaching 2× height | 50% | 19% |
| Percentage reaching 3× height | 37% | 9% |
To use the rule, compute the pattern's height, the difference between the highest high and the horizontal trendline in the formation. For upward breakouts, add the height to the highest high in the pattern. For downward breakouts, subtract the height from the value of the horizontal trendline. The result is the target price.
The lower portion of the table shows how often price reaches the target for various heights. For example, if you use the full height, price will reach the target between 40% and 68% of the time, on average, if your patterns are like the ones I tested.
For a more conservative target, calculate the height, divide by 2, and then apply the result to the pattern's high or low price.
Figure 9.5 makes applying the measure rule clearer. The height of the formation is the difference between the highest high (34.13) and the bottom trendline price (29.25), or 4.88. Subtract the result from the bottom trendline price, giving a target price of 24.37. The nearer target in the figure uses half the formation height, or 2.44, to give a price target of 26.81. An upward breakout target would be the height added to the top of the pattern, or 34.13 + 4.88 = 39.01.
Partial rise or decline. A partial rise or decline can be difficult to trade because price often pauses partway across the chart pattern on its way to the opposite side. This pause looks like a partial rise or decline. Wait before buying to be sure that price is unlikely to continue in the original direction. Try buying when price closes beyond the halfway point between the minor low/high and the trendline.
For example, if the top trendline is at 20 and price has declined from there to 14 before starting back up in what you suspect is a partial decline, buy when the price closes above 17 (that is half the distance between 20 and 14). You might use Fibonacci retracements of 38%, 50%, or 62% as buying locations, but I don't think they'll give you an edge. If price turns at those retracement levels, then consider opening a position.
Intraformation trade. If the pattern is tall enough, consider trading between the two trendlines. Buy after price bounces off the lower trendline and sell after it turns down at the top. If you are lucky, the pattern will break out upward and you can ride the stock even higher. Use trailing stops to protect your profits. When the stock climbs above the nearest minor high, raise your stop to just below the prior minor low. That strategy should give the stock plenty of wiggle room, but adapt it to your market conditions.
Stop location. Table 9.7 gives guidance on how often price will reach various parts of the chart pattern on the way to the ultimate high or low. Be sure to adjust the stop location for your tolerance to losing your shirt (or blouse).
Busted trade. If you are lucky enough to trade a busted pattern that single busts, then that's terrific. You could make a nice chunk of cabbage. Since busts happen between 53% and 64% of the time, the odds are on your side.
If the stock double busts, then don't blame me. If the stock triple busts, then the whiplash from bouncing from side to side will make you too dizzy to blame anyone.
One advantage to trading a busted pattern is that you know where the pattern ends, and so you know what the breakout price is (with some broadening patterns, it can be difficult to tell where the pattern ends and the breakout price).
I suggest you trade only downward busted patterns. Buy when the stock closes above the top of the pattern and hang on for the ride.
Experience
Let me tell you about what I found in my trade review.
Hughes Supply Inc.
Hughes Supply Inc. (HUG) in the fall of 1999 started forming a broadening formation, right‐angled and, yes, ascending. Although my notes go back to 1999, I don't have any for this trade. So let me wing it.
I bought 4 days after the stock touched the lower pattern trendline and received a fill at 13 even. When I bought, the stock hadn't risen much above the lower trendline (priced at 12.56), so I bought near the bottom of the pattern.
Unfortunately, the day I bought the stock peaked and reversed, completing a partial rise when the stock touched the lower trendline. The partial rise correctly predicted a downward breakout, and the stock continued lower. I sold my small position, received a fill at 12.34, and got my hand slapped for a loss of 5%.
I was late entering the trade, but I wanted to be sure price was moving higher, away from the bottom trendline when I bought. That sounds like an excuse, but knowing if price will turn at the trendline seemed like a wise choice. I only gave up 44 cents of profit by waiting.
I don't know if I had a stop in place to cash me out, and I'm unwilling to dig up my confirmation records to check. However, it's close enough to the 12.56 trendline that yes, I probably did use a stop to exit.
So the entry was late but justifiable, and the exit was perfect. I don't have a lesson to share. I traded this well and kept the loss small.
XL Group
In September 2009, XL Group (XL) started forming a right‐angled and ascending broadening pattern. It was a long one, lasting until June 2010. The stock made a partial rise, but that failed to see price break out downward. That didn't bother me because I trade from the bullish side.
I hid in the bushes and waited for the upward breakout. The breakout