Encyclopedia of Chart Patterns. Thomas N. Bulkowski
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is going down. A double top appears at EF. The two peaks top out near the same price. It confirms as a valid double top when price closes below the horizontal line, G. The next day, you sell your shares at the open and receive a fill at 10.60. The difference is $3.20 or 43% above the buy price.
In fact, if you had spotted an earlier double top (I), you could have sold a day after the downward breakout (J) and received a slightly better fill, at 11.00, for a net gain on the trade of 49%.
If you sold the day after J, you might be kicking yourself for selling too soon. Why? Because price continued to rise to E and higher to F. If you were astute, you may have recognized a 2B pattern at F and sold sooner, making even more money. Don't look for the 2B pattern in this book because I don't review it. Visit my website for details if you're interested in the 2B.
Of course, I cherry picked this trade, and often things aren't as easy as this example suggests. But the idea is simple. Buy bullish patterns and sell bearish ones. Yes, you'll have to find stocks that you believe show promise in an industry doing well and during a rising market (you will want the stock, industry, and market trending in the same direction for the best result).
You may want to score the chart pattern, too. I described the scoring mechanism in my second book, Trading Classic Chart Patterns. A review of the technique over a decade later shows it still works well. It will help you select patterns that perform better and avoid the duds.
Knots and Swing Trading Pullbacks
Let's dig in and discuss some swing trading setups. Figure 1.8 shows what I call a knot. It's a useful way of detecting when a pullback will start and at what price. It's ideal for swing traders who want to make money when price breaks out downward from a chart pattern in its initial push lower.
Let's look at Steelcase on the left of the figure. A double top forms at AB and confirms at C when price closes below the horizontal line. How low will the stock drop in its initial descent?
Answer: to the knot at D. I define a knot as a place in a strong trend (E to A in this example) where price moves sideways for at least 3 days. When it's the first knot closest to the double bottom (the first location of support, really, below the pattern's breakout), expect the stock to bottom there and begin a pullback.
In this example, knot D is the first support area below C. Price reaches the area at F and begins to pull back to the price of C.
In my experience with knots, I know to place an order to close out the trade at the top of the knot, not the middle or bottom. Sometimes, price touches the top of the knot and reverses. At other times, the stock drops like we see here at F before reversing.
Setup 2
Let's take the case on the far right of the figure (“Setup 2”). In the rise from I to H, there is no knot of support. The uphill move is fast and long.
The way to trade this is to split the move in half and place an order to close out the trade there. In this example, midway up the run from I to H is J. Place an order to cover a short at J. After the double top FG confirms when price closes below H, price drops to K before beginning a pullback.
Figure 1.8 Shown are three ways to trade a pullback.
You don't see this setup often because there is usually a knot along the uphill run from I to H, but it does happen. Take advantage of it and expect the stock to find support midway in the I to H run like it does here at J.
If the run does show a knot but it looks too far below the chart pattern, then split the run in half like I've explained. In technical terms, if support is too far away, then price will reverse closer to the chart pattern. What is closer? Most pullbacks bottom in the 7% to 8% range. If a knot is 10% or 15% away, then that's too far unless there's a fundamental reason to drive price down hard and fast (bad earnings, bad future outlook, that kind of thing).
If the move from I to H is exceptionally long, you might want to split the run into thirds and place a trading order a third of the way down to I from H. Search for other stocks showing the same pattern and see where they turn. The Patternz simulator can make the search easy.
Setup 3
Another setup is similar to Setup 2 except there's support between J and H, but not in the same upward trend. Let's rewind the tape and start at the beginning.
Imagine that the line separating Setup 3 from Setup 2 is missing. We see a strong move higher from I to H. We could take half that move and assume price is going to drop back to that area, just as we did in Setup 2. However, looking to the left of I, we see peak L. It's a mean‐looking knot of support with price going horizontal for a week or two (but need not be that extensive; a simple well‐defined top can do).
Instead of using Setup 2 to place the exit trade midway at J, it's more likely that the stock will drop to the price of L and reverse there. So L is our target. We place a stop a penny above G, place our order to short a penny below the price of H, and use the top of L as the exit.
Knots and Throwbacks
Figure 1.9 shows two more scenarios for swing trading the stock. The left panel shows a double bottom at AB, confirmed when price closes above C. As a swing trader, you don't want to wait to buy into this situation, so you place a buy stop a penny above C. That gets you into the trade right on time.
How far will price rise? Answer: to D. That's the first knot. The knot is the closest region to the breakout where price moves horizontally for at least 3 days. That horizontal movement is obvious because it rests in the circle to the left of D.
D is your short‐term swing target. The stock will rise and hit that region and likely turn back to the breakout in a throwback (which it did in this example, after reaching E).
Figure 1.9 Here are two setups that work well for swing trading throwbacks.
You can set a limit order to sell at the top of the knot, but the bottom of the knot works better (less risky). In this case, it did work better when the rise to E triggered the order and sold the position. You don't make a lot of money trading the throwback (7% or 8%), so you might have to increase the position size to make it worthwhile. Do place a stop‐loss order a penny below the lower of the two bottoms (below A in this case).
Setup 2
The prior setup captures the run up to the throwback. What if you want to capture more of an advance? This is a more risky setup, but it also works well. Look for the second higher knot. I show that at F. That's your target.
In this case, the knot is composed of peaks, a ragged top with price spiking upward. Price also moves sideways here for at least 3 days, with lots of overlap, so it's a good area of overhead resistance.
The stock recovers from the throwback and rises to G where it hits resistance setup by the second, higher knot, F. After that, price struggles to push through that resistance but eventually does in this example.
Setup 3
The right half of the figure shows a similar setup. A small double bottom is at HI, confirmed when price closes above J (it's hard to see where that is, though). In this setup, we have a measured move down pattern from L to K (first leg), K is the corrective phase, and KH is the second leg.
We know from studying measured moves that price returns to the corrective phase 77%