TRADING

STOCKS
USING
CLASSICAL
CHART
PATTERNS
 A Complete Tactical &
Psychological Guide
for Beginners and
Experienced Traders

Over 100 chart examples

Detailed entry and exit
strategies
Emphasis on managing risk
The mental game

BRIAN B. KIM
Copyright © 2014 Brian B. Kim
For my family.
 CONTENTS

PART I A FRIENDLY
INTRODUCTION
CHAPTER 1 Our Goal
CHAPTER 2 Trading
vs. Investing vs.
Gambling
CHAPTER 3
Emotional Detachment
and Acknowledging Our
Limitations
 CHAPTER 4 Basic
Trading Tools

PART II CLASSICAL
CHART PATTERNS
CHAPTER 5 Head &
Shoulders Top
CHAPTER 6 Head &
Shoulders Bottom
CHAPTER 7
Continuation H&S
Bottom
CHAPTER 8
Rectangle
CHAPTER 9
Ascending Triangle
CHAPTER 10
Descending Triangle
CHAPTER 11
Symmetrical Triangle
CHAPTER 12
Continuation Pennant
(Small Triangle)
CHAPTER 13
Ascending Wedge
CHAPTER 14
Descending Wedge
CHAPTER 15 Flags
and Channels
CHAPTER 16 H&S
Top Failure
CHAPTER 17 Double
Bottom
CHAPTER 18 Horn
Bottom
CHAPTER 19
Diamond
CHAPTER 20 Second
and Third Effort
CHAPTER 21 Support
and Resistance
CHAPTER 22 Pattern
within a Pattern
CHAPTER 23 Pattern
Failures and Mutations
CHAPTER 24 Do Not
Gamble on Earnings
Reports
CHAPTER 25 Being
Out of Position: Not
Trading No Matter How
Promising the Set-Up
and Breakout
CHAPTER 26 Taking
Profits
CHAPTER 27 Why
We Must Diversify Our
Trades
CHAPTER 28 The
Trader’s Routine:
Continuous Patience and
Diligence
CHAPTER 29 Trading
the Market Indexes, and
A Lesson in
Stubbornness
CHAPTER 30 50-day
and 200-day Simple
Moving Averages
PART III CONCLUSION
CHAPTER 31 Life
and Trading
CHAPTER 32
Suggested Reading

ABOUT THE AUTHOR

DISCLAIMER
 PART I

A FRIENDLY
INTRODUCTION
 CHAPTER 1

Our Goal

This book teaches you how to

trade stocks using classical
chart patterns and related
principles.

Clarity and usefulness

I strived to write a book that
covers the classical-charting
approach to trading in an
accessible and comprehensive
manner. This book gives
beginners enough information
to decide for themselves
whether trading in general
and classical charting in
particular fit their interest,
temperament, and style. My
goal is similar if you are an
experienced trader who wants
to learn more about classical
charting. I tried to give you
enough information so you
can decide whether to use
classical charting in your
trading.
My focus was on clarity
and thoroughness. My
experience with most books
on stock trading has been one
of frustration and confusion.
While they contained nuggets
of wisdom and some practical
advice, most books did not
describe the author’s trading
approach in enough detail for
readers to carefully try that
approach for themselves.
This shortcoming is
understandable. Writing
clearly is difficult. And I’m
certain that some readers will
wish that I had explained
some parts of this book better
or in a different way. Despite
the challenges of written
communication, I think I have
clearly conveyed enough
information for readers to
learn classical charting.
You will find that certain
themes, reminders, and
cautions are repeated quite
often throughout the book. It
would be too easy to justify
repetitive writing on
necessity, but, this time, I will
use this excuse. There are
many approaches to trading,
but there are relatively few
principles that are most
important for long-term
success as a trader. I tried to
emphasize these timeless
truths in different contexts
and situations for maximum
retention and awareness.

Trading is speculating

Before moving on, let’s make

sure we understand that stock
trading is speculating. Even
to me, an enthusiastic student
of the financial markets with
significant trading
experience, speculation at
times seems the opposite of
thrift, hard work, patience,
and all things that build
anything worthwhile.
Speculation seems nothing
more than a doomed get-rich-
quick scheme based on greed,
impatience, and laziness.
This characterization,
unfortunately, accurately
describes speculation as done
by many people. It is an
especially accurate
description of my early
trading and it will always
reflect the truth when we
deviate from good practices
and forget the fundamentals,
including controlling our
emotions and being patient.
It is obvious and true that
there is no easy road to
wealth in the stock market or
anywhere else. I don’t say
this to be condescending.
When I started to trade and
experienced some beginner’s
luck, I suspected trading
could be the easy road to
wealth. I was wrong. But I
learned that trading can be a
worthy intellectual and
financial endeavor if we
accept the fact that good
trading requires as much
discipline and resilience as
anything worth
accomplishing. If we try to
wish away this truth, we will
find that trading is a most
effective way to lose money.
Again, informed trading that
maximizes our chances of
success is built on methodical
risk management, continuous
patience, and never-ending
diligence. There is no other
way, and we should not want
it any other way.
Informed speculation
should meet the following
three requirements:

A systematic approach
that is understandable
and repeatable.
 A systematic approach
that allows a trader to be
profitable overall despite
having more losing than
winning trades.

A systematic approach
that stresses limiting
losses, not making
money, as the most
important priority.

I believe carefully
applying classical charting
principles meets these
requirements. This book
applies those principles and
where productive adds to
them with these requirements
in mind.

Classical Charting and

Technical Analysis

I use solely classical charting

as a trader because it provides
a simple yet versatile and
fascinating foundation on
which to trade stocks. A
classical chartist trades
geometric patterns such as
triangles, rectangles, wedges,
and flags formed by price
charts.
Classical charting is a
branch of technical analysis.
Technical analysis is a fancy
phrase for using the price of
stocks, or any freely-traded
financial instrument such as
bonds and futures, to make
trading and investment
decisions. Some traders use
price and many indicators,
which are themselves based
on price. I don’t use any
indicators except for the
occasional reference to
moving averages. We will
learn about moving averages
in Chapter 30.
I wrote this book to be as
clear, practical, and self-
contained as possible to
everyone who has a passing
interest in trading. Despite
this nuts-and-bolts approach,
I believe that experienced
traders can benefit from this
book. Learning is a never-
ending process. Many of the
most important truths and
insights are the most basic
and yet easy to forget.
Learning is as much about
retaining and reminding
ourselves of old truths as
learning new knowledge.
All chart patterns
discussed in this book are
applications of classical
charting principles that were
explained by Richard
Schabacker in Technical
Analysis and Stock Market
Profits, published in 1932,
and Robert D. Edwards &
John Magee, co-authors of
Technical Analysis of Stock
Trends, published in 1948.
Some readers may
disagree with my application
of classical charting
principles. That is fine. There
is room for disagreement
when interpreting chart
patterns. Classical chartists
have different trading styles
utilizing different entries,
timeframes, profit-taking
methods, and risk tolerances.
What is most important, and
what is not debatable, is
managing our risk and
limiting our losses. Whatever
our interpretation of a chart
pattern, our priority is
managing risk rather than
making money.

The charts in this book

[T]here is nothing new under

the sun.

Ecclesiastes 1:9

My impression when I read

Schabacker and Edwards &
Magee’s foundational works
on classical charting was one
of fascination but also
disbelief. Sure, those simple
and elegant price patterns
may have formed in stock
charts back in the 1930s,
1940s, 1950s, 1960s, and
maybe even the 1970s and
1980s, but surely such
geometric patterns are no
longer found in today’s ultra-
sophisticated markets? I
doubted, despite my respect
for Schabacker, Edwards, and
Magee for writing an
interesting analysis of stock
prices, whether books written
decades ago could be relevant
today.
My doubts were
reasonable but I found that
the principles explained in the
classic texts continue to be
very useful. The fact that this
book contains almost 100
unique chart patterns that
formed in the U.S. stock
market just in the past
couple of years is proof of
the continuing power of
classical charting. And I did
not include every pattern that
I found. Also, many more
tradable classical patterns
developed in every freely-
traded financial instrument,
including bonds,
commodities, precious
metals, and foreign stocks.
The financial markets have
been forming classical
patterns for a long time and
will continue to do so.
Just because a chart is
included in this book does not
mean I traded it. I traded
many of the patterns in this
book but it would have been
impractical and unwise for
me to have tried to trade all of
them.
When we look at the
charts, we must not get
impatient and decide to start
trading the next day. This
caution applies especially to
beginners. We must first
study. The market is not
going anywhere.
This book represents an
important fact that all traders
must remember but tend to
forget: there will always be
many more great trading
opportunities. It is crucial to
remind ourselves of this fact
because we will experience
losing streaks and become
frustrated. When we are
emotionally and financially
down, we are more likely to
do foolish things, such as
making large bets that place
all or most of our trading
capital at risk in a desperate
bid to make up our losses. It
is during challenging times
that it is most important to
maintain composure and
exercise strict risk
management. It will be easier
for us to maintain our
discipline and calm if we
truly believe and know that
there will be many more chart
set-ups to come.
 If, instead, we get
frustrated because we think
we have “missed all the good
trading opportunities,” then
we will try to force something
in unfavorable market
conditions. Knowing that
there will always be more
opportunities helps us
persevere through losing
streaks. And we will have
losing streaks even if we
trade only ideal setups.
Again, prices of financial
instruments have been
forming classical chart
patterns for many years, and
they will continue to do so.
Beginners may have a more
difficult time accepting this
fact because they are eager to
start trading and do not want
to miss out on any “once-in-
a-lifetime” trade setups that
will make them rich
overnight. We must realize
that we will not get rich
overnight. We must not think
about how a single trade can
make us. Instead, our goal is
to patiently and methodically
build our experience and
capital.
The more I trade, the more
I believe that surviving and
preserving my trading capital,
not making money, is my first
and only goal as a trader. If
we can hang around, then we
will always have the
opportunity to swing at very
favorable trade setups. And
they will come.
 CHAPTER 2

Trading vs. Investing

vs. Gambling
 [I]n an astonishingly large
proportion of the trading in
common stocks, those
engaged therein don’t appear
to know – in polite terms –
one part of their anatomy
from another.

Benjamin Graham

This book explains the

classical-charting approach to
trading stocks. But what is
trading?
One way to understand
trading is to discuss what it is
not. We can compare trading
to other activities such as
picking individual stocks,
using low-cost stock index
funds, and gambling in stocks
based on, say, hunches or tips
from a neighbor.
Let’s first define
investing. In my opinion, for
the vast majority of people
looking to put some of their
savings in stocks, investing
should mean buying shares in
a low-cost index mutual fund
that tracks the entire stock
market and staying invested
for at least 15 to 20 years, and
preferably 20 to 30 years and
more. If we were to stay
invested in low-cost index
funds for decades, we are
likely to do better than most
market participants, including
fancy hedge funds and other
professional asset managers.
Here is where human nature
comes in. I suspect many of
us do not like the “most”
qualifier to this otherwise
compelling proposition.
Rather than just doing better
than most people, we want to
beat almost everyone. So we
decide to look for ways to
beat the market.
Can we beat the market by
picking stocks by ourselves
or by buying shares in an
actively-managed mutual
fund run by professional
stock pickers? Individual
stock selection can be
investing, but can easily
become gambling. Why?
Because it is very difficult to
beat the market picking
individual stocks and trying
to do so often produces poor,
and even disastrous, results.
Wait a second, what about
Warren Buffett? Let’s say
that Warren Buffett’s
incredible long-term record is
indeed based on real skill and
not mostly extraordinary
luck. By the way, I don’t
think Mr. Buffett’s record is
all luck despite the fact that
I’m sure he would agree that,
as with anything in life, luck
can play a significant role.
Consider the following. Let’s
say that Warren Buffett and
100 more extraordinarily
skilled stock pickers, out of
tens of thousands, have
beaten by a meaningful
margin the stock market’s
long-run performance over 20
to 30 years or more. Nobody
could know 20 or 30 years
ago which stock pickers
would do well. Only those
investors lucky enough to
have picked and stayed with
the chosen few would beat
the market. That is, even if it
is possible to beat the market,
it is not likely we will find the
very few stock pickers who
will.
 We don’t have to believe
that it is essentially
impossible to beat the market.
I think, however, it is
important to acknowledge the
difficulty of doing so. Also, it
is good to know that low-cost
index funds are a very useful
investment tool.
Our next question may be:
if most people who want to
get into stocks should use
low-cost index funds, then
does that mean trading is
nothing more than reckless
and risky gambling?
Every form of financial
activity, from starting a
business to buying a house,
carries risk. Even if we invest
in index funds, we will lose
money if the stock market
remains depressed for years
and we are unable to stay
invested and sell after a
market decline. As with
investing, trading can easily
slide into gambling. The
difference between informed
trading and gambling lies in
the degree and manageability
of risk.
I differentiate trading from
outright gambling on the
basis of the following two
factors.
First, skilled traders know
that they are speculating. If
we trade stocks, then we are
speculating rather than
investing. Never think
otherwise. Traders know and
acknowledge the risks.
Gamblers, in contrast, are
often under the illusion that
they are engaging in a
relatively safe investment
activity when in fact they are
just praying for a miracle.
Second, skilled traders,
because they know they are
speculating, minimize their
losses on losing trades so that
they can be profitable overall
even if most of their trades
are losers. One $100 winner
makes up for many $10
losers. Uncompromising,
unsentimental, and cold-
hearted management of risk is
the trader’s top, and really the
only, priority. If we limit our
losses and keep our trading
capital intact, then we can
stay in the game. And when
we are in the game, we will
always find new opportunities
in the markets.
So trading, properly
done, is neither investing
nor gambling. The
possibility of
uncompromising risk control,
which we must implement
ourselves, and the potential
for profits is why I use a
portion of my savings to trade
the financial markets using
classical charting principles.
If I did not believe I had a
reasonable opportunity to
match and perhaps beat the
market as a classical chartist,
then I would put all of my
savings into savings accounts
and low-cost stock index
funds. If, after studying this
book, we do not think that
classical charting gives us an
intellectual framework to
trade stocks while effectively
managing risk, then we
should not become classical
chartists. We should not risk
even a small part of our
savings in a trading or any
endeavor that we do not
believe in. There is no law
that requires us to be in
stocks in any way. We don’t
even have to invest in index
funds. We don’t have to
prove anything to anyone in
the financial markets. We
should consider becoming a
classical chartist only after we
have studied the markets and
carefully considered the
potential risks and rewards.
We should take our time. The
market will always be there.
 CHAPTER 3

Emotional
Detachment and
Acknowledging Our
Limitations

Survival is the only road to

riches.
 Peter Bernstein

We are often taught, wrongly,

to avoid failure at all cost

This chapter, in my very

immodest opinion, is the most
important chapter in the book.
Discussing the distinction
between trading and investing
and gambling highlights the
most important foundation of
this book and for traders: the
utmost importance of risk
management by limiting our
losses and keeping our
trading capital intact.
If risk management is so
important, then why do so
many traders fail to manage
risk and suffer big and
sometimes irreversible
losses?
Because we are reluctant
to admit that we are wrong.
We live in a competitive
world where failure is not
celebrated. Traders think that
honoring their stops and
getting out of a trade at a
relatively small loss,
repeatedly, means they are
admitting, repeatedly, to the
world that they are life
failures. So we refuse to
honor our stops and fail to cut
our losses by exiting our
position. Instead, we stay in
until “we break even.” We
don’t want to admit failure on
a trade because we are smart
and smart people don’t lose,
especially money. Yet trading
using classical charting
principles almost guarantees
that we will have more losing
trades than winning trades.
The point is not to have more
winning trades than losing
trades. The point is to have
several $100 winners swamp
many more $10 losers.
In short, we have to be
willing to fail, and fail often.
If we think about it, we
cannot accomplish anything
worthwhile in life without
being open to failure. Let me
stress the following: I am not
saying that we have to risk
financial ruin to be a
successful trader. Quite the
contrary. As I have said and
will repeat many times
throughout the book, traders’
first and only priority is
financial survival by keeping
their trading capital intact
through even lengthy losing
streaks to be able to bet on
advantageous trade set-ups
after gaining experience. I
repeat: I do not mean
bankruptcy when I say a
trader must be willing to fail.
Successful trading is about
being wrong and losing
money on many trades and
yet being profitable overall
because the losses are only a
small fraction of our capital.

We may not reach our goal –

and that is fine

In addition to expecting to
lose on most trades, I think it
is very important for traders
to acknowledge the
possibility that we might not
make it as traders. Unless we
acknowledge the possibility
of failure, we will be so
caught up in “making it” and
getting rich as traders that it
will be impossible to trade
well. How can we trade with
a clear mind and a laser-like
focus on honoring our stops,
limiting our losses, and
acknowledging losing trades
day after day if we tell
ourselves that our life and our
self-worth depend on every
trade? That is too much
pressure for anyone.
This destructive potential
applies to everything in life.
It is impossible to succeed in
anything worth
accomplishing if we are
afraid of failing because we
will be too afraid to try or try
half-heartedly and timidly.
Don’t get me wrong.
Trying our best is a good
thing. But thinking that our
life and our self-worth
depend on succeeding as a
trader or anything else is a
different thing and harmful.
There is nothing wrong
with learning about the
markets, gaining experience
in the markets with minimal
loss in savings, and deciding
our interests lie elsewhere. If
you find the financial markets
to be as fascinating as I do,
then by all means apply
yourself diligently and with
purpose to become an
investor, trader, or whatever
kind of market participant
you wish to be. But do not let
the markets become a
destructive obsession. There
are so many more things in
life that are far more
important.

Diversify financially

So how do we avoid
becoming dangerously
obsessed with the markets?
How can we push ourselves
to follow a strict risk-
management process that gets
us out quickly from losing
trades? How can we avoid
thinking that our livelihood,
life savings, and self-worth
depend on the next trade
being profitable?
One way is to not have all
of our eggs in one basket. We
should trade with only a
portion of our savings.
Another way is to have
some income, whether a part-
time or full-time job or our
own business. Anything will
do. There is dignity in all
labor. Making money outside
of trading will increase our
chances of trading well.
Why?
First, the money we earn
will be a source of
psychological comfort and
strength. We will not be so
dependent on trading profits
to pay our bills.
Second, because our
electricity or car payment
doesn’t depend on “getting
out even,” getting lucky,
making money on the next
trade, or making money on
most of our trades, we are far
more likely to trade correctly
by doing the right things,
mainly by honoring our stops
and cutting losses as quickly
as possible.
Third, doing other things
and having other interests and
will get our mind off the
markets and that is a good
thing. Trading is a mentally
and physically demanding
activity because we must
constantly fight and control
our emotions. Traders need
regular breaks.

