CHARTING Bear-y Significant Patterns Identifying Bearish Chart Patterns (I) Bearish chart patterns form at the top of a bear market. What do they look like? by Thomas N. Bulkowski ince March 2003, the market has been trending upward. As I write this in August 2003, I'm starting to see bear- ish chart patterns dotting the stock market landscape like storm clouds brewing. What should you know about bearish chart patterns? This two-part article takes a close look at them. BROADENING FORMATION, RIGHT-ANGLED AND ASCENDING Figure 1 shows a right-angled and ascend- ing broadening formation. Prices along the bottom of the pattern follow a horizontal trendline; along the top, a trendline con- FIGURE 1: RIGHT-ANGLED AND ASCENDING BROADENING FORMATION. A partial rise in this chart nects higher highs. Thus, the pattern broad- pattern correctly predicts a downward breakout. ens out, but only on the topside. The pattern portends a bearish price reversal. In this example, prices started climbing in late March, entered the predicting an upward breakout. A partial decline is similar to pattern, then tumbled after the breakout, reversing the a partial rise flipped upside down. You need at least two short-term uptrend. touches of each trendline before you start looking for partial A key to this pattern and other broadening patterns is the declines. A partial decline occurs when prices touch the top partial rise. If prices touch the bottom trendline and climb but don't touch the upper trendline, then there is a good chance that prices will break out downward. I call that hump a partial rise because prices partially make their way across the pattern. Look for partial rises after four touches of the trendlines occur (at least two on each side). Only then is a partial rise valid. As a bearish chart pattern, the right-angled and ascending broadening formation isn't very bearish. Although prices can tumble, as shown in Figure 1, the average decline measures 18% for the 181 patterns I looked at. That's shy of the average 21% decline for other bearish chart patterns. BROADENING TOP Figure 2 shows what a broadening top looks like. It sports higher highs and lower lows bounded by two trendlines that widen over time. The price broadens out. A top means that prices enter the pattern from the bottom. The direction they exit is unknown until the breakout occurs. FIGURE 2: BROADENING TOP. The smaller head & shoulders buried within the In this example, prices tumbled despite the partial decline larger broadening top was another indication of the upward trend ending. 26 • December 2003 • Technical Analysis of STOCKS & COMMODITIES trendline, then dip but don't touch the bottom trendline before reversing. When prices touch the top trendline, expect an upward breakout. Partial declines work 86% of the time, and partial rises work 65% of the time for broadening tops, according to the 189 patterns I looked at. If the breakout is downward, expect a decline averaging 23%, but your results will vary. Figure 2 also shows other bearish patterns. A head & shoul- ders top appears just as prices peak. Prices break through the neckline, then pull back before continuing down. A descending scallop with its characteristic rounded bowl appears in August and suggests a continued decline. BROADENING WEDGE, ASCENDING Figure 3 shows an ascending, broadening wedge. It appears on the chart as a megaphone tilted up, hence the "ascending" part of the name. Higher highs and higher lows, each bounded FIGURE 3: ASCENDING BROADENING WEDGE. Prices didn't decline much from this wedge. by an upsloping trendline, form this pattern; thus, prices broaden over time. I uncovered 157 of these in the stocks I looked at. Of those BUMP-AND-RUN REVERSAL TOP showing a partial rise, 84% successfully broke out downward. I discovered this pattern, and Figure 4 shows a complicated That's key. Look for a partial rise sometime after two touches example of what the bump-and-run reversal top looks (BARR) of each trendline. Once prices break out downward, the aver- like. Prices start in the lead-in phase of the pattern following an age decline measured 20% for the patterns I examined. upsloping trendline. In the bump phase, the trend climbs even faster, following a steeper trendline. Prices then round over For more information, visit the S&C ad index at Traders.com/reader December 2003 • Technical Analysis of STOCKS & COMMODITIES • 27 CHARTING and crash through the trendline connecting