the bottom. Since a broadening formation should have five touches (three on one trendline, two on the other) before it becomes valid, point A in Figure 11.5 shows one likely investment location. Before placing the buy order, compute the target price using the measure rule. The target price will help you determine if the potential gain is worth the risk.
In the example shown in Figure 11.5, the purchase price is about 10.38 (at A) and the target price is 14.25, a 37% move. The stop‐loss should be 9.85 (15 cents below the low at A), for a potential loss of 5%, which gives a reward‐to‐risk ratio of 7 to 1, more than enough to risk a trade.
Long stop. Buy the stock soon after it touches the lower trendline and moves higher (after the pattern has fully developed following the identification guidelines). Place a stop‐loss order 15 cents below the lowest low (0.15 below point A). Should price drop, your position will likely be sold before a large loss occurs.
Price climbs across the pattern. Be ready to sell once price reaches the prior minor high. Confused? Look at Figure 11.3. On the way to point 5, be prepared to sell as the stock climbs to the price of point 3. Price may pause for a bit before moving higher and tagging the top trendline, or it may reverse at this point (which it does in Figure 11.3, at point 5). Make sure your stops have been raised to protect your profits.
Go short at the top, short stop. For short positions in broadening tops, open the short after price touches point B (Figure 11.5) and begins heading down. Place a stop 15 cents above the highest high (12.28 in this case) to limit losses. Lower your stop to the next minor high or apex of the broadening top (either 11.88 or 11.13 in Figure 11.5) once the stock nears point A. Sometimes the stock will not make it down to the trendline before beginning to move up. At other times, there is a lengthy pause before price turns around or continues down. A lower stop‐loss point helps you achieve at least some measure of profit.
Partial rise and decline. Partial rises and declines are like deer in mating season when you're driving: Look out for them. See the Glossary (“Partial rise” or “Partial decline”) for details on spotting the pesky critters. When you see a partial rise or decline, place a trade once the stock reverses course. If a breakout happens, then consider adding to your position.
Using a partial rise or decline to enter a trade before the breakout is a reliable trading technique. You get in at a better price, and they accurately predict the breakout direction.
Stop location. Use Table 11.7 for guidance on stop placement.
Busted trade. Consult Table 11.9 for tips on trading busted patterns. If you are lucky enough to trade a single busted pattern, you can make a lot of money.
Experience
Let me tell you about what I found in my trade review.
Advanced Micro Devices Inc.
Advanced Micro Devices Inc. (AMD) formed a broadening top in the first half of 2001. Here's my notebook for the trade entry: “2 August 2001. I bought at the market, filled at 19.64. The stock has bounced off the bottom of a broadening top. I hope prices will race across the pattern, but expect them to stall at 22, with eventual push to 25. Downside is old low at 16, or lower [trendline] boundary. Upside is 25, with possibilities of a climb into the high 30s. Resistance at 22, 25, 30. I expect a climb to 25 where it may be time to sell. Book score is +1, assuming an upward breakout.”
The book score is based on my book, Trading Classic Chart Patterns, which describes a scoring system to help improve selecting patterns that outperform. In this case, it didn't apply because the breakout was downward.
Notice that I didn't dwell on the potential loss (in percentage terms). Had I pondered that, I might have avoided this losing trade.
Lesson: Don't forget to assess the potential loss and avoid the trade if the loss is too high.
I bought the day the stock peaked. It dropped from there and soon was at the chart pattern's bottom trendline and dropping below it.
Here's my notebook: “15 August 2001. I sold at market. Fundamentals have changed with IBM saying they will no longer buy AMD‐based computers because customers prefer Intel. The stock has completed a partial rise and is expected to break out downward from the broadening formation. Yesterday, [the stock] closed below the 16 stop price, so it was time to sell. With September [traditionally the weakest month of the year] and October approaching, it's probably wise to exit the market. On the other hand, I don't really see the stock going much lower and expect that I sold near the bottom.”
In fact, the stock continued lower. Much lower. I sold at 15.70 for a 20% loss, but the stock bottomed at 7.69 or 51% below my sale price. As big as my loss was, I'm glad I sold.
Looking at the chart for the buy, the stock was well away from the bottom trendline, moving higher at a brisk pace (6 days in a row, it made a higher high). Maybe that was an indication of weakness. How long can the stock continue such a strong push upward? Perhaps running the chart through a momentum indicator would have provided a clue to the underlying weakness.
In this trade, I entered late but made a perfect exit (on the day price broke out downward).
Lesson: Before buying, don't be afraid to use technical indicators to uncover a weakening trend.
Chico's FAS
The 2009 bear market ended for Chico's FAS (CHS) in January, and the stock moved higher, ahead of the general market which didn't bottom until March. In June and July, the stock took a breather and formed the broadening top. I bought at what looks to be about a week before the breakout, just as price moved sideways at the top of the pattern. “24 July 2009. Buy reason: Broadening top. New management took over in January–February, so a turnaround is in place.” This was a buy‐and‐hold stock because I wanted to participate in the turnaround. Upside target was 17 and 27. The downside? “Stop: 8.94 –17.5%. Stop used: None. Long‐term holding, but 8 is a good exit price.”
The stock performed, moved up in a graceful turn, and peaked at 16.57 on 26 April 2010, quite close to my 17 target. I should have sold there. The stock was just 2.6% below my target, having made it there in less than a year. Hindsight…
Lesson: If the stock closes within 3% [or pick a value] of the target, consider selling.
The day the stock peaked, I placed a conditional order to sell the stock if the previous close was at or below 13.73 by October 2010. The order was 17% below the current high, but that's fine for a buy‐and‐hold, which often doesn't use stops at all.
About 3 weeks after the stock peaked, the company announced earnings that the market didn't like. The stock gapped open lower and continued down. Here's where the story gets strange.
The stock dropped all the way back to 8.22 (on 24 August, a 50% drop from the peak), but the conditional order never triggered. I must have removed the order but never made a note of it.
On 5 July, I wrote this: “This is well past the time to sell, but since I have so few bucks in it, don't worry about it.”
So the stock was within a handshake of my target and then dropped in half. Oops. I am tempted to write that I wasn't paying attention, but I was. I placed the conditional order