Diversify mentally

Ironically, not caring so much

and thus trading with
detachment is likely to make
us better traders. Experienced
and skilled traders know that
even a string of losses results
in only a small drawdown of
their capital if they strictly
limit their risk. Thus, they do
not worry about every dollar
and do not obsess over
getting out of a bad trade only
after breaking even. They
quickly cut their losses and
move onto better
opportunities. They remain
calm through winning and
losing streaks. They are not
too excited about profits nor
anguished by losses. They
focus on trading well and
cutting losses on the next
1000 trades and beyond. This
virtuous cycle is every
trader’s goal.
In short, not caring so
much about the outcome of
any individual trade is the
second crucial foundation
that complements risk
management in the trader’s
toolkit.
By all means traders
should put much effort into
studying the markets and
controlling their emotions.
We must exercise strict
discipline to trade only
compelling set-ups. But after
all the preparation, study, and
deliberation, we have to let
go. We have to say to
ourselves and believe, “I am
bigger than this trade. My life
is much more than how this
trade turns out or even
whether I succeed as a
trader.” This exercise is not
just a mental trick to make us
better traders. It is the truth.
Do we want our lives to be
defined by a series of trades,
no matter how profitable? Or
even a lifetime of successful
trading? Do we really think
we are a failure if we don’t
succeed as a trader? It would
indeed be a low bar to define
our life based on a series of
trades or whether we make it
as a trader. We have a much
better chance of succeeding
as traders if we don’t make it
our sole occupation, passion,
and interest.
I often think a 5th grader
could be a formidable
classical chartist likely to
outperform most adult
traders. The kid hunts for
well-formed chart patterns
and picks one. After entering
a trade, the mentor tells the
kid: okay, go out and play.
Explore the playground. Ride
your bike. Just go have fun
and forget about this trade.
Eat five scoops of ice cream.
Play catch or tag. Linger in
the yard as the sun sets. We’ll
come back in a couple weeks
and see what happened. If the
trade was profitable, so be it.
If the trade failed, then we’ll
move on to the next
compelling chart pattern. This
would be an excellent trading
routine.
Yes, we should devote
serious effort to studying
classical charting but we must
also live our life. The truth is
that the best books on
classical charting are not
difficult. The principles and
suggestions are logical and
straightforward. The great
difficulty is remembering and
following the rules because
our emotions will constantly
push us to bad trading
practices. We will find it
necessary to constantly
review and remind ourselves
of good trading practices
because we tend to forget so
easily and we are so very
stubborn. We are our own
worst enemy.
So I am suggesting that we
be open to the possibility that
we may not be successful
over the long run as a chart
trader. I believe this
acknowledgement increases
my chances of being a
successful trader over the
long run. By trading with just
a portion of my savings,
pursuing other opportunities
and interests, and
continuously acquiring
diverse skills and knowledge,
I am not so emotionally
caught up on the success of
my trading. And this
detachment is crucial to trade
well.
Some readers might ask if
such acknowledgement of our
limitations sets us up for
failure. There is a chance that
we will not commit seriously
to studying the markets and
trading well if we have other
plans. Wouldn’t it be better to
say there is no turning back
once we start trading? I don’t
think so. Optimism is good,
but it must be balanced with
planning and prudence,
especially in trading. All of
us will fail at many things in
life, and some of us may not
become successful traders.
Failure in trading doesn’t
make us a bad person, nor
should it mean losing our
savings. But I believe a “do-
or-die” attitude in trading
makes a large financial loss
much more likely. We should
be mature enough to tackle a
new challenge like trading
without confusing the
necessary dedication and
patience with a destructive
“my self-respect depends on
making a fortune in trading”
attitude. Mix energy and
dedication with intellectual
modesty, maturity, and
perspective. Adopting this
outlook is not preparing for
failure but wisely
acknowledging that we
cannot know everything and
that it is smart to prepare for
contingencies.

Benjamin Graham’s doubts

about fundamental investing

Let me make one more appeal

for intellectual modesty in all
our endeavors. Consider what
Benjamin Graham, a great
investor and Warren Buffett’s
teacher, said about his
profession (picking individual
stocks with the goal of
beating the broader market)
in his book The Intelligent
Investor:

[W]e must consider

the possibilities …
of making
individual [stock]
selections which
are likely to prove
more profitable
than an across the
board average.
What are the
prospects of doing
this successfully?
We would be less
than frank … if we
did not at the outset
express some grave
reservations on
this score. …
[T]here is
considerable and
impressive
 evidence … that
this is very hard to
do, even though the
qualifications of
those trying it are
of the highest.
(emphasis added)

If the founder of value

investing acknowledges the
stiff and perhaps
insurmountable challenges of
stock picking, then perhaps
classical chartists should also
consider the limitations of
charting. Graham did not say
that it was impossible to beat
the market although I think he
came very close to saying so.
He said it was very difficult
to beat the market and that
intelligent investors must not
take unintelligent risks while
trying. “Margin of safety”
was one of Graham’s
contributions to investing. By
investing in stocks with a
built-in margin of safety, and
it is not easy to find such
stocks, investors reduced the
risk of losing money but were
not guaranteed of beating the
market. Similarly, traders can
increase their odds of, but
never guarantee, long-term
success by minimizing their
losses and only making bets
on chart patterns with a
highly favorable reward-to-
risk possibility.
The point of quoting
Graham is not to say that
Graham urged stock pickers
to abandon fundamental stock
analysis and become classical
chartists. He did not. My
point is that intellectual
modesty is important. Realize
that we are wrong often and
that we do not have all the
answers. It is wise and
prudent to not stake all of our
savings on one investment or
trading approach.

Benjamin Graham on chart

trading

Genius is eternal patience.

Michelangelo

So few succeed in the market

because they want to get rich
quickly.

Jesse Livermore
What Graham did say about
technical analysis and
charting in Security Analysis,
his foundational book on
fundamental investing, is
very interesting and
informative:

Undoubtedly, there
are times when the
behavior of the
market, as revealed
on the charts,
carried a definite
and trustworthy
meaning of
particular value to
those who are
skilled in its
interpretation. If
reliance on chart
indications were
confined to those
really convincing
cases, a more
positive argument
could be made in
favor of ‘technical
study.’ But such
precise signals
seem to occur only
at wide intervals,
and in the
meantime human
impatience plus the
exigencies of the
chart reader’s
profession impel
him to draw more
frequent
conclusions from
less convincing
 data. (emphasis
added)

The point is not that

Graham embraced charting
although it is very interesting
that Graham, the father of
fundamental analysis, said
that charting can be useful.
Graham’s critique points to
one of the most important
ingredients for success in
trading, investing, and many
things in life: patience.
 As traders, we will
periodically lose focus and
discipline and make
suboptimal bets. We were too
impatient to wait for the
charts to tell a clear picture.
Then we are eager to make up
the losses by making more
bets on unfavorable set-ups.
We are afraid that if we don’t
trade these suboptimal
patterns then the market will
not offer any more trading
opportunities. We lose more
money and the destructive
cycle continues. And we are
too exhausted mentally and
financially to take advantage
of the inevitable reappearance
of favorable set-ups.
If there is only one thing
we get out of this book, that
one thing should be the
confident knowledge that
there will always, always, and
always be new trading
opportunities. Be patient. The
market is not going
anywhere. Patience gives us
the ultimate freedom to place
bets only on favorable trade
set-ups. It is accurate to
describe the trader’s
routine as not one of
constantly trading but
mostly waiting, observing,
and waiting some more and
only intermittently entering
trades. Incidentally, when on
a losing streak, closing all
positions and walking away
from the screen for a couple
of days or even weeks can be
very helpful. The market, and
new opportunities, will
always be there.
Let’s conclude. The most
important way I recognize my
limitations – that I may be
momentarily lucky, that
classical charting may be a
trading approach with deep
flaws that I don’t know about,
or that even if classical
charting is an effective
trading method I may not be
good enough to consistently
profit from it over the long
run – is that I diversify my
savings. Regardless of market
conditions, I only trade with a
portion of my savings.
Knowing that I have a
financial cushion gives me
the confidence to take
calculated risks. And
informed speculating is none
other than taking risks that
offer a potentially large gain
at the risk of a relatively
small loss.

Wrap up

Experienced traders may skip

Chapter 3 where I discuss the
most basic tools of trading.
I wrote Chapter 3 because
I wanted everyone, including
people who have never
looked at a stock chart, to feel
comfortable learning about
trading stocks using chart
patterns. While my goal was
not to write an encyclopedia
on trading, my goal was to
give the novice trader as
inviting a learning
environment as possible.
My goal is not to make all
of us classical chartists. My
goal is to do my best to help
us decide whether we might
consider trading stocks using
classical charting. If we
decide after reading this book
that trading is not for us, then
we should be proud of having
made the effort to explore a
new idea.
 CHAPTER 4

Basic Trading Tools

Simplicity is the ultimate

form of sophistication.

Leonardo da Vinci

Bar chart
Let’s start from the
beginning. What is a price
chart? The following chart of
Cray Inc. (the supercomputer
maker) is an example of a
stock’s price chart.
 This price chart records
the price history of Cray
using price bars. A price chart
that uses price bars is also
called a bar chart. While there
are other ways to visualize a
stock’s price history, I prefer
price bars and bar charts.
Let’s examine the
components of the price bar.
Look at the long price bar in
Cray’s price chart. The top of
every bar tells us the highest
price at which the stock
traded that day and the
bottom of the bar tells us the
lowest traded price of the
day. The short horizontal
hypen-like line sticking out
on the left of the price bar
tells us the price at which the
stock opened for trading that
day. And the short line
sticking out on the right side
of the price bar tells us the
closing price for the day.
Timeframes

I use daily, weekly, and

monthly price charts in my
trading. I use weekly and
monthly charts to get a big-
picture view of a stock’s price
history while I use daily
charts to make entry and exit
decisions. On weekly and
monthly charts, each price bar
represents a week’s and
month’s worth of trading,
respectively.
 I almost never look at
timeframes shorter than a
day. I don’t look at 1-minute
or 15-minute charts. I
occasionally look at 1-hour
charts.
I do not intentionally day
trade although sometimes a
position I entered in the
morning may be stopped out
by the end of the day and this
same-day round-trip is a day
trade.
Charting programs

Let’s talk about online

charting programs. Charting
programs display
continuously updated price
charts of stocks and other
financial instruments. I use
TC2000’s charting service
because I have found it easy
to use with good customer
support. You may choose to
use another charting package
as there are several good ones
available. Be sure to try
different services and choose
the one that you feel most
comfortable with. I like
simplicity, and I have found
TC2000 allows me to keep
things as simple as possible.
On the right side of my main
monitor is my list of stocks
that I scroll through while the
rest of the screen displays the
price chart. I use a horizontal
strip at the bottom of my
screen to view volume bars.
That’s it. I also have
convenient tab buttons that I
can click to switch between
daily, weekly, and monthly
charts.
Again, experiment and
choose a charting service that
makes things easy for you.
Understand that classical
charting does not require us
to install 20 screens showing
dozens of indicators.
Successful chart trading does
not require fancy chart
programs and expensive
equipment.
The most important battle
will not be on the screen but
in our minds.

Online brokers

I use two discount online

brokers. I have my trading
capital split into two accounts
as a form of diversification.
Not having all of my funds in
one location acts as a brake
during bouts of greed and fear
and helps prevent rash
decisions. There are several
good discount online brokers.
As with charting programs,
we should try several of them
and then choose. We may
simply choose the broker
with the lowest commissions.
That is perfectly fine. We do
not need fancy brokers with
high commissions to trade
well.
Online brokers are in a
fierce competition to earn our
business. After we have
traded with a brokerage for a
while, we can call customer
service and ask for a discount
on the commission rate. Even
if a brokerage advertises its
commission as, say, $9 a
trade, it will be open to
offering us a lower
commission to keep our
business. One of my brokers
reduced my commission by
30%.
 Our charting program and
broker should always play a
mere secondary role in our
trading. No amount of high-
end customer service or the
most sophisticated charting
features will guarantee
profits. How well we control
our emotions and apply good
trading practices will
determine our long-term
success. Keep it simple and
be patient.
We’re ready

Now we know how to read

the price chart of a stock that
is displayed on our charting
program. And we are ready to
spot patterns on a stock chart.
At first we may see patterns
where none exist. We will
force meaning onto a chart
for the sake of finding a
pattern. We might even think
that all good patterns are gone
and that we will have to force
it to make money. We will
always be wrong if we think
that good patterns will stop
forming. We need to be
patient.
Spotting classical chart
patterns does not guarantee
profits. Just because we find a
textbook chart pattern doesn’t
guarantee that we will
successfully manage our
emotions to properly enter
and manage the trade. Also,
the “perfect” chart pattern
may fail to break out or fail
after breaking out and
transform into something
entirely different. The only
thing we can do is to enter
compelling set-ups with
advantageous reward-to-risk
possibilities and, as we
discussed in Chapter 3, let go.
Let’s begin.
 PART II

CLASSICAL
CHART
PATTERNS
 CHAPTER 5

Head & Shoulders

Top

The first classical pattern

we’ll look at is the Head &
Shoulders top pattern. A H&S
top can form after a
significant uptrend and
indicates a possible trend
reversal that leads to a price
decline.

Boeing: 2-year H&S top

The following weekly chart,

where each price bar
represents a week’s price
range, shows a massive
textbook H&S top that
formed in Boeing from May
2006 to June 2008 with a
decisive breakdown that
penetrated the neckline in late
June 2008:

FIGURE 1
 A valid H&S top pattern
must have 3 peaks with the
middle peak, the head, rising
above the shoulder peaks and
the two shoulders must have
some overlap in price, and the
more overlap the better. The
pattern should form after a
significant rise in price. That
is, a reversal pattern must
have something to reverse. A
H&S top’s neckline connects
the bottom of the left
shoulder to the bottom of the
head. A H&S top is
completed when prices
decisively close below the
neckline after forming the
right shoulder.
Beyond these essential
features, there are many
variations to the H&S top. As
we gain experience looking at
charts, we will learn to focus
our attention on well-formed
patterns and ignore the rest.
Every chart offers
important lessons. Some of
the takeaways from Boeing’s
H&S top are:
First, we, especially
beginners, should strive to
trade only chart patterns that
are as well formed as this
H&S top. Of course just
because a pattern is textbook-
perfect doesn’t mean the
pattern will work and be
profitable. In fact, even
“perfect”-looking patterns
will fail most of the time. The
point is that we should not
force meaning onto charts
where there is none. We must
not project our hopes,
dreams, and wishes onto
charts. Classical chart
patterns that are potential
candidates for trading should
be clearly defined and easy to
spot. There was no doubt
when looking at Figure 1 that
Boeing was forming a
possible H&S top pattern.
Second, a weekly chart is
a valuable way to see the big
picture. Though I make
almost all entry and exit
decisions based on a stock’s
daily chart, I always check
the weekly chart to get a
sense of the overall context in
which a pattern is forming.
This massive H&S top in
Boeing was so big that a
trader would have likely
missed this topping pattern if
looking only at a daily chart.
It would have been a case of
losing sight of the forest for
the trees. And while such big
patterns are not very
common, they are common
enough to justify the regular
review of weekly charts.
Third, and this point will
be stressed many times, we
must be patient. Many
patterns take months and
sometimes, like Boeing’s
H&S top, years to develop.
While there are many shorter
patterns ranging from days to
several weeks discussed in
this book, know that
significant reversals of trend
take time to develop. Also
note how prices entered a
narrow trading range for three
months after breaking down
through the neckline. Three
months is a long time to be
staring at our screen everyday
waiting for the big move
down. The smart trader would
enter the trade, set a stop, and
go do other things. Of course
Boeing’s stock could have
moved up and triggered our
stop-loss order. If so, so be it.
We incurred a small loss and
would move on to other set-
ups.

Apple: 5-week H&S top

Our next H&S top is a 5-

week pattern that formed in
Apple from September to
October of 2012. This H&S
top was small in size but not
in effect as it started a 40%
price decline in Apple shares:

FIGURE 2
 What can we learn from
this pattern?
First, every principle has
exceptions. While major
reversal patterns can take
months or years to develop,
they can also form quickly as
it did in Apple. Thus, we
must never place a bet
without regard to risk relying
on a rule that is “supposed to
work.” There is no such
thing. Price is the ultimate
rule.
Second, we should never
ignore H&S patterns,
including small ones. H&S
patterns are one of the most
reliable classical patterns.
They are also one of the most
versatile patterns because if a
H&S top doesn’t work, a
“H&S top failure” is a
distinct pattern that can offer
compelling trading
opportunities. We’ll cover
H&S failure patterns in
Chapter 16.
Third, notice that prices
broke down through the
neckline of the H&S top and
the 1-year trendline at the
same time. Such interesting
coincidences are common in
classical charting. The fact
that these two developments
coincided did not guarantee
that the pattern would work.
But, at least in my mind,
these twin developments
increased the likelihood of a
powerful trend reversal.
Fourth, note the hard retest
of the neckline. Retests are
price reversals after
breakout that re-challenge
the breakout boundary.
Here, after breaking down
through the neckline of the
H&S top, prices reversed and
closed slightly above the
neckline before breaking
down in a sustained
downtrend. Some retests lead
to pattern failure while others
stop at or short of the
breakout boundary. All
retests challenge our poise.
We cannot know if or when
retests will occur. We must
be ready for them.
After we view some more
charts to get a feel for
classical chart patterns, we
will discuss in depth how we
can enter trades and set stop-
loss orders. There is no rule
that works ideally every time.
For now, know that retests of
key pattern boundaries
happen often and that the
only thing we can control is
our entry and stop points.
Lastly, let’s discuss short
sales of stocks. Shorting
allows a trader to profit from
price declines in stocks. Since
there are both bullish
(pointing to a possible
increase in price) and bearish
(pointing to a possible decline
in price) classical chart
patterns, buying and shorting
stocks allows us to use the
full range of classical
charting tools.
That said, I understand
some of us may be
apprehensive about shorting a
stock, especially if we have
never done so. I was
unfamiliar with the concept
of shorting when I started to
trade. Some of us may have
ethical objections to shorting.
We don’t have to short
stocks, but we should make
our decision after learning
about shorting, and, if we are
open to it, trying some very
small short sales to gain
familiarity. We should decide
based on knowledge rather
than fear. And if we decide to
add shorting to our trading
kit, we can always trade a
smaller size when shorting as
I usually do.

ICA: 11-week H&S top

As noted, there are many
variations to each classical
pattern. The following H&S
top in ICA, a Mexican
construction company, shows
one of my favorite variations
in a H&S top:

FIGURE 3
 First, note the head of this
4-month H&S top was itself a
smaller H&S top pattern. I
find this pattern-within-a-
pattern very interesting just as
a visual phenomenon. It can
also have great practical value
as it can offer us the
opportunity to enter a trade
earlier than otherwise. For
example, here, we might
consider shorting shares upon
the completion of the smaller
H&S top pattern, then
perhaps shorting additional
shares upon completion of the
larger H&S top. Every
situation will be different, and
just because we have a
pattern-within-a-pattern does
not mean we will have an
early, or any, entry
opportunity. And we must
remember that even the most
promising textbook patterns
fail, and fail often.
Second, note the down-
sloping neckline. Necklines
and key boundaries need not
be perfectly horizontal. They
can be up-sloping or down-
sloping. I prefer to trade
patterns with boundaries that
are as horizontal as possible
because they clearly indicate
the major highs and lows that
must be overcome for a
decisive breakout. We will
talk more about the merits of
horizontal vs. slanting pattern
boundaries in later chapters.
 Third, despite there being
many legitimate and
compelling variations to the
textbook H&S pattern, we
should try, especially as
beginners, to stick as much as
possible to trading patterns
that resemble the textbook
form. Too often traders label
a chart as a H&S top even
though none of the basic
requirements of the pattern
are met. Traders who appear
in the media are not immune
from making this error. I
think it is beneficial to follow
the principles spelled out by
Schabacker and Edwards &
Magee, especially regarding
pattern shape. I do not follow
everything that the founders
of classical charting say in
their books, but I do follow
their physical requirements
for the classical patterns.