the lead-in phase. That's how it's supposed to work. Figure 4 shows a dual BARR top, so called because it has a second bump. Of the 650 patterns I looked at, just 8% had more than one bump. The average decline measured 24% below the trendline. BARR tops are complicated to spot, so here are the guide- lines. First, look for prices following an upward trendline that approximates 30 to 45 degrees. Avoid steep trendlines. The lead-in section is just before prices jump up in the bump phase. The lead-in height should be at least $ 1 (preferably $2 or more), measured vertically from the highest high to the trendline. Prices gather momentum and the trendline slopes upward at 45 to 60 degrees, or more, on high volume. The height of the bump should be at least twice the lead-in height. What we are looking for is excitement in the stock - momentum players bidding up the price. When they stop pushing prices up, the downhill run phase begins. FIGURE 4: DUAL BUMP-AND-RUN REVERSAL. Sometimes a second bump The downhill run sees prices return to the 30-degree appears after a BARR top. trendline that connects the lead-in phase to the bump phase. Prices may slide along this trendline but usually work their way lower. Occasionally, prices bounce upward and form a second bump, as shown in Figure 4. That does not change the bearish picture. DIAMOND TOP I bought many trinkets for my ex-girlfriend (if you can call a shiny red Corvette a trinket - she loved the snap-together model), but a diamond wasn't one of them. Even though I proposed and she accepted, I was never fond of the stones. The diamond chart pattern I view in a similar way. I cannot recall ever buying a stock because I saw a diamond bottom, but I do recall selling because I saw a diamond top. Figure 5 shows a typical example. You might first scoff at its shape, but diamond chart patterns are rarely perfect. The diamond shape is usually pushed to one side or the other, making the diamond harder to spot. Prices trend up to the pattern, but the breakout can be in any direction, FIGURE 5: DIAMOND TOP. Diamonds rarely show a perfect diamond shape. For more information, visit the S&C ad index at Traders.com/reader 28 December 2003 • Technical Analysis of STOCKS & COMMODITIES CHARTING including horizontal. Most of the 111 diamond tops I looked at broke out downward. Thus, they acted as reversals of the prevailing short-term uptrend. The pattern's volume tends to recede, as it does in so many other chart patterns. One of the things I do like about diamonds is that a quick decline often follows a quick rise. The quick rise occurs when prices shoot higher, taking just a few days to make a vertical climb of several points. After the diamond reverses the quick rise, prices often tumble back to the point where the rise began. Keep that quick rise, quick decline pattern in mind, as it occurs often. DOUBLE TOP Figure 6 shows a classic double top, but they actually come in four varieties: Adam & Adam, Adam & Eve, Eve & Adam, and Eve & Eve. An Adam top appears narrow, pointed, with perhaps a single spike at the top. An Eve top is more rounded, broader. The figure shows an Eve & Eve double top. FIGURE 6: DOUBLE TOP. This is an example of an Eve & Eve double top. A twin top pattern is not a true double top until prices close below the lowest low in the pattern. That's called the confir- mation price, and Figure 6 shows an example. It's also the breakout price, and I found that prices dropped 20% in the 454 patterns I looked at. In a study of 1,280 twin peak formations, I found that 65% continued higher without dropping below the confirmation price. That's why it's so important to wait for confirmation. If you own a stock in a bull market, chances are the price will continue rising. Don't sell until you are sure the price is going down. That's not a license to let losses run away from you. Use common sense and good money management. HEAD & SHOULDERS TOP The head & shoulders top looks just like it sounds. First a left shoulder forms, then a higher head, then a right shoulder. A neckline joins the shoulder valleys (the armpits, if you will). When prices close below the neckline, the pattern becomes a valid head & shoulders top. Expect lower prices to the tune of FIGURE 7: HEAD & SHOULDERS TOP. This chart pattern is a popular and reliable 23%, on average. performer. When looking for head & shoulders tops, search for sym- metry. Often, the shoulders will appear similar in width and