Wait for breakout. Because the breakout direction isn't known until price closes outside one of the trendline boundaries, don't try to anticipate the breakout direction. Price may reverse at the trendline, handing you a loss.
Stops location. Let's say price breaks out upward. Compute the target price and make a profit‐and‐loss assessment of the potential trade. What is the likely downward move compared with the target price? Does the potential profit justify the risk of the trade? For Figure 10.7, there is support in the 46‐to‐47 area.
Looking for prior peaks and valleys helps determine support and resistance levels. In March 1995 (not shown in the figure), there was an area of congestion bounded by a symmetrical triangle with an apex at about 46. Additional resistance appeared in July and October, as shown. Together, the 46‐to‐47 area made a good location for a stop‐loss order.
Let's say the stop price you select is at 45.75, just below the bottom of the support area. If the breakout price is 50.50 (which is the close the day after the upward breakout), that gives a potential loss of less than 10%. With a target price of 55.50, or 10% upside, the win/loss ratio is an unexciting one‐to‐one. In such a situation, you could either tighten your stop by moving it higher (and risk getting taken out by normal price action) or look elsewhere for a more profitable trade.
Remember there is no rule that says you have to place a trade. Let me also say that I'm not a fan of win/loss ratios. If you trade patterns well, the profit should come.
Intraformation trading. If the broadening pattern is tall enough, go long after price rebounds off the lower trendline and hope for an immediate upward breakout. Only try this if you're an experienced swing trader and only after the pattern passes all of the identification guidelines.
Partial decline. A partial rise correctly predicts a downward breakout 47% of the time. However, a partial decline correctly predicts an upward breakout 75% of the time. So if you can tell when a partial decline is in place, meaning the broadening pattern is fully formed (see “Partial decline” in the Glossary for details), then consider buying the stock and hoping for an upward breakout. The partial decline might be a pause that happens as price moves to the lower trendline, so if price breaks out downward, then close out the position. Otherwise hold onto the trade and hope price starts to head back up.
Busted trade. With a 60% average rise after a single busted downward breakout, busted patterns might be the way to profit from this chart pattern. See Table 10.9 for details.
Experience
I have traded this chart pattern a number of times. Let me tell you about what I found in my trade review.
Cisco Systems
Let's start with three trades in Cisco Systems. All of them traded the same broadening pattern that formed in June to September 2000.
In the first trade, the stock looked to be doing a partial decline. The pattern had a flat top with three trendline touches and three touches of the lower trendline, too, just as you would expect. The pattern looked ripe to break out upward in the high‐tech boom of the 2000 market (but the general market turned bearish in March, before I bought. I'm not sure I knew that at the time).
I bought the stock after it broke out of a small congestion area (it was a small downward trending pennant with an upward breakout buried within the broadening pattern). I expected the stock to break out upward from the broadening pattern. Instead, it touched the top trendline and headed lower. As a swing trade, it would have been good to sell then, but I didn't. I rode the stock lower and sold after a downward breakout.
The second trade was also within the same pattern, but I bought as price dropped before breaking out downward. This was a “hip shot,” a trade I just glance at and make, confident that it'll work. Each time I pen those words in my trading notebook, I know the trade is going to be a loser (that's what I learned over the years, perhaps well after this trade). Hip shots just don't work for me. Now, I take my time to analyze the situation before trading.
Anyway, I thought the stock was going to turn, but it didn't. It kept going down.
With the third trade, I bought at the lower trendline, expecting an upward bounce. Instead, it closed the day outside the pattern's boundary, breaking out downward from the pattern. The next day, I closed out all three trades and took a loss of 15%, 8%, and 4% on them, respectively.
My notebook tells what I learned.
Lesson: If an upside breakout from partial decline does not appear immediately, sell.
Lesson: Do not buy more of a stock as it moves downward across the broadening pattern. Wait for it to bounce off the bottom trendline. Otherwise, the breakout could be downward, resulting in multiple losing trades.
Lesson: Close out the trade when the market tells you you're wrong.
National Fuel Gas
National Fuel Gas (NFG) in late 2004 formed a broadening pattern. This pattern broke out upward, and I bought the next day, the same day the stock closed back inside the pattern (I didn't know it at the time).
From my notebook: “9 March 2005. Buy reason: Busted triple top, upward breakout from RABFD [right‐angled broadening formation, descending]. The other natural gas companies have stocks that are moving up almost vertically. This one is pausing from recent gains in the rounding turn. Earnings are weak, but the market doesn't seem to mind. I expect the stock to move up as it follows the other natural gas companies higher. Earnings come out in April, and I expect them to be good, sending the stock higher. I think the price is anticipating a strong showing. The stop is a close one just in case (7% away).”
On 18 April, I have this curious entry: “I removed the stop intraday as I was getting used to my broker. The stock dipped below the stop price, but I didn't have a stop in place, so I wasn't taken out. Stop remains at 27.43.” To me that sounds confusing, as if I removed the stop and put it back in, too afraid that price would take me out. It worked this time, but it's not a habit you want to form.
On 29 April, I was stopped out of the stock and took a 6% loss. The timing of the sale is odd, though. I sold when the stock was about midway down the height of the broadening pattern. My assessment of the trade says that I sold too early.
Indeed, the stock continued lower. Two days later, the stock busted the upward breakout when it closed below the bottom of the pattern. But that was as far as it dropped. The stock climbed from there, busted the downward breakout, and soared like I thought it would originally. The stock peaked at 63.71 in May 2008, a massive 133% above my sale price. You probably heard me yelling at the time about missing another big gain.
I picked the right stock, at the right time, but watched from the sidelines as it became an eagle and soared. However, I think I traded this correctly. I bought the day after the breakout, so I got in quick at a good price and sold when it was clear the stock was dropping. Waiting for it to turn at the bottom of the pattern, in this case, was not a mistake because it did break out downward. The stock just decided to turn back up from then on.
Lesson: If a stock doesn't perform as expected, get out.
Lesson: Don't lower or remove a stop unless you have a good reason for doing so. Being afraid price might trigger the stop is exactly the wrong reason for removing it.
Southwest Airlines
Southwest Airlines (LUV) in mid‐2004 showed a similar situation. I identified a broadening pattern in the spring and bought after the throwback completed. In other words, I was late buying into the stock. Had I placed a buy stop