LifeLock, Inc.: 2-month H&S

top
The next H&S top is a chance
to apply what we learned
from Apple’s H&S top. We
see LifeLock breaking down
from a H&S top, and this
breakdown coincided with the
breaking of a yearlong
uptrend line:

FIGURE 4
 The next chart zooms in
on the H&S top and breakout
area:

FIGURE 4.1
 Let’s talk about how much
we might risk on a trade. It
seems most professional
traders risk no more than 1%
of their trading account on a
single trade. I think most
traders and especially
beginners should not risk
more than 0.4% to 0.8% of
their account on a trade.
While our risk tolerance and
trading capital will vary, we
must pursue risk management
and the limitation of losses as
our most important goals. For
example, if our trading
account is $50,000, we
should risk no more than
$200 (0.4% of $50,000) to
$400 (0.8% of $50,000) on
any individual trade. These
are general guidelines and I
think the more cautious we
are, the better.
Let’s use the next chart
that shows a H&S top that
formed in QQQ, the ETF that
tracks the Nasdaq 100 index,
to see what these risk
guidelines mean in terms of
the nuts and bolts of entering
and exiting a trade.
Classical patterns form in
the major stock indexes and
the ETFs that track them just
as in individual stocks. I
always watch closely the
index ETFs – SPY for S&P
500, QQQ for Nasdaq 100,
DIA for Dow Jones Industrial
Average, and IWM for the
Russell 2000 index – to get a
sense of the overall market.
While I trade mostly
individual stocks, I also know
that most stocks move with
the overall market. So if the
market indexes are dropping
sharply, then I will be more
cautious about trading bullish
set-ups.

QQQ: 6-week H&S top

The following chart shows a

H&S top that formed in
QQQ, the ETF that tracks the
Nasdaq 100 index, from
August to October 2012:

FIGURE 5
 If we have a $30,000
trading account and we don’t
want to risk more than 0.7%
of our account on any single
trade, then we have $210
(0.7% of $30,000) to risk on
this H&S top. Let’s say that
we decide to short shares at
the breakout day’s closing
price of 67.26. Where might
we place our buy-to-cover
stop order that will cut our
losses should the breakout
reverse and the pattern fail? I
use the last day rule, a
concept I learned from Peter
L. Brandt, to place most of
my stops. How does it work?
For short trades, we place our
stop just above the high of the
last day in which prices
traded above the breakout
boundary. For long trades, we
place our stop just below the
low of the last day in which
prices traded below the
breakout boundary.
 Here, following the last
day rule would mean placing
a stop just above 68.18, say,
at 68.20 or so. Some of us
may prefer to give more
cushion to our stops. If we
do, then we must keep our
potential loss within our
maximum risk tolerance.
Note that a buy-to-cover stop
order at 68.20 is very close to
and barely above the neckline
of the H&S top. A stop at
68.20 seems at risk of getting
triggered by mere normal
price volatility in QQQ.
Indeed, QQQ experienced a
hard retest after breaking
down through the neckline.
While prices did not close
above the neckline, they did
trade above it by trading as
high as 68.30. Placing a stop
at 68.20 or even 68.25 meant
we got stopped out.
By the way, there is
absolutely nothing wrong
with getting stopped out.
Remember, classical chartists
can have more losing trades
than winning trades and still
be profitable overall. Risk
management, not profits, is
our priority. So getting
stopped out for a very modest
loss means we are managing
risk.
As we noted, every rule
has exceptions. While I
faithfully apply the last day
rule in most of my trades, the
particularities of this H&S
top meant we had to consider
placing our place a stop a bit
farther away from the
neckline to account for
normal price volatility,
including a possible retest. So
we modify the last day rule.
Here, I would look at the
price range on the day before
the breakout. The closing
price on the day before the
breakout was 68.35. Placing a
stop just above this closing
price, say, at about 68.37 or
68.40, is a reasonable choice.
If we want even more leeway,
then we may choose to place
a stop just above the high of
the day before the breakout.
Remember that the more
leeway we give a trade, the
more likely we have to use a
smaller position to keep our
possible loss under our
maximum-risk limit.
Every chart presents
different entry and exit
scenarios. Still, I have found
in my trading that the last day
rule usually works very well
by placing my stop at a
reasonable distance from the
breakout boundary and from
normal volatility and from
even the reach of hard retests.
When the last day rule does
not produce a satisfactory
stop point, I improvise. How I
improvise is far less
important than that I keep my
possible maximum loss
within my risk tolerance.
Sometimes we’ll just have to
pick a spot. Nothing can
protect us from prices just
barely triggering our stop and
then reversing and making a
powerful run. We must not let
such events frustrate us too
much. Such hit and runs will
happen to everyone no matter
what rule we use to place our
stops. There is nothing
magical about the last day
rule. It is simply a trading
tool to manage risk. Some
trades work out and others
will not. We must accept this
reality. Such ever-present
uncertainty is the price we
pay to limit our losses and
stay in the game long enough
until we gain enough
experience to take advantage
of great market conditions.
Remember, there will always
be other trades.
Let’s go back to the QQQ
set-up. Let’s say we decide to
place our stop at 68.37, just
above the closing price of the
day before breakout. We
shorted shares at 67.26 and
placed our stop at 68.37. That
means we are risking $1.11
for every share of QQQ that
we short. If we have a
$30,000 account and we want
to risk no more than 0.7% on
any single trade, then we
have $210 to risk for this
trade. Divide $210 by $1.11,
the distance in dollars from
67.26 to 68.37, and we get
189.1. So we can short 189
shares and likely limit our
potential loss to $210 at our
chosen entry (where we
shorted) and exit (where we
may buy to cover) spots. I
always like to stay under my
maximum risk, so I would
short only about 180 shares.
Of course, we may choose to
further reduce our position
size. A 180-share short
position is the maximum size
given our risk parameters.
 There are several more
points to discuss.
First, trading commissions
will be another cost. If our
broker charges us, say, $8 per
trade, that means our round
trip trading cost will be $16.
Commissions add up. They
are another reason why we
should trade only compelling
set-ups.
Second, we may lose more
than we had planned if a
stock gaps up or down. A
gap up happens if, after we
shorted 180 shares of QQQ at
the closing price of 67.26 and
placed a buy-to-cover stop at
68.37, the next day QQQ
starts to trade at, say, 69.50.
This overnight price jump up
that produced a gap between
today’s and yesterday’s price
bars is called a gap up. An
overnight jump down in price
is a gap down. The result is
that instead of losing only
$1.11 a share, we would be
stopped out with a loss of
$2.24 for every share we
shorted for a total loss of
$403.20 plus trading
commission. We lost almost
twice as much as we were
willing to risk on this trade.
This scenario doesn’t happen
often but it is common
enough that we must always
be mindful of it and is one
more reason why we must
always diversify our trades
and never bet our entire stake
on one or even a series of
trades. It is perfectly
acceptable and expected to
lose more than we had
planned on some of our
trades. What is important is
that such greater-than-
expected losses, which are
unavoidable at times for
everyone, mean nothing more
than minor additional losses.
Third, we might have
noticed that I did not include
the volume bars for the charts
we have analyzed so far. I
have included volume bars in
later charts where I thought
volume was one of the
decisive factors in making a
trading decision. But I
personally have found that
volume is often not a decisive
factor in many of my trades.
Edwards & Magee stress the
importance of volume. And
volume is often a vital clue,
especially in situations when
the volume conforms to the
textbook descriptions laid out
by Edwards & Magee. But I
have found that textbook
classical patterns form and
work a lot of times without
volume confirmation. So,
volume, while important, is
only one factor in my
decision-making and the lack
of volume confirmation
doesn’t disqualify a pattern to
me. In short, volume is like
any other factor in trading
and classical charting: it is
not a guarantee that “must”
and “should” work. Prices
will do whatever they want to
do. Risk management is the
only thing we can control.
However, volume is
always a crucial factor in
thinly-traded or low-volume
stocks. Thin stocks tend to be
more volatile and more risky.
I often pass on a promising
pattern developing in a low-
volume stock because the
extreme volatility makes
entering and exiting a trade
within my risk parameters so
difficult. The lure of thin
stocks is that powerful moves
happen quickly and thus we
may make a lot of money
quickly. But I have found that
it is much easier to lose a lot
of money quickly with thin
stocks. So I usually stay away
from them.
Fourth, where might we
take profits if the trade is
successful? So far, we have
concentrated, properly, on
placing our stop orders so that
we limit our losses if the
trade fails. While risk
management is our first goal,
we trade to make money, and
taking profits is an important
skill. Classical charting
provides a general guideline
for taking profits in the form
of the size of the pattern that
launches the up or down
move. The height of a
classical pattern’s widest
point is used to project or
“measure” the possible up or
down move from the
breakout point. So, in the
H&S top pattern in QQQ, we
measure the distance from the
top of the head to the
neckline and project that
distance down from the
breakout point. This
measurement is the minimum
move that could happen.
But, again, as with all
“rules” in classical charting,
these profit-projections are
general guidelines. As I have
repeated and will repeat many
more times, the only thing
traders can control is risk
management. Patterns, even
after decisive breakouts, fail
often. When prices, after a
decisive breakdown from a
textbook H&S top pattern,
reverse and go straight up, we
must take our small loss
according to our pre-
determined stop-loss level
and get out of the trade. We
must not stay in the trade and
refuse to take our now
rapidly-growing losses
because “the measurement
rule guarantees that prices
will soon go in the right
direction (down) again and
produce the projected profit.”
Wrong. The only guarantee in
the financial markets is that
risk, indeed catastrophic risk,
is everywhere. Traders work
with this harsh reality, but
traders can do so on their
terms by always diversifying
their trades, always honoring
their pre-determined stops,
and getting out with a small
loss if the trade doesn’t work
out.
We said that the general
rule is that the projected
move is the minimum move
that could happen. Look
again at the small H&S top
that produced a massive 40%
decline in the price of Apple
shares. The takeaways from
Apple’s H&S top are that we
should never ignore a H&S
top pattern whatever its size
and that there is no correct
answer as to when to take
profits. There was no way to
know that this small H&S top
would lead to a 40% decline.
If we took profits after a 20%
decline and happily looked
elsewhere for other trade set-
ups, then we should not be
angry or embarrassed about
the stock continuing to drop.
Even here we must remember
that there will always be more
opportunities.
 CHAPTER 6

Head & Shoulders

Bottom

The head and shoulders

bottom pattern is just that: a
H&S top pattern turned
upside down.

Caesars Entertainment: 5-
month H&S bottom

Here is our first H&S bottom

pattern:

FIGURE 6
 The H&S bottom has three
valleys with the middle
valley, the head, deepest.
Note how this H&S bottom’s
right shoulder took the form
of an ascending triangle. We
will discuss ascending
triangles in Chapter 9. So we
have another pattern-within-
a-pattern and a decisive
breakout from the ascending
triangle coincided with the
breakout from the H&S
bottom. As we will see here
and in other charts, the more
powerful the breakout, the
more difficult it can be, and
sometimes too risky, to
enter the trade. The next
chart focuses on the breakout
from the right shoulder:

FIGURE 6.1
 Caesars Entertainment’s
stock jumped 11.5% on the
breakout day. Buying shares
at around the closing price of
the breakout day and placing
our stop just below the low
meant risking over 11% of
our position. That is a lot to
risk and I would avoid trading
such a set-up unless the
pattern was very promising
and the breakout decisive. As
this H&S bottom had good
form and produced a decisive
breakout, I would look to
trade this breakout if I can
buy a reasonably-sized
position while staying within
my risk limit.
If our trading account is
$50,000 and we don’t want to
risk more than 1% of our
account on any single trade,
that means we have $500 to
risk on this trade. Entering at
8.71 and placing a stop at
7.80 means risking $0.91 on
every share of CZR stock we
buy. We divide $500 by
$0.91 and get 549. So, we can
buy around 540 shares for
$4703 and stay under our
maximum risk barring any
gap downs in price. (I usually
round down to account for
commissions and to get an
even number.) I think this
entry and stop-loss placement
constitutes a prudent and
promising trade given the
pattern and breakout.
 There are alternative entry
and exit strategies.
One option is to buy a
larger position at the closing
price of 8.71. Assuming the
same $50,000 account, how
do we risk no more than 1%
of our account on this trade?
We move our stop up and
place it closer to the
horizontal upper boundary of
the ascending triangle. If we
raise our stop to, say, $8.08,
rather than putting it at $7.80,
then we can buy 790 shares
for $6880 and stay within our
$500 maximum risk. I did not
use a magic formula to pick
8.08 as an alternative stop
placement. I picked 8.08
because it seemed reasonably
far below the upper boundary
of the ascending triangle to
not get triggered too easily by
normal volatility. That said, a
hard retest or even just
normal volatility has a much
higher chance of triggering a
stop at 8.08 than at 7.80. If
our higher stop survives, then
we make more because we
have a larger position. But if
prices trigger our stop and
then turn around and shoot
up, then we lose $500 and
miss a 60% surge in two
days. We took a calculated
risk and lost. But we traded
the set-up well. We took a
good swing at a compelling
set-up while staying within
our risk parameter. We
suffered a minor loss and we
move on to the next
promising pattern. We cannot
control prices. We can only
control how we manage risk.
There is a second option.
We can place a buy-stop
order in anticipation of a
breakout from the right
shoulder. So far we have
discussed stop orders in the
context of getting out of a
trade if the trade doesn’t
work. Stop orders can be also
be used to enter trades. In the
H&S tops discussed above,
we could have placed a stop
order to sell short a chosen
number of shares at a level
somewhere below the
necklines. Such an order
would be filled by our
brokers if prices traded at that
level.
For Caesars
Entertainment’s H&S bottom,
we can place a stop order to
buy a certain number of
shares at a price somewhere
above the upper boundary of
the ascending triangle right
shoulder:

FIGURE 6.2
 Let’s say we choose to
place a buy-stop order at
8.30, which is above the
horizontal boundary of the
right-shoulder ascending
triangle and just below the
slightly ascending neckline of
the larger H&S bottom. If
prices trigger our buy-stop
order at 8.30 and continue to
go up to break out of the
H&S bottom, then we have
the advantage of having
entered earlier at a lower
price. Entering earlier means
that we can buy a larger
position and still place our
stop below the low of the
breakout day. If we have a
$50,000 account and
faithfully follow the
maximum 1% loss per trade
rule, we have $500 to risk on
this trade. Entering the trade
at 8.30 and placing our stop at
7.80 means I can risk $0.50
per share. We divide $500 by
$.50 and get 1000. We can
buy 1000 shares, which is a
25% larger position than
buying at 8.71 and using a
higher stop, for $8300 plus
commissions and yet give our
position much more cushion
to survive normal volatility
and even hard retests. We
also have the potential to earn
significantly more profits
should the trade work.
Important point: whenever
I use a stop order to enter a
trade, I always use it as part
of a One Triggers Another
(OTA) order. For example,
the night before what may be
the breakout day for Caesars
Entertainment’s H&S bottom,
I enter a stop order to buy
1000 shares at 8.30 that,
when triggered, enters
another order, a stop-loss
order that will trigger if the
breakout fails and prices
decline to my pre-determined
stop level. Every trade must
have an exit order, a sell stop
for a long position and a buy-
to-cover stop for a short
trade.

Drawbacks to using stop

orders to enter trades

As with any trading tool, buy-

stop and short-sell-stop orders
do not always work well.
Here are some of their
drawbacks.
First, our buy-stop order
could be triggered by a false
breakout or an out-of-line
price move. These are price
moves that spend only part of
the day outside the pattern
boundary and then retreat
back inside the boundary by
the end of the trading day.
These retreats can also trigger
our stops. Again, there is
nothing wrong with being
stopped out for a small loss.
As we know, we must be
ready to take many small
losses. But losses can add up,
and more importantly, they
can exhaust us mentally. And
preserving our mental
capital is just as important
as safeguarding our trading
account. Every trade is a
calculated leap of faith. While
we can keep risk at
manageable levels by always
diversifying our trades and
following other prudent rules,
we still need confidence to
take swings at set-ups. If we
lose our nerve, then we
cannot trade well.
Repeatedly getting stopped
out by false breakouts will
weaken our trading psyche.
So when the real breakout
happens, we feel too spent
financially and
psychologically to make an
appropriate bet. We have lost
our nerve. And the inability
to take calculated risks can be
just as frustrating as a string
of losses.
 Thus, there are advantages
to waiting towards the end of
the trading day to see if prices
will close decisively above
the pattern boundary and then
manually entering a trade.
The closing price is the most
important price because it
indicates where many traders
felt comfortable holding their
positions over night. My
experience has been that most
trades, including many of the
best set-ups, gave me plenty
of time to enter manually
toward the end of the
breakout day. Looking at the
charts above, we did not have
to use stop orders to short the
H&S top patterns in Apple,
LifeLock, and QQQ. We
could have entered around the
closing price towards the end
of the breakout day.
Of course, there will be
set-ups when not using a stop
order to buy or short will
mean missing the trade
because it would be too late
and too risky to enter after
prices have broken out and
travelled far away from the
boundary. But that’s trading.
We catch some, and we miss
some. If we miss a breakout
from a pattern that we’ve
been watching for weeks,
months, or even years, we
have to remember that there
will always be more and
better opportunities. So when,
not if, we miss a trade, we
must quickly move on.
The second potential
drawback to entering a trade
using a stop order is our old
enemy: gap ups and gap
downs. Actually, we can
think of gap ups and downs
as valuable friends because
the ever-present possibility of
price gaps forces us to never
risk too much on any trade.
As we will see, devastating
price gaps of 40% and 50%,
while rare, do occur. Such a
huge loss on a position that
represents 8% or 10% of our
trading account will sting but
overall is still a very
manageable setback. But a
50% loss on a position that
represents our entire account
is far, far worse and
something that we must avoid
through prudent
diversification and risk
management.
Coming back to Caesars
Entertainment, let’s say that
the stock price had opened at
9.50 on the breakout day after
an overnight gap up and then
immediately reversed and
dropped straight down back
into the pattern and triggered
our stop. (In real life the stock
opened at 7.85 and closed at
8.71 on the breakout day.) If
we had a buy-stop order for
1000 shares at 8.30, then we
would find that this buy-stop
order, which is a market order
that triggers at the current
trade price, was filled once
prices were at or above 8.30.
Since the stock, after the
overnight gap up, started to
trade at 9.50, our buy-stop
order was filled at 9.50. We
paid $1.20 more than we had
planned for each of our 1000
shares. And when our stop
was triggered at 7.80, our
losses were $1.70 per share
compared to the $0.50 per
share that we had allotted for
this trade.
 The result is that we lost
$1,700 on this trade. If we
have a $50,000 account, a
$1,700 loss represents a 3.4%
loss of capital. Such a loss
stings, but it need not be
anything more than that. Our
trading account is still
essentially intact and we
simply move on.
We cannot predict
overnight price gaps, but we
can still mitigate their
potential damage. One way is
to only rarely use stop orders
to buy or short. Another way
is to use a smaller position
size when using a stop order
to potentially enter a trade.
We can always add to our
position if circumstances
permit.
If we feel that a potential
breakout from an explosive
pattern seems “catchable”
only through a stop order to
buy or short but we prefer to
enter a trade manually, then
we can simply not trade. It
takes much wisdom, patience,
and strength to pass on a
trade. It will be easier to pass
on a trade if we remember
that there will always be more
opportunities.
A couple of other
takeaways from this H&S
bottom in Caesars
Entertainment.
First, always look for
patterns within larger
patterns. The smaller pattern
can give us an early entry
point and also help us identify
and make sense of the larger
pattern.
Second, most patterns take
time to develop. This H&S
bottom took five months to
form.
Third, breakouts can move
very fast. So fast, in fact, that
we may miss it or we may
decide to not trade it. Our
task is not to trade every
breakout. Our task is doing
the right thing, and that can
mean not trading a breakout.