height, and will be nearly the same distance from the head. The typical volume pattern shows the highest volume on the left shoulder, followed by the head, with the lowest volume on the right shoulder. That's a typical pattern, and Figure 7 shows a different combination that occurs about a third of the time - volume is highest during formation of the head. If you have a volume pattern that's different from the typical pattern, don't worry. It's price you should be worried about, because you can't deposit volume into your bank account. If you own a stock showing a head & shoulders top, wait for confirmation, then sell. A pullback to the breakout price occurs about 45 % of the time, giving you another opportunity to dump it before the decline resumes. Take it or suffer the loss. HEAD & SHOULDERS COMPLEX TOP Now that you know how to find a head & shoulders top, look to the left and right of the pattern and search for additional More info: Traders.com/reader 30 • December 2003 • Technical Analysis of STOCKS & COMMODITIES CHARTING FIGURE 8: COMPLEX HEAD-AND-SHOULDERS TOP. Once you locate a head & FIGURE 9: HORN TOP. The twin spikes of the horn top on the weekly chart form at shoulders top, look to the left and right for additional shoulders. the pinnacle of this stock. shoulders. You will often find them. Figure 8 shows an CLOSING POSITION example of a complex head & shoulders top. This one has two If you own a stock and see a bearish chart pattern forming, ask left shoulders, a single head, and two right shoulders. Sym- yourself how far prices might fall. Look for a support zone metry is important, and the two left shoulders often appear below the pattern. Always wait for confirmation (that's similar in width and shape to the two right ones. The distance usually when prices fall below the lowest low in the pattern) to the head is similar to its mirror image. For example, see before selling. In a bull market, the tendency is for prices to how the inner left and right shoulders are just two days wide keep climbing, so it may pay to be patient. and are about the same distance from the head? Their heights are not exact, but patterns are rarely perfect. Contributing Writer Thomas Bulkowski is a private investor The outer left shoulder forms its own head & shoulders top, and the author of two books, Encyclopedia Of Chart Patterns with the left shoulder high being the head of the smaller pattern. and Trading Classic Chart Patterns. He may be reached via Note how a downsloping neckline - if it's steep enough - email at [email protected]. will never trigger a sell signal. For steep necklines, sell if prices drop below the right shoulder valley (which will be the lower SUGGESTED READING of the two armpits). The small head & shoulders doesn't really Bulkpwski, Thomas N. [ 1997]. "The Bump-And-Run Rever- suffer from an excessively steep neckline because prices do sal," Technical Analysis of STOCKS & COMMODITIES, close below it, but you give up a few points waiting for a Volume 15: June. neckline confirmation. Another example of a right-angled and [ 1998]. "Double Tops," Technical Analysis o/STOCKS ascending broadening formation appears in July. & COMMODITIES, Volume 16: January. [1997]. "The Head & Shoulders Formation," Techni- HORN TOP cal Analysis of STOCKS & COMMODITIES, Volume 15: Horns are another pattern I discovered as I was searching for August. double tops on the weekly scale. Horns appear as two tall spikes [2000]. Encyclopedia Of Chart Patterns, John Wiley separated by a week and look like a steer's horns, hence the & Sons. name. To identify them, switch to the weekly price chart and find . [2002]. Trading Classic Chart Patterns, John Wiley & two upward spikes that appear longer than most others over the Sons. prior year. Expect a price variation between the two highs. Look for clear visibility to the left of the pattern, meaning that the Charts by Thomas Bulkowski pattern should be at the top of a minor high like the one shown in Figure 9. The middle week of the three-week pattern should have a high well below the two outer spikes. The week after the pattern should show prices dropping down, with the high price well below the horn top. The pattern confirms when prices close below the lowest low in the three-bar pattern. The average decline I measured in the 188 horn tops was 21%, which is about average for all bearish chart pattern types. 32 • December 2003 • Technical Analysis of STOCKS & COMMODITIES