Callidus Software: 10-month

H&S bottom

This H&S bottom’s right

shoulder was a rectangle
pattern:

FIGURE 7
 The next chart focuses on
the breakout from the right
shoulder:

FIGURE 7.1
 Let’s again assume that
we have a $50,000 trading
account and we don’t want to
risk more than 1% ($500) of
our total capital on any single
trade. Entering at the high
(5.20) of the breakout day
and placing our stop just
below the low, say, at 4.84,
means we risk $0.36 a share,
which still allows us to buy
almost 1390 shares ($500
divided $0.36) for about
$7,200. Such an entry and
exit gave us the possibility
but never a guarantee to profit
significantly from a continued
breakout from a promising
pattern while placing our stop
reasonably far away from the
upper boundary of the right-
shoulder rectangle to survive
retests and significant
volatility.
If the breakout in Callidus
Software reversed and we
were stopped out, this losing
trade cost us about $500 from
our $7,220 position. That’s a
6.9% loss on our position but
a 1% loss of our trading
account. Most traders,
especially beginners, would
be wise to keep our maximum
possible loss on any
individual trade under 1% of
our total account. As noted, it
seems most professional
traders stay under the 1%
figure. If I were starting out
again, I would try to keep my
loss on any single trade to
under 0.5% of my account.
We will lose the most money
when we lack experience in
the markets. We need time to
learn, and we might as well
lose less money when we are
at our worst.

Quarterly earnings reports

All publicly-traded
companies report their
financial results every three
months. We must watch for
upcoming earnings reports. It
is entirely unpredictable how
investors and traders react to
earnings reports. A “good”
earnings report can be seen as
bad if there wasn’t enough
good news. A “bad” earnings
report can be seen as good if
there was less bad news than
expected. Moreover, stock
prices can crash even after an
objectively good earnings
report for any or no reason.
There is no way to predict the
market’s reaction to earnings
releases. Thus, we should not
enter a position just before an
earnings release nor hold a
position through an earnings
report.
Even if it seems prices are
about to break out of a
promising pattern, I stand
aside and wait if an earnings
report is to be released soon.
It can be frustrating to not
trade a promising breakout
because of an imminent
earnings release. But we must
stand aside because the utter
unpredictability of the
market’s reaction to earnings
means that we have no way to
manage risk. Here, again, it
helps to remember that there
will always be other patterns
to trade.
Here, the market reacted
favorably to Callidus
Software’s earnings report.
The stock jumped the day
after earnings were released.
It was not until the next day
prices went up again and
broke through the upper
boundary of the rectangle
right shoulder and decisively
closed above it. The timing of
the earnings release and the
market’s reaction to it were
favorable. The market’s
reaction was not so positive
as to cause an explosive
breakout that made entering
the trade too risky. Prices
increased strongly but still in
a controlled pace that gave
traders plenty of time to buy
shares at prices that offered a
favorable reward-to-risk
possibility. Also, we could
have more confidence in the
breakout because the
uncertainty surrounding the
earnings release was out of
the way. Note also that the
volume on the breakout day
was heavier than in previous
days. Such volume
confirmation makes it more
likely, but never guarantees,
that the breakout is
significant.
There are no guarantees in
trading except that we will
lose a lot of money if we do
not respect risk. One factor
that increased the risk on this
trade was that Callidus
Software is a relatively low-
volume stock. I consider
stocks whose daily volume
is often under 100,000
shares to be thinly traded.
And I usually avoid stocks
whose daily volume is often
under 50,000 shares as they
can be even more volatile.
We can refer to a stock’s Beta
to get a sense of the stock’s
volatility but I rely mostly on
what I see on the chart:
CALD shares often had wide
daily trading ranges. For
example, the stock jumped
7.6%, 8.8%, 5.5%, and 3.9%
in the days around the
earnings report and breakout.
Isn’t that good for the trader
who owns this stock? We
must remember that what
goes up quickly can come
down even faster. There was
no guarantee that the
breakout from this H&S
bottom would work even
after prices closed decisively
above the upper boundary of
the right-shoulder rectangle.
The market could have
changed its initial positive
reaction to the earnings report
and pushed down prices
anytime after breakout. And
relatively low-volume stocks
can crash very quickly. Given
this risk in low-volume stocks
like CALD, a fine idea is to
trade a smaller size here. We
don’t have to risk our
maximum on every trade.
Maybe we decide to risk only
0.5% or even less. Or perhaps
we decide to skip this trade.
That is perfectly acceptable as
well. We always have a
choice. Nobody forces us to
trade. We need to evaluate
every breakout with one
overriding question in mind:
do we have a favorable entry
spot that limits risk?
As we’ve repeated many
times already and as we will
and must hear many more
times: our number one task as
traders is to manage risk and
not to make money. Put
another way: concentrate on
doing the right thing rather
than making money. When
we manage risk in a
systematic way, we will be
able to trade for the long run.
The financial markets are
always unpredictable, and
quarterly earnings reports add
another layer of risk and
volatility. We can avoid the
market’s unpredictable
reaction to earnings reports
by simply not trading through
earning releases. And risk and
unpredictability are
compounded in low-volume
stocks.

Hewlett-Packard: 10-week
H&S bottom

The next chart shows

quarterly earnings reports
producing very volatile price
moves in Hewlett-Packard
shares:

FIGURE 8
 I know what many of us
are thinking because I had the
same thought: those 12% and
17% one-day price jumps
seem too good to pass up so
I’ll just hold my position
through earnings releases and
hope that the market reacts
positively to the earnings
news. But these price
increases could just as easily
have been comparable or
worse price drops. Indeed,
Hewlett-Packard’s stock
declined by more than 12%
on the third earnings report
shown on the chart.
Recall our discussion
about the distinction between
informed trading and outright
gambling. Informed trading is
about entering at a spot on the
chart that maximizes potential
gains while defining and
limiting risk. Yes, we expect
to have more losing trades
than winning trades. Yes,
price gaps, up or down,
unrelated to earnings news
mean sometimes we lose
more than we had planned.
Yes, all financial activities
involve risk. But we must not
think that just because the
financial markets are
synonymous with uncertainty
that there aren’t degrees of
risk. Trade entries and exits
that are likely to keep losses
within our risk parameters are
not the same thing as taking a
position before an earnings
report on simply the hope of a
positive market reaction to
the news. We have no way to
quantify the market’s future
reaction to a report the
contents of which we know
nothing about.
That said, some of us (or
is it all of us?) will, hopefully
only occasionally, gamble on
earnings reports. We should
not do it, but some of us will
give in to the temptation. If I
were to hold a position
through earnings reports, the
following situation would be
the only instance when I
would consider doing so. The
next chart focuses on the left
portion of Figure 8 where the
H&S bottom formed:

FIGURE 8.1
 We have a H&S bottom
and a breakout on a gap up in
price. My experience has
been that breakouts on price
gaps tend to work more often
than not. That said, we must
never go all-in on any single
pattern no matter how
promising the breakout. Even
textbook-perfect patterns fail
often. Here, the gap-up in
price was just another factor
to consider when deciding
whether to trade this pattern. I
would trade this pattern given
the symmetry of the H&S
bottom (the left and right
shoulders were about the
same size), the breakout on a
gap up, and a favorable entry
spot. As noted on the chart,
we risked about 2.3% of our
position had we bought
shares around the closing
price of the breakout day and
set our stop somewhere
reasonably below the
neckline.
If we had bought shares
upon the breakout, we gained
about 15% on our position in
the next two weeks. Then
prices traded in a narrow
range for the next month and
the quarterly earnings report
was to be released soon.
What now? The correct thing
to do is to sell our entire
position and book a 15%
profit. But we are human, and
we want more. If we are
going to gamble, then we
should do so with only a very
small position. In this case,
we would get lucky as the
stock jumped 12% on the
earnings report. Yes, we can
do the wrong and
irresponsible thing and get
lucky and make money. But
we will run out of luck and
take a large hit to our trading
capital if we continue to take
such gambles. Doing the right
thing means doing the
unexciting thing over and
over: honoring our stop, not
chasing a missed breakout,
not gambling, and just
waiting. Doing the right thing
doesn’t guarantee profits, but
it is the best way to be a long-
term player in the trading
game, and longevity is the
best way to be profitable in
the long run.

Lannett Co.: 5-month H&S

bottom
Our next chart is another
variation of the H&S bottom:

FIGURE 9
 Note that the right
shoulder of the H&S bottom
is much smaller than the left
shoulder. While symmetry
between the left and right
shoulders is one of the
defining traits of a textbook
H&S pattern, as with all
pattern “rules,” there are
exceptions. A H&S bottom
such as this one where the
right shoulder is significantly
smaller than the left can
launch a powerful move. It is
as if the stock is itching to get
moving and doesn’t have the
patience to form a right
shoulder that is of similar size
to the left shoulder.
Note also that this pattern
gave us plenty of time to
enter the trade. We could
have bought shares toward
the close of the breakout day
or anytime during the next
day. It was not necessary to
use a buy-stop order to trade
this breakout.
So was it as easy as
buying shares once prices
closed above the neckline of
the H&S bottom? The major
strike against this pattern was
that the stock was very thinly-
traded. Less than 20,000
shares traded per day on
many days during pattern
formation. As noted, I usually
avoid stocks whose average
daily volume is less than
50,000 shares. And I would
recommend that beginners
avoid entirely such low-
volume stocks. As we gain
experience, we may decide to
trade, very carefully, some
patterns that form in thin
stocks. If I were to trade this
H&S bottom pattern, I would
use a position that was at
most 30% to 40% of my
normal position size.
Would I trade this set-up
using a smaller position? Yes.
The 6-month H&S bottom
looked very promising with a
clearly defined left shoulder
and head. Another reason is
that, despite the low volume,
the stock traded relatively
“cleanly,” especially during
the formation of the right
shoulder. Thinly-traded
stocks can jump wildly
around and make risk control
very difficult if not
impossible. A stock’s chart
looks clean to me when there
are few price gaps unrelated
to pattern breakouts. As
noted, breakouts on price
gaps support but does not
guarantee the validity of the
breakout. The charts of some
volatile stocks have price
gaps almost every day. In
contrast, Lannett’s stock
traded cleanly and in a tight
range during the weeks
leading up to the breakout.
Of course explosive
volatility can appear anytime,
especially in thin stocks, but
the clean price action and low
volatility during the
formation of the right
shoulder would be an
important factor in support of
not eliminating this pattern
from my list of trade
candidates. Yet it is perfectly
acceptable to pass on this
pattern because of the stock’s
low volume and the risk that
accompanies a thin stock.
Again, I recommend
beginners to trade only stocks
whose average daily volume
is at least 200,000 shares.

Penn Virginia Corp.: 8-month

H&S bottom

The next chart shows another

pattern-within-a-pattern. Note
how the breakout from the
small symmetrical triangle
launched the breakout from
the larger H&S bottom:

FIGURE 10
 Now let’s zoom in on the
right shoulder area:

FIGURE 10.1
 The breakout from the 4-
week symmetrical triangle
that constituted a portion of
the right shoulder of this
H&S bottom was an ideal
spot to go long. This entire
set-up – from the year-long
H&S bottom pattern (the
lengthier the build-up, the
more powerful the breakout
may be), the symmetrical-
triangle right shoulder that
offered an opportunity to
enter early, and the textbook
breakout on heavy volume –
was very promising. Indeed, I
would seriously consider
risking more than my
standard maximum risk and
buy a larger position size.
That said, I would still not
risk more than 1.5% of my
account even on such a
promising pattern because
there are no guarantees in
trading. There are no rules
that are supposed to work.
This enticing H&S bottom
that seems so promising? The
market could care less as it
can crash prices even after a
decisive breakout. The
pattern boundaries we draw
are just that: nothing more
than lines that we use as
trading tools. The market and
prices will do what they do.
They are never wrong.

Always be cautious
By now we may have noticed
a recurring theme. We discuss
some exciting aspects of
classical chart trading and
then immediately remind
ourselves of the utmost
importance of caution. We
may wish it were otherwise
but catastrophic risk lurks
everywhere in trading and the
financial markets. If we are
not careful, then we may lose
it all. But we need not be
pessimistic. We can learn to
implement an
uncompromising risk
management strategy that
allows us to be long-term
players in the trading game.
The only thing standing in the
way of prudent risk
management is ourselves.
Compelling set-ups such
as this H&S bottom in Penn
Virginia Corp. should
motivate us to do the utmost
to preserve our capital for the
really promising charts. Such
patterns can reaffirm our
passion for trading. Of course
we don’t know which set-ups
will work as even textbook
patterns fail often. But one
decisive winner can make up
for many more small losses
and produce overall
profitability. If we lose our
capital on suboptimal trades
by chasing missed breakouts,
entering at unfavorable spots,
or just gambling outright,
then we will be too exhausted
financially and mentally to
place a meaningful bet when
a truly compelling pattern
emerges.
I have experienced this
painful situation many times.
After losing money chasing
breakouts and trading poorly
formed patterns, I have
simply lost the nerve to make
a meaningful bet on the next
promising trade. Then I watch
from the sidelines as this
pattern launches an explosive
and very profitable trend. I
get more frustrated. I chase
this breakout by entering at a
spot that carries more risk
than my maximum-loss limit.
I get stopped out and lose
more money. I have lost not
only my nerve, but also my
detachment and my form. I
am in a destructive cycle of
negative feedback loops.
When traders are in this
situation, and all of us will be
in this situation from time to
time, we can exit our
positions, walk away from the
screen, and take a break from
the market. We must rebuild
our mental strength. We must
regain our nerve, perspective,
and balance. We must take
our time. The market will
always be there when we are
ready to trade again.
Constantly reminding
ourselves that there will
always be more great set-ups
can help us not chase missed
breakouts and also give us the
confidence to take a break.
Even if we missed this Penn
Virginia set-up, the existence
of this and many other
exciting patterns should
remind us that we will always
have the opportunity to make
a comeback. The key is to be
still standing when favorable
market conditions reappear.
And effective risk
management keeps us in the
arena.
United Community Banks: 7-
month H&S bottom

Our next example shows yet

another variation to the H&S
bottom pattern. This time, the
right shoulder took the form
of a small H&S bottom:

FIGURE 11
 The next chart focuses on
the right shoulder:

FIGURE 11.1
 Here, we again have a
situation where the next
earnings report was to be
released not so long after the
breakout. If we bought shares
around the closing price of
the breakout day, we were up
by about 8-9% on our
position right before earnings
release. What should we do?
An almost 10% profit in less
than a month is a good trade.
I would sell my entire
position, book my 10% profit,
and move on to other set-ups.
But the reality is that we are
all susceptible to the
temptation to gamble on
earnings reports. And if we
choose to gamble, and it’s a
choice as no one is forcing us
to stay in this trade through
the earnings report, I think we
should gamble with no more
than one-third of our original
position.
 CHAPTER 7

Continuation H&S
Bottom

A continuation H&S bottom

is a H&S bottom that forms
after a sustained rise in prices
and signals possibly another
uptrend in prices.
Deluxe Corp.: 2-month
continuation H&S bottom

Our first continuation H&S

bottom pattern:

FIGURE 12
 Deluxe’s stock had been
in a sustained uptrend for two
months when the stock
paused (left shoulder),
declined and then increased
again (head), and paused and
dipped again (right shoulder)
before shooting up
(breakout). The result was a
well-defined continuation
H&S bottom. Note the
horizontal neckline,
abbreviated right shoulder
(breakouts from which can
lead to powerful trends), and
a clean decisive breakout
through the neckline.
All trends, up or down,
pause at some point. The
pause can take the form of
price gyrations that do not
form any classical pattern. Or
the pause can be in the form
of price action that evolves
into a classical pattern. And
that classical pattern can be
either a continuation pattern
that continues the previous
trend or a reversal pattern that
reverses the previous trend. In
Deluxe Corp., the pause
formed a continuation pattern
in the form of a continuation
H&S bottom.
Thus, when I see a stock
in a sustained trend, I wait for
the inevitable pause because
that pause can take the form a
tradable classical pattern that
gives me an entry
opportunity. Before, I used to
ignore stocks in sustained
trends because I thought, “I
missed that breakout. Nothing
I can do here.” It is smart to
not chase breakouts. My
mistake was failing to realize
that every chart can form a
compelling set-up at any
time, even after making a
strong run.
We have to accept the fact
that we will miss many good
trades. In fact, we must not
try to find and trade every
compelling set-up. We need
to concentrate when trading,
and we should not spread our
attention and capital too thin.
Most importantly, we have to
remember that money we did
not make is not money we
lost. Missing a breakout or
choosing one pattern that
later fails over another that
turns out to be a big winner is
part of trading. Nobody knew
which patterns would work. It
is foolish to get angry over
something that we have no
control over. It is far better to
miss a trade than to lose
money.
Note: not every price
move is due to a breakout
from a classical pattern.
Strong trends start without
any connection to a classical
pattern. As classical chartists,
we don’t buy shares just
because a stock is going up or
short shares just because the
stock is going down. We look
for tradable classical patterns
that provide favorable entry
spots.

Flotek Industries: 6-week

continuation H&S bottom

Here, a breakout from a 6-

week H&S bottom was part
of a price action that also
broke above a multi-month
declining resistance line:

FIGURE 13
 As Flotek was in a steady
downtrend from October
2013 to January 2014, we
might call this pattern a
reversal H&S bottom. But as
Flotek had been in a year-
long uptrend before this
recent decline, it is also
reasonable to label this
pattern a continuation H&S
bottom. The label is
unimportant. The important
thing is whether a pattern
offers an advantageous entry
spot with a favorable reward-
to-risk possibility.
Note the powerful
breakout from the 6-week
H&S bottom as prices
jumped 5.8% on the breakout
day. Buying shares toward
the close of the breakout
meant risking more of our
position than required for
most of the patterns we have
examined so far. Still, trading
this breakout would have
been a reasonable decision,
especially if we decided to
use a smaller position to
make sure we stayed below
our maximum risk. Not
trading this breakout was also
a reasonable decision as there
will be many more set-ups
with less risky entry points.
We could have anticipated
the breakout and placed a
buy-stop order just above the
H&S bottom’s neckline.
Here, such a buy-stop order
would have worked well. But
remember that every situation
is different and that buy-stop
orders do not always work to
our advantage. We discussed
how they can produce bigger-
than-expected losses if prices
jump overnight and then
reverse and trigger our stop.
We cannot and should not
trade every breakout. Our
task is to learn the many
variations in classical patterns
and figure out the kinds of
set-ups that we like. Classical
charting does not have too
many fundamental principles.
But countless interesting
possibilities arise from the
relatively-few bedrock
guidelines. We are free to use
our imagination and
discipline to apply classical
charting in ways that we
prefer if we keep risk
management as our top
priority. Trading is in some
ways the ultimate freedom.
Isn’t that a big part of why we
are interested in trading?

Taser International Inc.: 9-

month continuation H&S
bottom

Taser International’s stock

had more than doubled in six
months and then started to
trade in a range for nine
months starting in late 2012.
It turned out that during these
nine months the stock was
building a base from which to
launch another powerful
uptrend. The base was the
following 9-month
continuation H&S bottom:

FIGURE 14
 Another pattern within a
pattern. The right shoulder
developed in the form of a
descending flag. The
breakout from the flag started
the breakout from the larger
H&S bottom pattern.
Let’s zoom in on the right
shoulder:

FIGURE 14.1
 Note the unmistakable
increase in volume at
breakout as indicated on
Figure 14. While breakout on
heavy volume can never
guarantee the pattern’s
ultimate success, it is a strong
indicator of a significant
breakout from a meaningful
boundary.
This set-up also produced
a fast breakout. Let’s say we
had been monitoring this
pattern develop and saw the
breakout from the right
shoulder. Towards the end of
the breakout day, we see that
entering around what was
going to be the closing price
meant that we had to risk
almost 7.5% of our position.
And a possible 7.5% loss on a
normal-size position is likely
to exceed our maximum-loss
limit for a single trade. On
other hand, the pattern looks
very promising and the
heavy-volume confirmation
on breakout makes the pattern
even more enticing. What can
we do?
While there is nothing
wrong with not trading a
breakout because, for
example, we feel entering the
trade means chasing a
breakout, we can always
consider using a smaller
position. Using a smaller
position helps us trade with
less emotion and thus
correctly. A smaller position
allows us to set our stop-loss
order at a more logical level:
reasonably far away from the
breakout boundary to give
our position a reasonable
chance to survive normal
volatility and possible retests
while still keeping our
potential loss under our
maximum-loss limit. Always
consider whether we can use
a smaller position to trade a
promising pattern that has
experienced an explosive
breakout.
 CHAPTER 8

Rectangle

Our next pattern is the

humble rectangle.

Chiquita Brands: 3-month

rectangle

Here is our first rectangle:

FIGURE 15
 Let’s focus on the
breakout area:

FIGURE 15.1
 Even the simplest-looking
pattern and breakout offer
trading challenges. Note the
somewhat indecisive
breakout with multiple retests
of the upper boundary. The
first retest was especially
tricky because it would have
triggered a stop-loss order
that was placed just below the
low of the breakout day.
Here, placing our stop using
the last day rule was
problematic because the
breakout day had very little
price action below the upper
boundary of the rectangle. A
stop-loss order placed just
below the low of the breakout
was simply very close to the
breakout boundary and
exposed to getting triggered
on retests and even normal
volatility.
What are our options?
We could have set our
stop a bit lower, say, just
below the opening price of
the day before the breakout or
even further down and reduce
our position size accordingly
to stay within our risk
parameters.
Another option is to re-
enter this trade if we got
stopped out. If we got
stopped out after placing a
stop at, for example, 5.57,
then we could re-enter on the
day after the first retest and
place a stop just below the
low of the hard retest, say, at
5.54. There is no guarantee
that this second stop will
survive. We are simply
placing our stop at a spot that
seems to have a reasonable
chance of surviving volatility
while staying within our risk
limit. Risk management, not
making money, must remain
our priority, especially when
making multiple attempts at a
set-up. Here, the second stop-
loss order would have
survived the second retest
that came three weeks later. I
will always consider re-
entering a trade if I am
stopped out by a retest where
prices do not decisively close
below the breakout boundary.
Sometimes I will enter for the
third time if the pattern seems
promising enough and I have
suffered negligible losses on
my initial attempts. That said,
becoming fixated on any
pattern because we think a
pattern “owes” us is
dangerous and unnecessary.
There will always be other
set-ups to trade. We should
almost always move on after
two attempts.
A crucial takeaway from
Chiquita’s chart is that we
must expect retests, and we
must learn to deal with
them. One of the best ways
to deal with retests is to
ignore them. That is, we
enter at an advantageous spot,
place our stop at a reasonable
level, and we move on.
Anxiously watching every
price tick in fear that our stop
will get triggered will lead to
mental exhaustion, and when
we trade while tired, large
losses are not far away.
Perhaps an even more
important lesson is that we
must be patient and give the
pattern time to work. After
buying shares and setting our
stop, we had to be patient
through two hard retests over
three weeks. The stock started
to make big gains five weeks
after breakout.
The Chiquita chart also
shows the importance of
detachment. The ideal way to
trade is to dispassionately
enter and set a stop and then
do other things. Agonizing
over whether our stop will
survive a retest is the worst
thing we can do. If our stop is
triggered, so be it. We
consider re-entering if
practical and advantageous to
do so. If we decide not to re-
enter, then we move on.

Lions Gate Entertainment: 6-

week rectangle

FIGURE 16
 After the decisive
breakout, a retest challenged
but did not penetrate the
upper boundary of the
rectangle. It is fascinating
how often pattern boundaries
turn back retests. But we
must not get overconfident
and assume the inviolability
of boundaries. The market
does not care where or how
we draw boundaries. Decisive
breakouts can be followed by
tough retests that penetrate
deep inside the pattern and, of
course, even lead to pattern
failures. No matter how
decisive and indisputable a
breakout looks, we must
always stay within our risk
parameters and enter a stop-
loss order as soon as we enter
every trade.

A pattern is almost always

open to multiple
interpretations
I think we had two
compelling ways to interpret
the following chart of Lincoln
National. The first
interpretation of the price
action is a breakout from a
rectangle:

FIGURE 17
 The other interpretation is
a breakout from a
continuation H&S bottom:

FIGURE 17.1
 Note the abbreviated right
shoulder, which can signal a
potentially powerful move to
come, and the slightly rising
neckline.
Both interpretations are
compelling and provide a
clear entry and exit strategy.
A caution regarding the
freedom we have in drawing
boundaries and interpreting
charts: we must not impose
our wishes onto charts by
drawing lines that reflect our
hopes rather than the price
action. In a battle of wills, the
market will always win.
Let’s examine a third way
to interpret Lincoln
National’s chart, that of a
broadening triangle, also
called a megaphone, to
emphasize the point that chart
patterns are simply trading
and risk-management tools:

FIGURE 17.2
 A megaphone is usually a
bearish chart pattern where
prices decline after breaking
below the lower boundary.
But prices do not have to
respect our boundaries or
expectations. All classical
patterns can launch a
powerful move in the
direction opposite the
expected direction. The
megaphone, as it did here,
can launch a powerful
uptrend after prices decisively
close above the upper
boundary.
A lesson is that we must
always keep an open mind
rather than being obsessed
with a particular outcome –
our preferred outcome. All of
us will at times fight, with no
success, the price action. We
do not want to and cannot
believe what we are seeing
because the price action is
doing something that it is
“not supposed” to do. In a
battle between our fantasy
and reality, guess which side
wins?
If we remained flexible,
we were much more likely to
spot and trade well a breakout
either way. Spotting a pattern
and the breakout are only part
of trading well. We need to
determine a good entry and
exit strategy that manages
risk. And the megaphone
interpretation simply did not
give us as favorable a trading
strategy as the rectangle and
continuation H&S bottom
interpretations. It was not
impossible to trade this
breakout well on the basis of
a megaphone interpretation.
But the rectangle and
continuation H&S bottom
interpretations provided
clearer and more favorable
entry and exit points because
of modest differences in the
drawing of the pattern
boundary. We could enter the
trade a bit earlier using the
rectangle and continuation
H&S bottom interpretations
and also benefit from their
horizontal or nearly
horizontal breakout
boundaries. As we will
discuss further later, patterns
with horizontal boundaries
offer some advantages over
slanting boundaries to traders.

Skechers: 4-month rectangle

One more rectangle:

FIGURE 18
 The breakout was clear
and gave traders plenty of
time to enter. We could buy
shares towards the close of
the breakout day and even the
next day and stay within our
risk parameters. And note that
the minimum price target was
quickly met. While the
general rule is that a
measured price target is
usually the minimum price
move, it is also true that at
anytime prices can reverse
and lead to pattern failure. I
almost always take profits on
most of my position when a
price target is met. When, as
here, the price target is met
and the next quarterly
earnings report is due soon, I
will exit entirely from my
position.
 CHAPTER 9

Ascending Triangle

The ascending triangle is a

pattern that indicates a
possible upward price move.
It has a horizontal top
boundary and a rising lower
boundary with increasingly
higher lows.
Marchex Inc.: 10-month
ascending triangle

FIGURE 19
 The next chart focuses on
the breakout area:

FIGURE 19.1
 One of the ironies of
trading is that an explosive
breakout both confirms the
significance of the pattern
and makes trading the pattern
more difficult. The powerful
breakout in Marchex is an
example. Placing a buy-stop
order in anticipation of a
breakout would have worked
well in this case, but
remember that a stop order to
buy or short is not a perfect
tool.
We face a tricky situation
here. We know in hindsight
that Marchex went on a
powerful run after breaking
out of the ascending triangle.
In hindsight it is easy to say,
“we should have bought a
large position after breakout.”
But we trade in real time, and
in real time the dilemma was
whether to buy shares on the
breakout day and risk up to
10% of our position. Another
factor to consider was the fact
that Marchex was a relatively
thinly-traded stock. So we
had a powerful breakout from
a textbook pattern in a low-
volume and volatile stock.
What are some of our
options?
First, we can simply not
trade. It is better to miss a
trade than to chase a breakout
and lose money. Let it go.
There will be others.
Second, we could have
placed a buy-stop order in
anticipation of a breakout.
This option is no longer
available after breakout but it
is still worth mentioning
because buy-stop orders can
be a valuable tool especially
if we learn to use a smaller
position size to account for a
possible gap up in price.
Again, buy-stop orders are
not foolproof and can
produce bigger-than-expected
losses.
 Third, we can buy a
smaller-than-normal position
at around the closing price.
There is no correct choice
among these options.
Sometimes one option will
work better while other times
a different choice will
produce the better outcome.
Whatever option we choose,
we must be guided by our
most important objective:
controlling risk and cutting
losses.
Cheesecake Factory: 3-month
ascending triangle

The next chart shows a well-

formed ascending triangle in
Cheesecake Factory from
July to October 2013:

FIGURE 20
 Sometimes the earnings-
induced breakout is so
powerful that it puts the trade
out of our reach. Other times
the earnings news will
produce a decisive yet
manageable breakout that
provides a favorable entry
spot, as happened in this
ascending triangle. We could
have bought shares around
the breakout day’s closing
price and set a stop just below
the breakout day’s low.
Note the earnings news
led to a breakout on a gap up
in price. Not all price gaps are
significant, but price gaps that
overcome key resistance or
support levels are often
decisive clues.
After breakout, the stock
reached its measured price
target, which is the height of
the ascending triangle as its
widest point – here, $5 –
projected upward from the
breakout level. The price
target was met on the dot. I
almost always take profits at
the measured price target.
Although price targets are
generally minimum price
goals, I still exit most of my
position when targets are
reached. If prices continue to
go up or down and leave us
behind, then so what? We
bank our profits and move on
to other set-ups.
After reaching the price
target, Cheesecake’s stock
price went sideways for two
months before breaking
down. Note that the stock
formed a 2-month H&S top
from which the decline
started.
Some takeaways from
Cheesecake’s chart:
First, the importance of
taking profits when the
measured price target is
reached. Many good traders
say that it is the sitting on our
position, never our thinking,
that makes the big money.
This idea can work well,
especially in powerful bull
markets, but as with
everything, not always.
Depending on market
conditions, I may take profits
well before the price target is
reached.
Second, again, we must
not gamble on earnings
releases by entering a large
position just before earnings
news.
Lastly, in this case there
was an attractive entry point
even after the powerful
breakout on earnings. As we
noted, most trades, including
many of the best trades, give
us plenty of time to enter.
They key is to be not
mentally and financially
exhausted when the fat pitch
is served.

Dollar Tree Stores: 8-week

ascending triangle

Here is another breakout on a

gap up in price:

FIGURE 21
 Such a “breakout gap,” the
same one we saw in
Cheesecake Factory’s
ascending triangle in Figure
20, is more often than not
evidence of a meaningful
breakout.
Also notice that we need
to modify the last day rule to
set our stop here. Because of
the gap up, there was no price
action within the pattern on
the breakout day. One
alternative is to set a stop just
below the closing price of the
day before the breakout. Or,
if within our risk parameter,
we can set our stop below the
low price of the day before.
Every stop placement will
depend on the particular traits
of each pattern. Here, the
breakout on a gap up was not
so powerful as to make
buying shares too risky.
After reaching the price
target, prices traded in a
narrow range until the
quarterly earnings report.
Again, I would have exited
from my entire position
before the earnings release.
Here, the stock price dropped
sharply on earnings news.

Dollar Tree Stores: Was that

a continuation H&S bottom
instead?

Is it possible to interpret
Figure 21 in a different way?
The following chart shows
how we could have
interpreted it as a
continuation H&S bottom:

FIGURE 21.1
 How we interpret and
label the price action is up to
each of us. We could call this
chart an upside down Mt.
Everest. What is not
debatable is the importance of
risk management and limiting
losses.

Michael Kors Holding: 5-

month ascending triangle
The next ascending triangle
developed a symmetrical
triangle inside its boundaries:

FIGURE 22
 The next chart zooms in
on the breakout area:

FIGURE 22.1
 I am always interested in a
pattern-within-a-pattern
because it often provides an
opportunity to enter the trade
earlier than otherwise. For
example, here we had a good
rationale for buying shares
when prices closed above the
symmetrical triangle’s upper
boundary but before closing
above the ascending
triangle’s upper boundary.
Doing so meant buying
shares two or three days
earlier than had we waited for
prices to close above the
upper boundary of the
ascending triangle. A couple
of days may not seem like
much but slight edges can
make a big difference.
Classical charting is about
exploiting small edges over
many trades. In this case, the
advantage of entering a few
days earlier was not only
higher profits should the
pattern work but simply
securing an entry in this
trade. For if we had waited
for a more decisive breakout,
we would find that buying
shares required taking on
significantly greater risk as
prices gapped up three days
after they initially closed
above the symmetrical
triangle’s upper boundary.
Caution: the chance of
being left behind is never a
good reason to enter a trade.
Here, I think the breakout
from the symmetrical triangle
was a good spot to buy
shares. That said, I also think
waiting for a more decisive
breakout from both the
smaller symmetrical triangle
and larger ascending triangle
was a reasonable decision.
We could not know that
prices would gap up three
days after they broke out of
the symmetrical triangle.
Even after the gap up, we
could buy a smaller position
to enter this trade and stay
within our risk parameters. Or
we could decide to trade other
set-ups instead. There will
always be others.

Nu Skin Enterprises: 7-week

ascending triangle

Nu Skin Enterprises formed

an ascending triangle from
May to July 2013:
FIGURE 23
 The breakout from the
ascending triangle was clear
enough but not explosive. I
like such a “controlled
breakout” because it almost
always creates a favorable
entry spot that doesn’t ask us
to risk too much of our
position. Prices steadily
moved higher the next two
days and then jumped 20% on
the third day after the
breakout. Prices paused for a
week before moving higher
again. This simple 7-week
pattern produced a 30% profit
in two weeks. A lesson is that
we should not place too much
emphasis on spotting and
trading the giant multi-month
or multi-year patterns.
Relatively small patterns like
this ascending triangle that
form after a powerful run (Nu
Skin stock had gone up more
than 50% in the three months
prior to forming this
ascending triangle) often
launch another powerful run.
These modest but potentially
powerful patterns are called
halfway continuation patterns
because they often form at
about the midpoint of the
overall move.

Sealed Air Corp.: 14-week

ascending triangle

We have a decisive breakout

from a well-defined
ascending triangle:

FIGURE 24
 The stock is making a
good run and seems poised to
reach its measured price
target. But the next earnings
report is to be released soon.
What should we do?
My opinion is that we
should sell our shares rather
than stay in and hope that the
market reacts positively to the
earnings report. If we must
stay in, despite nothing and
no one forcing us to hold our
shares through an earnings
release, then we should
gamble with just a small
portion of our original
position, say, no more than
20% to 30%.
What we must not do is
keep our full position because
the stock price “should” and
“must” reach its measured
price target. No. Wrong.
Never. There are no such
guarantees in the markets.
Measured price targets are
just possibilities. They serve
as useful reference points but
never as scientific certainties.
The market doesn’t care what
the price target is. How the
market reacts to earnings
news is entirely
unpredictable. The only
certainty is uncertainty. It is a
highly unoriginal statement,
but it is true, and often
forgotten. Good earnings can
be seen as bad while bad can
be good. Or, good can be not
quite good enough and thus
bad but the stock price may
skyrocket anyway. Or crash.
Nobody knows. We must not
gamble on earnings reports.

Sealed Air Corp.: was Figure

24 a symmetrical triangle and
not an ascending triangle?

Some of us may object that it

is more accurate to draw and
label the Sealed Air Corp.
chart as a symmetrical
triangle as follows:

FIGURE 24.1
 Drawing our boundary as
an ascending triangle meant a
horizontal upper boundary
with only one price touch
point. There were two other
price peaks that came close to
the upper boundary. In
contrast, interpreting this 14-
week pattern as a
symmetrical triangle and
drawing a slightly descending
upper boundary created an
upper boundary with three
solid price touches. More
touches on a boundary are
good. Then is there a
reasonable basis for
interpreting this pattern as an
ascending triangle?
First, the two highs came
close enough to the upper
boundary for it to be
reasonable to label this chart
as an ascending triangle.
Remember that patterns do
not have to be perfect to be
useful. Pattern boundaries are
just lines that we draw and
use as trading tools and
nothing more. There is no
rule that says that prices must
stay within their “proper”
(our) boundaries. Prices will
go wherever they want to go.
While it is fascinating to
observe how often prices do
stay within the lines that we
draw, we must never forget
that prices can run over our
lines anytime. It can be costly
to draw very precise pattern
boundaries because we then
expect and demand prices to
respect these sacred lines. We
become too invested in the
inviolability of our chosen
boundary. And when prices
violate our lines, we go into
denial and become blind to
the actual price action.
Second, some traders will
say, with merit, that whatever
we call this pattern, a
breakout of significance will
have to close decisively
above a meaningful resistance
level. Here, the upper
boundary of the ascending
triangle was such a level
because that line represents
the highest price reached
within the pattern and a level
of resistance that has rejected
three attempts to overcome it.
So some traders will say fine,
we’ll call this pattern a
symmetrical triangle if you
wish, but a breakout from a
symmetrical triangle is not a
true breakout until it closes
above a significant prior high.
The next example
illustrates this point.

Spring Nextel Corp.: 6-month

symmetrical triangle

Let’s see how this set-up

illustrates the previous point.
First, the big-picture view:

FIGURE 25
 The next chart focuses on
the second half of the
symmetrical triangle:

FIGURE 25.1
 And the next chart zooms
in on the breakout area:

FIGURE 25.2
 The stock closed above
the symmetrical triangle’s
upper boundary but was
turned back on its first
attempt to close above the
horizontal resistance formed
by the previous significant
high. The rejection led to a
hard retest where prices
traded but not close below the
upper boundary of the
symmetrical triangle.
Another, some would say the
real, breakout came eight
days later when the stock
decisively cleared the
horizontal resistance level.
Some will argue that the
initial close above the upper
boundary of the symmetrical
triangle was a good entry
signal. After all, a stop placed
at a reasonable distance away
from the boundary would
have survived even the hard
retest. A long position entered
at the initial breakout would
have meant an earlier and
thus more profitable entry.
This analysis, too, has merit.
I think we should
incorporate the wisdom of
both sides in our trading.
Breakouts are about
overcoming key resistance
and support levels. While
sloping lines can be precise
resistance and support levels,
horizontal lines present the
clearest picture of support
and resistance. But charting is
also about exploiting small
edges, and we may prefer to
enter a bit earlier as signaled
by the symmetrical triangle
interpretation. After all, a
failed breakout means just a
minor loss while a successful
breakout means we have a
running start.

Symetra Financial Corp.: 4-

month ascending triangle

Our last ascending triangle

shows the upper boundary
offering stiff resistance
against multiple breakout
attempts:

FIGURE 26
 The many decisive
breakouts we have analyzed
so far may give us the
impression that all breakouts
are very clean and easy to
trade. This impression is false
and dangerous. While it is
true that many of the best
trades start with clean
breakouts, some struggle to
get going.
In Figure 26, the
congestion at the upper
boundary that seems like
nothing in hindsight lasted a
week. We have to accept the
fact that not all breakouts will
be clean. All we can do is
enter and set our stop at a
spot that limits our risk. If we
get stopped out, no problem.
If the trade starts to work, we
find out when the next
earnings report is due and
where we might take profits.
Whatever happens, we move
on to other set-ups. There are
always more opportunities to
be found.
 CHAPTER 10

Descending Triangle

Our next pattern is the

descending triangle, which
indicates a possible
downward move in prices. It
has a flat lower boundary and
descending upper boundary
with lower highs.
Caesars Entertainment: 4-
week descending triangle

Our first descending triangle

is small but well-defined:

FIGURE 27
 The breakdown through
the lower horizontal boundary
was decisive. When the
measured price target was
reached in a week, I would
cover my entire position.
Then came a retest where the
stock nearly reached the
lower boundary of the
descending triangle. If we
missed the initial breakout,
the retest offered a second
chance to enter a short trade.
 A note of caution: I almost
always use a smaller position
when entering a trade in a
stock that has already reached
its price target and then has
returned to retest the breakout
boundary. My rationale is that
the pattern breakout has
already served its purpose.
This situation is different
from the common and
expected retest that occurs
within a few days or a few
weeks of a breakout and
where prices have yet to
make significant progress
toward the price target.
With Caesars
Entertainment, shorting again
or for the first time just under
the lower boundary during
the retest level would have
worked well as prices again
declined. Note the upcoming
quarterly earnings release and
the caution we must exercise
by covering our short position
and getting out of this trade.
NutriSystem Inc.: 4-month
descending triangle

An upcoming earnings
release again affects our
trading in the next example:

FIGURE 28
 NutriSystem formed a
textbook descending triangle.
After a decisive downward
breakout, the downtrend
paused and prices traded
within a narrow range for a
week until the earnings
report. If we had shorted
shares after the breakout, we
would cover our shares
before the earnings release.
Prices declined 12% on the
earnings news and then
declined another 12% in the
following days. Yes, we
would have made a large
profit if we had stayed with
our short position. But I have
no doubt that staying in our
short position would have
been the wrong thing to do.
We have to remember that
while doing the right thing,
which should be our
definition of trading well,
does not guarantee a profit, it
does dramatically increase
our chances of preserving our
capital. In contrast, doing the
wrong thing by taking on too
much risk or gambling on
earnings can sometimes lead
to large profits but it
dramatically increases the
odds of crippling losses.
Nobody knew how the
market would react to the
earnings report. That 12%
decline could have been a
20% or even a 40% increase.
The following are some
questions we might have
about this set-up.
First, since the next
earnings report was due a
week after the breakout,
should we have traded this
breakout? My opinion is that
we should consider trading
every decisive breakout,
including a breakout very
close to the next earnings
report, because prices can
travel far in a short time. For
example, it was very possible
for NutriSystem’s stock, after
breaking down through the
lower horizontal boundary of
the descending triangle, to
decline another, say, 10% to
20% in the days leading up to
the earnings release. If this
decline had occurred, then we
would cover our short
position before the earnings
release and book a significant
profit. A week and perhaps
even a couple of days is
enough time for a stock to
make a significant move in
the anticipated direction to
make breakouts in situations
like NutriSystem’s worth
trading.
Second, was the
breakdown from the
descending triangle in
anticipation of a bad earnings
report? Some traders and
investors made a bet on the
basis of their opinion or guess
that the market would react
negatively to earnings, but no
one knew for certain. It is
obvious but worth repeating:
no one and no chart knows
the future direction of stock
prices.
We must not risk our
precious capital on the
utterances of those who claim
to know something. I think it
is a common mistake to think
that those in Wall Street
know, or at least have a better
idea of, the future. The same
caution must be applied to
our charts, especially with a
breakout from a pattern just
before an earnings release as
we are tempted to think that
the price action must be
reflective of somebody
knowing something and is a
reliable forecast of the future.
The market can coldly
reverse a decisive breakout
anytime it wishes and
produce outright pattern
failure.
A third question may be: if
NutriSystem’s stock
increased on earnings news,
then wouldn’t our stop be
triggered and we would be
out of our position with just a
small loss? So isn’t it a win-
win strategy to stay in our
short position? If the price
continues to decline, then we
profit. If the price goes up,
then we get stopped out for a
small loss.
My response is that if it
were guaranteed that our stop
would be triggered at exactly
or near where we placed our
stop, then yes, staying in our
short position through the
earnings release is the
dominant strategy. But there
are no such guarantees in
trading. While the stock
gapped down on earnings
news, it could have gapped
up just as easily. And the gap
up could have been huge. I’ve
seen price gaps measuring
20% to 40% and more. And
even larger gaps have
happened and will happen.
By getting out of our position
before the earnings release,
we avoid this immeasurable,
unpredictable, and
unnecessary risk.
Let’s review. We should
not hold a position through an
earnings release, no matter
how promising the chart
pattern and how clean the
breakout. The only time I will
seriously consider holding a
very small position through
earnings is if I am sitting on a
significant profit. Even a
reduced exposure does not
guarantee that we will make
money in the trade. The profit
that we made when we exited
most of our position may turn
into an overall loss if prices
gap in the direction opposite
the anticipated direction. We
may even suffer a very large
loss if the price gap is large
enough.
 The only guarantee in
trading is that we will suffer
psychologically and
financially if we don’t respect
risk. Our priority is protecting
our capital. An intact trading
account allows us to take
advantage of favorable
market conditions and highly
advantageous set-ups.
 CHAPTER 11

Symmetrical
Triangle

Unlike ascending or
descending triangles,
symmetrical triangles do not
indicate the likely direction of
the breakout because both the
upper and lower boundaries
converge to an apex. Thus,
prices can break up or down.
Still, I would say that most
symmetrical triangles are
continuation patterns that
continue the previous trend.

Chicago Bridge & Iron: 4-

month symmetrical triangle

The first symmetrical triangle

we will look at formed in
Chicago Bridge & Iron from
May to September 2013. It
had textbook form and
produced a clean and decisive
breakout:

FIGURE 29
 This textbook symmetrical
triangle was one of the most
meaningful classical patterns
for me in 2013.
Why?
Because I did not trade the
breakout despite having
watched the pattern develop
for months. I did not trade the
breakout because I did not
believe the breakout. I saw
the breakout, but I didn’t
believe anything would come
from it.
Why?
The stock had made an
incredible run and was just
under the old high set before
the financial crisis of 2007-
2009. I thought that the
uptrend was surely over.
Even the humble old-industry
name of the company
contributed to my inaction.
Could such a heavy-sounding
name continue to go up? Of
course nobody knew that the
stock would make another
powerful run after the
decisive breakout from this 4-
month symmetrical triangle.
Not knowing the future was
not my mistake. My mistake
was ignoring the breakout
and eliminating the pattern
from trade consideration
because the stock was doing
something that I didn’t want
it to do and couldn’t believe it
could do: continue to go up.
This humble, textbook
symmetrical triangle
reminded me, again, that my
job as a trader is to believe
what I see, what the price is
doing, rather than believe
what I want to believe or
what “should” happen. Spot a
pattern, observe the breakout,
enter if there is a favorable
entry point, and place a stop
that limits the potential loss.
Then move on to other charts.
Repeat.
Here, we would have
risked less than 3% of our
position to enter a promising
trade by buying shares at the
closing price of the breakout
day, $62.98, and setting our
stop just below the low at, for
example, $61.11. Yet I did
not take a swing at this set-up
because I refused to accept
what my eyes were telling
me: a decisive breakout from
a textbook symmetrical
triangle. We’ll talk more
about Chicago Bridge &
Iron’s chart in Chapter 21.

Central European Media: 3-

month reversal symmetrical
triangle

A reversal symmetrical
triangle reverses the previous
trend. The reversal
symmetrical triangle in
CETV featured a textbook
shape and a hard retest after
breakout:
FIGURE 30
 From May to August
2013, Central European
Media formed a textbook 5-
point reversal symmetrical
triangle. The pattern formed
after a steep multi-year
decline in which the stock
lost more than 90% of its
value.
Prices closed above the
upper boundary on August
12. For the next four days
prices retested but did not
trade below the upper
boundary. On the fifth day
there was a hard retest where
the stock price penetrated the
upper boundary and traded as
low as $3.61. This hard retest
was tricky but also supported
the idea that the initial
breakout had significance
because even this deep retest
would not have triggered a
stop-loss order set just below
the low of the breakout day.
Also, prices reversed and
closed above the upper
boundary by the end of the
day of the hard retest.
If we had already bought
shares after the August 12
breakout, we could consider
adding a modest position to
our original position after the
hard retest. If we had not yet
entered this trade, the retest
day was a good time to enter
while setting a stop just
below the low of the retest.
Prices jumped 8.4% the next
day and surged higher for the
next 2 months.
This example is a good
trade but also a set-up that we
had to be extra careful with
for several reasons.
While CETV was not a
low-volume stock, it is a low-
price and very volatile stock.
Extra caution is warranted if
we choose to trade such
stocks. It is a good idea to use
a smaller position in this
situation. It is also perfectly
fine to avoid stocks trading
under a certain dollar amount
no matter how promising the
patterns they are forming. We
have to remember that there
will always be more great set-
ups. Look again at the
symmetrical triangle that
formed in Chicago Bridge &
Iron in Figure 29 – a humble
name, an old-school industry,
a textbook pattern, a clear
breakout, and not even a
retest of any kind to deal
with. Never forget: there will
always, always, always be
other opportunities.
We might have guessed
what our next point of caution
is. Our good friend the
quarterly earnings report.
How many times have we
said that we shouldn’t gamble
on earnings reports? CETV’s
powerful uptrend was
annihilated by a bad earnings
report. The stock dropped
54% in one day.
 There are so many basic
lessons to be repeated here.
Never bet our entire trading
account on one stock. Take
profits on all or at least most
of our position when the
measured price target is
reached. Gamble with just a
small slice of our original
position if we decide to take
an unnecessary gamble on an
earnings release. Let’s say we
were happy to sell all our
shares with a 30% gain on
this trade. Then who cares if
the stock gains another 50%
after we sold? Yes, we are
human, so we will be
somewhat disappointed. But
the trader who is successful
over the long run will take the
30% gain and move on to the
next opportunity. Because
there will always be more
great setups.
Lastly, it was possible to
interpret the CETV chart as
an ascending triangle:
FIGURE 30.1
 As we noted, some traders
prefer to interpret a price
action as a pattern with a
horizontal boundary
whenever reasonable to do so.
Note that the initial breakout
that occurred in the
symmetrical triangle was not
a breakout in the ascending-
triangle interpretation. The
decisive breakout from the
ascending triangle came five
trading days later.
 Again, there is merit in
both interpretations. The
symmetrical-triangle
interpretation allowed a trader
to enter the trade several days
earlier and the hard retest also
provided a second chance to
enter. The ascending-triangle
interpretation signalled the
trader to wait for a more
significant breakout because
it was the 8.4% price jump
that decisively closed above a
significant prior high within
the pattern. The interpretive
choice is ours depending on
our temperament and trading
style. Whichever
interpretation we choose, we
must stay under our
maximum risk with our entry
and exit points.

Chiquita Brands: 4-month

symmetrical triangle

We have another well-shaped

symmetrical triangle:
FIGURE 31
 Note that the breakout
came on a large gap up in
price. Let’s zoom in on the
breakout area:

FIGURE 31.1
 We saw how powerful
breakouts, while exciting and
possibly indicating a big
move to come, can make
entering the trade difficult or
inadvisable by forcing us to
risk a larger percentage of our
position than we would like.
For example, here, the
breakout came on a 11% one-
day jump. Fortunately, we
didn’t have to risk 11% of our
position to enter this trade.
Even entering around the
closing price of the breakout
day and setting our stop just
below the low price of the
breakout day meant risking
under 5% of our position. The
specific price action in every
breakout will be different
and, in this case, there was
significant trading within the
pattern boundary on the
breakout day to give
reasonable cushion to a stop
placed just below the low of
the day. While this stop could
still get hit by a hard retest,
the stop was reasonably far
away from the pattern
boundary and the closing
price to make, in my mind,
the trade a worthwhile risk.
Prices increased another
10% in the days after the
breakout. Then the stock
paused. And the next
quarterly earnings report was
due to be released within a
week. I would sell my entire
position before the earnings
release and book a significant
profit. I would also continue
to monitor this chart. We
don’t need to check every
hour. A quick but focused
look once a day is sufficient
to spot interesting
developments. The stock
neither surged up nor broke
down in response to the
earnings report. Instead, the
stock continued to trade
within a narrow range.
 This range-bound action
was potentially significant
because small continuation
patterns such as pennants
(small symmetrical triangles)
and flags (small rectangles or
parallelograms) can form
after the initial breakout. The
fact that Chiquita’s stock
traded within a relatively
narrow range in the days
leading up to the earnings
report and continued to do so
in the days following gave
rise to the possibility that a
continuation pennant or flag
was forming. Pennants and
flags are by definition, given
their small size, patterns with
narrow price fluctuations.
The range-bound price
action was also significant
because it offered an
advantageous place to enter
an anticipatory trade. I say
anticipatory because there
was not yet a decisive
breakout from a well-formed
pennant or flag. I do not
usually enter anticipatory
trades and I think classical
chartists should mostly trade
breakouts from classical
patterns. Still, there is value
to considering different ways
to apply classical charting
principles. We can adopt only
those methods that we feel
comfortable with. Here, we
could consider entering an
anticipatory trade because a
low-risk entry spot arose two
days after the earnings release
when the stock closed a little
above the retest low. If we
were to buy shares at this
point, and if the stock price
subsequently declined below
the lowest point of the retest,
then we would be stopped out
for a very small loss barring
any price gaps down. Instead,
the stock price jumped 7.9%
next day and broke out of a 2-
week pennant. Of course
nobody knew the stock would
jump nearly 8%. And some of
us may feel that anticipatory
trades, including this one,
blur the line between
disciplined trading of clear
breakouts and random
trading. But others may
decide to make this
anticipatory trade because
they saw a small edge. There
is no single correct way to
trade. We can choose a style
that suits us best.
It is sometimes the case
with small continuation
patterns like this pennant that
we see the pattern only after
the breakout. Hence the
usefulness of an exploratory
position that tries to
anticipate a breakout. My
guess is that most of us would
not have entered an
anticipatory position, and that
is fine. I think it would have
been reasonable to buy a
smaller than usual position
even after the 7.9% breakout.
With the earnings release out
of the way and a decisive
breakout from a pennant,
entering a smaller position
that kept our potential loss
under our maximum risk was
a worthwhile trade to make.
One last word on
anticipatory trades. I hesitated
discussing such entries
because they can lead us
away from the discipline and
strict risk management that
are so important to long-term
survival and profitability. We
may get the idea that we have
a good excuse to take larger
and reckless risks in the name
of anticipating a breakout.
This danger is why I repeat
again and again, and will
repeat again and again, that
every trade we enter must be
at a spot on the chart that
offers an advantageous
reward-to-risk possibility and
keeps our potential loss under
our maximum risk.
 It is vital for us to embrace
these cautionary principles
and to recognize that such
rules are not meant to
needlessly limit our trading.
Instead, anticipatory entries
when properly done can
reduce risk and increase
profits. They can be the
profitable outlet for
disciplined creativity.

Energen Corp.: 2-year

symmetrical triangle
This symmetrical triangle is
one of the largest patterns in
the book. Let’s first look at
the weekly chart as it
provides a useful big-picture
view of the set-up:

FIGURE 32
 Note the crash due to the
financial crisis of 2007 to
2009 when Energen, like
many stocks, lost more than
50% of its value. The stock
started to recover in 2009 and
peaked in the early part of
2011. Then the stock made a
series of lower highs and
higher lows over the next two
years. A giant symmetrical
triangle was forming. Would
the triangle launch another
upward run or start a decline?
Whichever way the stock
broke, the size of the pattern
suggested that the move
could be very powerful.
I think now is a good time
to remind ourselves of the
importance of not getting
obsessed with any set-up.
Recall our discussion on how
we need to trade with
emotional detachment. The
danger with massive multi-
year patterns like this triangle
is that we can get too attached
to them. We imagine all the
money we’ll make if a mega
pattern reaches its measured
price target. So we might
even plan to go all in. We
must never try to define our
trading career in a single
trade. If we do, our career
may end, and not in the way
we hoped. Even the most
promising, textbook-perfect,
straight-A-plus, well-
mannered, and superfood-
eating pattern must be looked
at in terms of the cold bottom
line: is there an advantageous
entry point with a favorable
reward-to-risk ratio?
Successful trading is about
patiently implementing a
repeatable process that
manages risk over many
trades.
Another fact we must
remember: all patterns can
fail any time, even after a
decisive breakout that seems
to confirm without any doubt
the significance of the
pattern. Let’s say there was a
decisive upward breakout
from a hypothetical 3-year
symmetrical triangle. We buy
shares at the breakout and we
are quickly up 15% on our
position. We are very happy
and excited. Then the stock
price starts to come back
down and soon retests the
breakout boundary. Then the
stock closes below the
boundary. We are frustrated
and hope our stop won’t be
triggered. But we are stopped
out the next day. We are
angry. How could this
happen? There was a perfect
breakout from a perfect
pattern. So we enter again
with a very large position
without any justification. The
stock continues to decline.
We double our position. The
stock will turn around soon.
We know it. The perfect
pattern won’t allow us to lose
money. The stock continues
to crash and we lose a lot of
money. The lesson is that we
must not get attached to any
single trade.
Trading well is not about
finding perfect patterns or
making money. It is doing
the right thing over and
over by trading only
advantageous set-ups and
waiting patiently when
there are none.
 Let’s return to the Energen
set-up and look at a daily
chart to get a better view of
the breakout:

FIGURE 32.1
 A closer look at the
breakout and ensuing action
shows that the breakout from
this massive pattern did not
lead to easy profits. It is true
that the stock made steady
gains for a week after
breaking out. Then prices
paused and traded in a
choppy and somewhat
downward manner for a
month. That’s a full month of
the stock going nowhere. No
easy profits so far. Then the
stock declined farther to do a
hard retest of the symmetrical
triangle’s upper boundary.
During the retest, the stock
price traded below but did not
close below the upper
boundary. This development
did not guarantee that the
pattern would work. But it
did support the view that the
upper boundary was now an
important support level and
that the initial breakout still
had significance. The
resilience of the upper
boundary was good news, but
the hard retest triggered stops
set close to the boundary,
including a stop based on the
last day rule. That’s no big
deal. Our stop served its
function and we would be out
with a small loss.
The next question is
whether we should re-enter
this trade after getting
stopped out by the hard retest.
If I were stopped out by the
hard retest on June 24, I
would have reentered this
trade around the closing price
of the retest day and set my
stop just below the retest low.
I would re-enter for the
following reasons.
The stock price closed
above the pattern boundary
after the retest. And most
importantly, the retest day
created a favorable reward-to-
risk scenario with logical
entry (closing price) and exit
(just below the lowest reach
of the hard retest) points. Let
us repeat: the fact that prices
closed above the pattern
boundary after the hard retest
did not guarantee that the
pattern would work and that
there would be no further
retests. But it did create an
entry spot with a potentially
very favorable reward-to-risk
possibility. That did not mean
we had to enter the trade, but
if we did, it did mean that we
had a justifiable reason for
the trade and that any loss
would be very small. If
another retest triggered my
stop order, then I would be
out again with a small loss
and I would then move on to
other charts. But if the stock
started to move up from here,
then my position’s upside
potential was much greater
than my potential loss barring
a price gap down. The stock
went up about 10% in the
next month. That’s a good
gain, but a month of patience
was required. Again, nothing
easy so far.
Furthermore, we are now
only days away from the
quarterly earnings report. I
almost always exit my entire
position before the next
earnings report. One
exception is when I’m sitting
on a substantial profit and
decide to keep at most about
a third of my original position
through the earnings report.
Here, if I had bought shares
after the hard retest, I would
be sitting on a 10% profit.
And I may unwisely decide to
risk a small portion of this
profit through the earnings
release. Doing so is a pure
gamble. The fact that prices
broke out of a mega pattern
and that the pattern survived a
hard retest do not predict or
guarantee that the market will
react positively to the
earnings report. Prices will do
whatever they want. In this
case, the market reacted
positively to the earnings
report. But staying in, even
with a small position, was the
wrong decision and a bad
trade.

Evercore Partners: 4-month

symmetrical triangle

Our next example presents

another situation where the
earnings report was due a few
weeks after the breakout:

FIGURE 33
 Notice the six solid price
touches with the upper and
lower boundaries. Also note
when the stock traded but did
not close outside the lower
pattern boundary. That is
called an out-of-line
movement. Remember that
prices do not have to stay
within our boundaries. The
lines we draw allow us to
visualize the price action and
help us spot logical entry and
stop points that keep us
within our risk parameters.
Patterns don’t have to be
perfect to be very useful
trading tools.
It was possible to interpret
the out-of-line movement as a
breakout attempt to the
downside from a 5-point
reversal symmetrical triangle.
And some of us may have
entered a short position when
prices broke down through
the lower pattern boundary. If
so, we would also place a
buy-to-cover stop order,
perhaps just above the high of
the day. By the end of the
trading day, however, we saw
that the stock price closed
back above the pattern
boundary. We may have
decided to exit our short
position then or, if not, we
would have been stopped out
the next day when the stock
traded above the high of what
turned out to be a one-day
out-of-line movement.
The loss we suffered from
this unsuccessful short
position would be nothing
more than a minor annoyance
if we used the appropriate
position size. We could
consider it a bet that was
worth taking because the risk
was well defined and limited.
Whether or not we entered
a short trade due to the out-
of-line movement, it was
productive to continue to
monitor the pattern. It was
clear that prices were coiling
and still possibly forming a
symmetrical triangle.
The next breakout was to
the upside. Had we bought
shares at around the closing
price of the breakout, our
position would be up by
about 7% by the time
earnings were due to be
released. That’s a good gain
in such a short period. It
would be wise and proper to
sell our entire position and
move on to other patterns.
But let’s assume that our
emotions push us to gamble
and we decide to sell two-
thirds of our original position
and keep one-third through
the earnings release. In this
case, our irresponsible and
unnecessary gamble
somewhat “worked” in that
prices initially increased but
prices soon stalled and did
not go higher for a month.
Had we chosen to unwisely
gamble on the earnings
report, we were rewarded (for
our bad and risky behavior)
with significant gains only if
we stayed patient for several
months. Prices rarely go
straight up or down. They
often build a foundation
before starting a trend and
also take frequent breaks, and
some of these foundations
and breaks take the form of
classical patterns. Remember
that not all price moves can
be explained by classical
patterns. Prices go up,
down, and sideways for any
or no reason. Not all trends
are launched by classical
patterns.

Genworth Financial: 2-month

symmetrical triangle

This pattern shows again the

utmost importance of
patience:
FIGURE 34
 After a clean breakout, the
stock stalled and traded in
narrow range for 3 weeks.
That’s right: that little area
enclosed in the small box was
three weeks. It was possible
to interpret this 3-week price
action as a small rectangle or
a continuation flag. Whatever
our label, we had to wait
patiently for almost a month
until prices broke out of it
and made large gains. If we
cannot control our emotions,
do not learn to relax, and do
not learn to step away once
we have entered a position,
there is little chance that we
would have had the patience
and peace of mind to stay
with our position until the
real uptrend began.
Of course there was no
guarantee that the uptrend
would be so powerful, or that
there would be any trend. No
one could know what would
follow.
This Genworth chart
shows perfectly that the only
things we can control are: (1)
entering a trade at a favorable
spot, (2) setting a stop that
keeps potential losses within
our risk tolerance, and (3)
then turning our attention to
other charts, projects, and
interests. The breakout was
reasonably decisive but soon
stalled. Unless we accept the
fact that we have no control
over prices and there is
nothing more we can do other
than to let the pattern play
out, we will fail in this trade
and in trading. Each bar in
that stall area represents a
day. Imagine staring at our
screen wondering and
agonizing over whether and
when the stock will continue
the uptrend started by the
breakout – for three weeks.
We cannot do it. We can, but
we’ll be physically and
emotionally spent in a few
days. If we get exhausted, we
don’t have the mental and
physical strength to stay
patient. So we may sell our
shares and watch as a
powerful trend leaves us
behind. Then we chase the
breakout at high risk because
our weak emotional state
means that we lack patience
and discipline. As soon as we
enter at a high price the stock
reverses and we are out with
a large loss. Our emotional
state continues to deteriorate
and we continue to chase
trying to make up our losses.
The result is more losses.
This is a self-destruct process
that we must avoid.
For these reasons, we must
pursue other interests besides
trading. I don’t mean we
should take trading lightly.
Trading is a serious endeavor
that will challenge our
mental, physical, and
intellectual reserves. But
being a serious trader does
not require us to obsess over
every price tick. Quite the
opposite. Proper trading
involves a lot of letting go
and, quite frankly, not caring
at a certain point. Letting go
after entering a trade and
putting in our stop order.
Remember that the small
rectangle within which
Genworth’s stock bounced
around represents three weeks
of our life. How stupid,
wasteful, and weakening is it
to worry about what a stock
will do? If the stock moves
higher, then fine. If the
pattern fails, then our loss is
limited to just a fraction of
our trading account and we
can look forward to other
opportunities.

Lions Gate Entertainment: 5-

month symmetrical triangle
Trading demands patience in
many ways. We wait
patiently for a breakout. We
wait patiently for a resolution
after a breakout. Patience also
means persistent diligence in
following a chart for weeks
and months and even years as
the price action evolves. The
next chart shows the
importance of not quitting on
a chart after a decisive
breakout stalls.
Let’s look at the weekly
chart to get an overall sense
of the pattern:

FIGURE 35
 It is a classical pattern as
elegant, well-formed, and
simple as the very first chart
we looked at. But trading is
also about the details,
specifically, advantageous
entries and loss-limiting exits.
And upon closer examination,
we had to meet successfully a
couple of stiff challenges to
trade this set-up well.
The next chart is a daily
chart that focuses on the
breakout and the subsequent
price action:

FIGURE 35.1
 The breakout from the 5-
month symmetrical triangle,
shown on the left part of the
daily chart, was decisive. The
stock rose in the following
week but soon stalled and it
looked as if there may be a
hard retest of the upper
boundary when prices
declined in late September.
But there was no hard retest
and prices made steady gains
over the next month. Two
months have now passed
since the breakout. The
quarterly earnings report was
due soon. Prices declined
sharply in the week leading
up to the earnings release.
Then prices jumped 14% on
earnings news but there was
still no resolution to the fact
that the stock had been
essentially trading in the
14.50 to 16.50 range since the
breakout. Indeed, the stock
remained in this range for
another two months.
It would have been
understandable to quit on this
pattern and move on to other
set-ups. And we should look
at set-ups where a breakout
may be imminent. But there
is also much value to
continuing to keep up with
“old” patterns because a
relatively small but powerful
pattern can develop over
several weeks. Realize the
effectiveness of a brief but
focused look at a pattern
every couple of days or so.
Here, such continuous
diligence allowed us to spot a
smaller symmetrical triangle
develop. The breakout came
on a gap up in price. We
could have entered around the
closing price of the breakout
day and set our stop
somewhere below the upper
boundary and remain well
below our maximum risk.
The stock marched higher
from here.
So in a sense this second
smaller triangle launched the
“real” uptrend. There was no
way to anticipate this
development other than to
stay patient and continue to
monitor the chart.

Lincoln National Corp.: 15-

month reversal symmetrical
triangle

This symmetrical triangle was

a reversal pattern. Here’s the
weekly chart:

FIGURE 36
 Next is the daily chart
with a focus on the breakout
and retest:

FIGURE 36.1
 The first breakout failed
when prices closed decisively
below the upper boundary
within a week. Failed
breakouts, disappointing and
jarring as they may be, do not
necessarily mean that the
pattern has also failed. We
will find that some breakouts
succeed only on their second
or even third attempt. But we
do need to move on at some
point. I will consider trading
a second breakout attempt but
will almost always move on
after the second try.
Here, the second breakout
was successful. The higher
volume and gap up in price
strongly supported the view
that this second breakout was
the real breakout. What isn’t
so clear is whether we should
trade this breakout. The gap
up meant that we would have
to chase this breakout to enter
the trade. It wasn’t
unreasonable to chase if we
bought a smaller position. Or
we could have let this
breakout go on its way
without us. There will always
be other opportunities,
including set-ups where we
don’t have to chase at all.
Lastly, note that the day
before the second breakout,
the stock closed modestly but
clearly above the upper
boundary of the symmetrical
triangle. I think that this re-
close above the boundary
offered a good chance to buy
shares and set our stop just
below the retest low. The
possible downside was
defined and limited while the
upside was potentially much
greater, which is a concise
and cogent definition of good
trading.

Cheniere Energy: 7-month

symmetrical triangle
The next example involves
another tricky breakout. The
following weekly chart shows
a textbook symmetrical
triangle that formed from
May to November 2013:

FIGURE 37
 Weekly charts are useful
because they give us
perspective and a sense of the
overall situation. But they can
hide the gritty details of a
breakout, and the
particularities of every set-up
can reveal both obstacles that
we need to deal with or avoid
as well as edges that we can
take advantage of.
The next chart, a daily
chart, reveals a tricky
breakout:

FIGURE 37.1
 The stock closed above
the upper boundary of the
symmetrical triangle on the
last trading day in November.
While not a decisive
breakout, buying shares here
with a stop just below the low
of the day was a reasonable
entry with limited risk. The
next day the stock traded a bit
below the upper boundary but
closed above it. A more
severe retest came the
following day as the stock
closed below the upper
boundary and also triggered
any stop set just below the
breakout day’s low. Anything
is possible at any point on a
chart. The stock could
continue to decline and the
pattern could fail before
evolving into a completely
different set-up. Or it could
attempt another breakout. I
think the best thing to do in
this situation, if we were
stopped out, is to simply wait
and see how the chart
develops. We didn’t have to
wait long as the stock closed
above the upper boundary the
next day. Should we buy
shares again here? Some of
us, as a matter of principle,
may decide to never trade
more than once the same set-
up. The pattern works the
first time or does not.
If we are still interested in
trading this pattern, what
factors should we consider?
The first factor is, as always,
risk management. Does the
set-up offer an advantageous
entry spot? Here, the answer
was yes. We could buy shares
when the stock re-closed
above the pattern boundary
and set our stop just below
the lowest reach of the hard
retest. Our risk was well-
defined and likely very
limited. If we got stopped out
again, then we could move
on.
Volume was another
factor to consider. The next
chart focuses on the price
action and volume in the
breakout area:

FIGURE 37.2
 The volume on the hard
retest was lower than during
the initial breakout and the
second breakout after the
hard retest. It was possible to
interpret this volume action
as hinting that there was
greater enthusiasm and
strength among buyers than
sellers. But this was just one
possible interpretation. It was
not and could never be a
certainty.
 Another factor to consider
was that although the stock
re-closed above the upper
boundary, it did so by a small
margin.
So we had to weigh the
volume action, which seemed
to favor the upside, against a
hesitant breakout, which
made another hard retest very
possible.
I would re-enter this trade
around the closing price of
the second breakout based on
the favorable volume action
and, most importantly, the
fact that my potential loss
was very limited while the
upside was much greater. In
this case, I would have been
rewarded with a 7% price
jump on heavy volume the
next day. But we’re far from
being done with this chart.
Next question: is it too late
to enter this trade after the
7% jump? We know that
powerful breakouts can make
entering trades difficult by
forcing us to chase and risk
more than we would like. The
situation is sometimes so
difficult and risky that not
trading the breakout is the
correct decision. But we need
not rule out chasing if we can
chase while staying under our
maximum risk. Here, buying
a position that was about one-
third to one-half the size of
our normal position made our
risk acceptable even if we
placed our stop below the low
of the hard retest.
And I think setting our
stop down there was better
than placing it, say, just
below the low of the day
when the stock increased 7%.
While the 7% increase on
heavy volume seemed to
confirm the pattern and
breakout, there was no
guarantee that the stock
would only go up from here.
Indeed, the stock reversed
immediately after the 7%
jump and declined over the
next week.
While this decline did not
reach the pattern boundary, it
would have triggered a stop
set just below the low of the
7% day. The stock lost all of
its 7% gain and then some.
And the stock could decline
farther and still stay above the
upper boundary. Prices could
return all the way back to the
upper boundary before
reversing and launching a
powerful uptrend.
So a reasonable spot to
place our stop-loss order is
below either the low of the
hard retest or the low of the
day before the 7% jump.
While we could place a stop
at a higher price, it meant an
increased chance that our
position will get stopped out.
Getting stopped out for a
small loss is not the problem.
The danger in this situation is
getting caught in a painful
and destructive downward
spiral. We’ll discuss this risk
next.

Yoda said something about

anger and suffering

We can get caught in a

negative spiral if we get
angry, frustrated, and greedy
after we get stopped out by
the price decline following
the 7% jump. If we simply
accept our small loss and
move on, then there is no
problem. But there is a
problem if we get obsessed
with making money from this
pattern and we rashly buy
shares again. Then we set our
stop very close to our entry
because we want to keep this
emotional trade on a short
leash and we cannot bear the
thought of losing more
money. But normal volatility
stops us out again. We get
angry and buy another
position. And so on. Our
losses pile up. The situation
become very dangerous if we
decide to simply not place a
stop-loss order because we
believe the pattern “has to
work.” A big loss results if
we refuse to get out even as
the stock continues to fall.
The ultimate danger is if we
convince ourselves that the
pattern, despite these early
difficulties, will work given
its textbook shape and
therefore go all in.
What led us to this self-
destruction? Greed and fear.
We wanted to make a lot of
money right now with this
pattern. We feared moving on
could mean never finding
another good set-up. As
ridiculous as this fear may
look to us as readers, we are
all susceptible to such short-
sightedness when we are
fearful and angry.
 Contrast this painful
experience against traders
who are unattached to the
outcome of any single trade.
Let’s say some traders chase
the breakout with a smaller-
than-usual position and set
their stop just below the low
of the hard retest. If they get
stopped out, then they are not
bothered much about losing a
small fraction of their trading
account. They know that they
have given this trade a fair
chance to work. They move
on to other opportunities.
They may not even check
back until weeks or even
months later as they are busy
doing other things. Had they
followed every price move,
they would have been
strongly tempted to sell their
position after the stock erased
all of its gains from the 7%
jump.
Finally, note how things
were far from easy even if we
had bought shares the day
before the 7% jump. We were
soon sitting on a 7% profit,
but this profit cushion did not
make weathering the ensuing
price decline easy if we were
anxiously watching the price
action. All of us are
susceptible to fear and
frustration if we watch our
profits get chipped away day
after day. We need to let go
after entering a trade.
Unfortunately, every
trader is likely to experience
this negative spiral. And we
are most likely to fall into this
diabolical trap when we
forget that there will always
be more profitable set-ups. A
good way to recover our
composure is to open this
book and see how many
intriguing patterns have
appeared in U.S. stocks in
just the past couple of years.
We should do this now:
grab pen and paper and
write “THERE WILL
ALWAYS BE MORE
GREAT SET-UPS” and
post it on the wall. Say and
believe these words every
day.

Northrop Grumman: 5-month

symmetrical triangle

The next chart shows the

situation in Northrop
Grumman from August 2012
to March 2013:
FIGURE 38
 Northrop Grumman made
strong gains up to August
2012 then stalled and traded
between $65 and 70 for eight
months. The second half of
this range-bound price action
turned into a symmetrical
triangle that launched another
strong uptrend.
The next chart focuses on
the breakout:

FIGURE 38.1
 Heavy volume
accompanied the decisive
breakout through the upper
boundary of the symmetrical
triangle. If we had bought
shares around the close of the
breakout day and set a stop
just below the low, we would
risk about 2% of our position
on a pattern that held much
promise give its size, shape,
and breakout. But, as always,
these positive factors did not
mean that the pattern was
guaranteed to work.
Indeed, prices hugged the
upper boundary for more than
a week after breaking out.
Four days after the breakout,
prices closed slightly below
the boundary. Prices
continued to trade just above
and below the upper
boundary for two more days
before breaking out of this
congestion that included four
hard retests. If we were
checking the price action
often, then we were much
more likely to lose our
discipline and sell our shares.
Then, of course, we would
have missed the upward surge
that started just days later.
Again: enter and forget.
Repeat.
Lastly, note how the hard
retests didn’t get close to
triggering a stop placed just
below the low of the breakout
day.
Principal Financial: 9-month
symmetrical triangle

The next chart includes an

early look at a very
interesting and useful pattern,
a H&S top failure pattern. I
learned this pattern from
Peter L. Brandt. We will look
at many more H&S top
failure patterns in Chapter 16.
These patterns are H&S tops
that start an upward price
move when prices decisively
close above the high of the
right shoulder.
Figure 39 is a weekly
chart that gives us the big-
picture view of the set-up:

FIGURE 39
 This stock had traded
above $50 in 2008 before
losing 90% of its value during
the global financial crisis of
2007 to 2009. The stock
recovered rapidly from the
lows of spring 2009 as it
increased five-fold in six
months. Then it traded
between $20 and $30 for 3
years. By the middle of 2012,
the stock seemed to be
forming a giant H&S top. The
left shoulder, head, and
possible right shoulder of this
potential H&S top were
clearly visible by the middle
of 2012. Note how the
possible right shoulder
formed a symmetrical
triangle. If this massive 3-
year topping pattern was
going to become a H&S top,
then we would look for the
stock to break down from this
symmetrical-triangle right
shoulder.
 The next chart is a daily
chart that focuses on the
symmetrical-triangle right
shoulder and the breakout:

FIGURE 39.1
 Instead of breaking down
through the lower boundary
of the symmetrical triangle,
the stock gapped up through
the upper boundary. The
stock went on to gain more
than 50% in the following
year.
We didn’t have to
interpret this multi-year set-
up as an H&S top failure. We
could have looked at the set-
up as a textbook 8-month
symmetrical triangle that
formed after a multi-year
trading range.
But I have two reasons for
discussing this set-up as a
H&S top failure.
First, as we will discuss in
Chapter 16, this pattern can
be very useful and powerful.
The more patterns and thus
more possibilities we know,
the more productive and
creative we can be.
Second, the possible H&S
top would have been a
massive topping pattern had it
been completed. The fact that
a pattern this big failed
suggested that the new trend
could be similarly massive.
Some of the most powerful
trends start when a stock goes
in the opposite direction from
the expected direction. That
said, some of us will prefer to
look at this set-up as simply a
symmetrical triangle. After
all, the triangle was a large
pattern on its own that could
start a powerful move.
Whatever our preferred
interpretation, our goal is to
continuously acquire
knowledge, including
different perspectives, to gain
as much an edge as possible.
A little edge can make a big
difference.
In terms of trading tactics,
we could buy shares around
the closing price of the
breakout day and place a stop
just below the closing price of
the day before rather than just
below the low of the breakout
day. In this case, we have to
modify the last day rule for
placing stops because the
breakout day did not have any
trading inside the pattern
boundary due to the gap up in
price. We could place our
stop a bit lower or even
below the low of the day
before. Our stop placement
depends on our trading style
and risk tolerance. The most
important thing is that we
stay below our maximum risk
in every trade.

Parker Drilling: 2-month

symmetrical triangle

Our next symmetrical triangle

was another instance where
volume helped us analyze the
situation:

FIGURE 40
 Volume helped us in two
ways.
First, the volume generally
declined as the symmetrical
triangle formed. One of the
requirements of a textbook
symmetrical triangle is
decreasing volume during
pattern formation. That said, I
feel that declining volume is
not an absolute requirement
and I have seen many
symmetrical triangles that
work well without a clear
trend of declining volume.
But when there is volume
confirmation, then it can be
an important factor
supporting the pattern
interpretation.
Second, the fact the
breakout occurred on volume
that was heavier than any day
during pattern formation
strongly suggested that the
pattern boundary and the
breakout through it had
significance. In fact, the
breakout day’s heavy volume
was not exceeded until a
month later when extremely
heavy volume accompanied
the earnings report.
The breakout came on an
8% price jump. As we have
seen, a decisive breakout can
be both exciting and
daunting. The 8% surge made
the breakout decisive but the
trade riskier. If I were to trade
this breakout, I would buy a
position that was about one
half of my normal position
size at around the breakout
day’s closing price and set
my stop just below the
breakout day’s low. This
trade would gain about 15%
in two weeks. Then I would
sell my shares before the
earnings release. If I were to
gamble on earnings, then I
would keep at most one-third
of my original position
knowing that the stock could
drop by double digits in
response to the earnings
report. Had I stayed in, I got
lucky as the market’s positive
reaction to the earnings report
sent the stock higher by
almost 20% in the next three
days. But remember that
getting lucky is not the same
thing as trading well by doing
the right thing. While nothing
guarantees a profit in a trade,
doing the right thing over
many trades is the best
strategy for long-term
profitability.

Rite Aid Corp.: 7-week

symmetrical triangle

Our next symmetrical triangle

formed in Rite Aid after the
stock had gone up more than
50% in two months:

FIGURE 41
 The breakout came on a
decisive 4.3% gap up. The
next day the stock went up
another 4.5%. But not many
breakouts go straight in the
anticipated direction. Here,
the stock declined 5% over
the next three days. And the
stock still had more room to
decline before touching the
upper boundary in what
would be a normal retest. So,
again, few things are as easy
as they look. The only thing
we can do is to enter a trade,
set a stop, and move on.
Let’s talk about trading
this set-up.
First, the forceful breakout
made buying shares and
setting our stop a bit tricky.
Buying shares around the
closing price of the breakout
day and setting our stop
reasonably far away meant
risking about 4.5% to 5% of
our position. Depending on
our maximum risk and
trading style, we may decide
to buy a smaller position than
usual. Let’s say we decide to
be cautious, which is always
a good approach, and buy a
position that is about half the
size of our normal position
size.
Second, where could we
place our stop? Notice that
we need to modify the last
day rule for placing a stop
because the gap up meant that
there was no trading within
the pattern during the
breakout day. Some possible
places for our stop orders are:
(1) just under the pattern’s
upper boundary, (2) just
under the closing price of the
day before breakout, or (3)
just under the low price of the
day before breakout.
A hard retest was likely to
trigger a stop placed just
below the upper boundary
and even a stop placed below
the closing price of the day
before. Simply lowering our
stop placement was not so
easy to do because doing so
meant risking even a larger
portion of our already
reduced position.
This set-up is a great
example of how a textbook
pattern and a decisive
breakout are not necessarily
the best trades. Trading is all
about advantageous entries
and loss-limiting stops. We
must not trade just because
there is a breakout. Knowing
when not to trade is an
important skill. The specifics
of the Rite Aid set-up and
breakout did not create the
most favorable entry point
and stop level. But the set-up
wasn’t so unfavorable as to
call for automatic
disqualification. We have
options. First, we could pass.
Second, we could buy a
smaller position and set our
stop somewhere below the
upper boundary. And third,
we could enter a position and
place our stop somewhere
above the upper boundary
and hope that a hard retest
does not occur. There is no
right answer. If we decide to
trade and choose either the
second or third option, we
must not get obsessed over
making money on this pattern
if we get stopped out. If I
were stopped out, then I
would move on without
trying a second time because
I know there will be many
set-ups and breakouts with
much more favorable entry
and exit points.

NxStage Medical: 6-week

reversal symmetrical triangle

Our next symmetrical triangle

was a bottoming pattern that
reversed a sharp downtrend.
Volume helped us make
sense of this pattern:

FIGURE 42
 In a textbook bottoming
reversal symmetrical triangle
that launches an uptrend, the
first major touch point would
be with the line that would
become the lower boundary,
the second touch with the line
that would become the upper
boundary, the third touch
with the lower boundary, the
fourth touch again with the
upper, and a fifth major
contact with the lower
boundary. Then the stock
would break out through the
upper boundary. In Figure 42,
we have four solid alternating
touches with the lower and
upper boundaries but we
don’t have the fifth touch on
the lower boundary. But
patterns don’t have to be
perfect to be useful and
profitable. The stock was
clearly coiling and forming a
symmetrical triangle of some
kind. Would this triangle
continue the previous
downtrend or reverse the
downtrend and start a new
uptrend?
Let’s see if volume
provided clues.
First, volume steadily
declined as prices coiled into
a triangle. This fact supported
the interpretation that a
meaningful coil was taking
place.
Second, volume was
higher on up days than on
down days. This fact
supported the interpretation
that buyers were more
enthusiastic than sellers and
thus the bias could be to the
upside, though we could
never be sure. Note how
volume spiked as the stock
went from the first touch
point on the lower boundary
to the second touch point on
the upper boundary. Volume
then declined as the stock
declined to the lower
boundary. An even larger
volume spike occurred as the
stock went up from the third
touch point to the fourth.
Volume decreased again as
the stock declined from the
upper boundary. Note prices
did not go all the way down
to the lower boundary, which
would have been the textbook
fifth touch. Finally, volume
increased as the stock broke
through the upper boundary.
A powerful uptrend followed.
 So we should be mindful
of the volume accompanying
the price action without
falling into the trap of
thinking that it is infallible.
Some cautionary points.
The chart does not fully
capture the volatile nature of
this stock. Large daily price
moves were common. We’re
happy when we’re on the
same side of a powerful
trend. But we have to
remember that sharp trends
can reverse quickly. We have
to bring to every trade the
utmost caution and prudence:
enter a trade only when the
reward-to-risk ratio is
favorable, always use stops
that limit losses, and take at
least some profits at
measured priced targets.
Also, it was easy to miss
the breakout from this
relatively small 6-week
pattern. If we missed the
breakout, then we must not
chase and exceed our risk
parameters. It is frustrating to
watch a powerful trend take
off without us. When such
frustration hits, our job is to
remember that there will
always be more opportunities.
 CHAPTER 12

Continuation
Pennant
(Small Triangle)

Pennants are small triangles

that sometimes form after a
powerful run or soon after a
breakout. We can think of
them as when stocks take a
breather before starting
another run.

Capella Education

Figure 43 is a weekly chart

that shows a 9-month reversal
symmetrical triangle that
formed from July 2012 to
April 2013:

FIGURE 43
 And the following chart,
Figure 43.1, is a daily chart
that focuses on the reversal
triangle in the bottom right
portion of Figure 43:

FIGURE 43.1
 Some of us may object
that this price action is not a
reversal symmetrical triangle.
There is something about it
that is ungainly. We might
also note that it has only four
touch points compared to the
five touch points of a
textbook reversal
symmetrical triangle. These
are valid objections. And
there is nothing wrong with
moving on to other charts if
we don’t believe in the
pattern or see anything
interesting. We have to
believe in and be excited
about the pattern’s
possibilities to trade the
pattern well using good risk
management. If we don’t see
a valid reversal symmetrical
triangle, then how can we
trade it?
Let’s stay on this point. I
am always amazed at how
often I look at another
trader’s “H&S top” or a
“descending triangle” and I
don’t see these patterns.
Sometimes I see the pattern
but they are too loosely
formed for my preference.
Remember that it is a good
idea to try to trade only
patterns that can be used as
textbook examples. Other
times I just don’t see any
price action resembling the
named pattern. We must not
trade a chart just because
another trader says there is a
pattern. The temptation to
trade another trader’s
identified pattern will be
strong if this trader is an
“expert” who appears in the
media. Some well-known
traders do offer interesting
analyses and insights, but in
my experience only a very
small portion of the charting
analysis in the media has
value.
Why might this be the
case?
First, as mentioned, we
many simply not see, for
example, the H&S top that
another trader has identified.
Such disagreement results
from the fact that traders may
have different requirements
for classical patterns. There is
room for different opinions
when interpreting charts. That
said, we should try to stick as
close as possible to Edwards
& Magee’s descriptions of
each of the classical patterns.
Edwards & Magee’s classic
text has proven to be
timeless. We should not
deviate too much from the
fundamental principles that
they have laid out.
Second, even if we agree
with another trader that a
H&S top may be forming, we
are almost certain to have
different entry and exit
strategies and also different
risk tolerances. In short, we
have to do our own
homework and stay within
our comfort zone. Don’t
worry about what others are
doing. Nobody has the single
correct method. We need to
focus on doing the right
things, namely, entering at
advantageous spots and
limiting losses. How we
accomplish these tasks is up
to us. Classical charting
offers traders different ways
to trade the same pattern. And
we should welcome the
freedom, flexibility, and
choice.
Let’s return to the Capella
chart. I would not have
identified this chart as a
reversal symmetrical triangle
until the 18% jump in
response to the earnings
report. And of course it was
impossible to anticipate this
18% gap up. Further, it was
too risky to buy shares
immediately after the
breakout because we had to
risk too much of our position
to do so. So does this set-up
have any value to us?
I think there are two
takeaways.
First, we should be open
minded. This reversal
symmetrical triangle did not
have the textbook-specified
five major touches with the
pattern boundaries and looked
a bit “off” to some of us. But
patterns don’t have to be
perfect to be useful.
Remember how the reversal
symmetrical triangle in
Figure 42 did not have the
fifth contact but still served as
a useful and tradable
interpretation of the price
action.
Second, while we could
not anticipate nor trade the
18% jump, the magnitude of
this price gap suggested the
possibility of a powerful
trend to come. This big move
arguably constituted the
decisive breakout from a
reversal symmetrical triangle.
And while the breakout was
untradeable, the stock could
form another pattern, like a
small continuation pattern,
that might offer a compelling
trading opportunity. So far we
have not committed our
money and are simply
appraising different
possibilities that may alert us
to a trading opportunity.
There was value to
continuing to watch this
chart. And we were rewarded
with an opportunity to enter
this trade through a
continuation pennant that
formed within 3 weeks of the
18% jump.
The next chart focuses on
the price action following the
untradeable breakout:

FIGURE 43.2
 On the right side of the
chart, we see a textbook
continuation pennant (or, if
you prefer, a small triangle)
forming within a few weeks
of the 18% breakout.
Small continuation
patterns can be another and
perhaps better opportunity to
enter a trade if we missed the
initial breakout or if the initial
breakout was not tradable as
in Capella. Small patterns like
this pennant can start big
moves. Here, prices increased
20% over the next week.
There would be another
opportunity to buy shares, but
not before our patience was
tested. Before we discuss yet
another entry opportunity,
let’s first note the volume
bars. Capella is a volatile and
thinly-traded stock. We must
use extra caution when
trading such stocks. The next
chart focuses on the price
action after prices broke out
from the first pennant:

FIGURE 43.3
 The first pennant produced
a 20% gain in a week. Then
prices paused and traded in a
narrow range for the next
three weeks. In fact, prices
seemed to be coiling to form
yet another continuation
pennant. There seemed to be
a decisive breakout from this
second continuation pennant
but, the next day, the
breakout lost momentum and
prices closed decisively
below the upper boundary of
this second pennant two days
later. Prices continued to
decline and plunged well
below even the lower
boundary of this failed
pennant.
This second pennant failed
decisively. But we had good
reason to trade the breakout
from the second pennant.
This trade would have been
based on a clear breakout
from a well-shaped classical
chart pattern. Remember that
a good trade is not the same
thing as a profitable trade.
Buying shares after a clean
breakout from the second
pennant was a good trade
even if the trade resulted in a
loss because the trade had a
favorable reward-to-risk
possibility. We were
justifiably, but not overly,
disappointed when the
pennant failed but we could
confidently move on knowing
that we limited our losses to
just a small fraction of our
trading capital.
Almost as important as
limiting our loss is continuing
to watch the chart. Continued
attention did not require
hourly or even daily looks at
the chart. A focused glance
every couple of days was
enough to alert us to the
possible development of
another bigger continuation
pennant. Prices broke out of
this larger pennant when
prices jumped 9% on
earnings news. Incidentally,
note that it was possible to
interpret the price action from
the failed second pennant to
the breakout from the larger
pennant as a continuation
H&S bottom with a down-
sloping neckline. But how we
label a price action is of little
importance compared to the
utmost importance of
managing our risk on every
trade, and here, it was
difficult to buy shares after a
9% jump that required us to
risk up to 10% of our
position.
As we should not hold a
position through the earnings
release, we should not have
bought Capella shares in
anticipation of a positive
reaction to the earnings news.
And by doing the right thing,
we correctly “missed” the 9%
gain. Should we buy shares
towards the end of the
breakout day? I say no
because we were out of
position. If we were to buy a
regular position around the
closing price of the breakout
day and set our stop using the
last day rule, then we would
be risking almost 10% of our
position. I think 10% is too
much to risk no matter how
exciting the set-up and
breakout. We have to
remember that the breakout
from the second pennant
failed only 6 weeks ago. And
this breakout, too, could
reverse and lead to pattern
failure. The problem is not
failed patterns. The problem
is the excessive risk I would
be taking on if I were to enter
the trade after the breakout.
Buying a smaller position is
always an effective way to
reduce risk.
The set-up tested our
resolve and psyche even if we
used a smaller position as
there was hard retest of the
upper boundary the very next
day. Again, placing our stop
reasonably far away, ideally
below the low of the breakout
day, was important. If we
tried to get away with a stop
placed closer to the upper
boundary to lose less money
if we were stopped out, then
we got stopped out and faced
a difficult situation. Do we
enter again and risk getting
stopped out again? I think it
is important that if we decide
to enter this trade after the
breakout, we should do it
right the first time: use a
smaller position and set a
wide enough stop to give our
position a fair chance to
survive normal volatility and
even hard retests. If we get
stopped out, we can move on
knowing that we gave the
trade a fair chance to work
while staying below our risk
limit.
Of course there was
another option: do not trade
the breakout, even with a
smaller position. We don’t
have to trade every breakout.
As we saw, some breakouts
are untradeable. Much effort
and discipline will be
required to stop ourselves
from chasing untradeable
breakouts, especially if the
stock is soaring and we are
left behind. While this
breakout from the larger
pennant was not completely
untradeable, it also was not
the most favorable set-up.
Even if we decided to stay
out, we could continue to
observe the chart. Several
days later we saw prices
trading in a very narrow
range and making a very tight
coil. Could another
continuation pennant, this
time a very small one, be
forming? This development
stresses the importance of
diligently going through our
charts. Simply checking in
every couple of days would
have alerted us to this 4-day
pennant.
Since breakouts from
pennants can be explosive,
one way to trade a potential
breakout from this possible
pennant was to enter a buy
stop order just above the
preliminary upper boundary
and set a sell stop order
around just below the
preliminary lower boundary.
We would risk just over 3%
of our position to possibly
catch early a powerful
breakout from this pennant.
Prices jumped 4.6% to
decisively break out from the
third pennant in three months.
If we did not want to use a
buy-stop order and deal with
its associated risks, then we
were still in a good position
to buy shares after the
breakout. Buying shares
around the closing price of
the breakout day meant
risking about 4.6% of our
position, which is much less
than the 9% we had to risk to
chase the breakout from the
large pennant. It always pays
to continuously follow a
chart’s evolution.
 CHAPTER 13

Ascending Wedge

The ascending or rising

wedge is our next classical
pattern. It has two rising
boundaries lines where the
lower boundary’s angle of
ascent is steeper than the
upper boundary’s slope.
Despite its name, an
ascending wedge is a bearish
pattern that indicates a likely
downtrend as prices break
down through the lower
boundary.

PFL Energia: 10-week

ascending wedge

Our first ascending wedge is

from PFL Energia, a
Brazilian electric utility:
FIGURE 44
 Note the generally
declining volume during the
formation of the wedge. As
we noted, volume
confirmation is not necessary
but helpful when analyzing a
pattern. Notice how the stock
traded and even closed above
the upper boundary of the
wedge. Such peeking is
common in rising wedges.
The signal to go short came
when prices closed decisively
below the lower boundary.
We could set our stop just
above the high of the
breakdown day. Finally, note
the higher volume as the
stock started to break down,
which supported the
downtrend interpretation.
Everything about this rising
wedge was by the book. Our
bottom line will be much
better if we strive to trade
only such textbook set-ups.
Oriental Financial Group: 3-
month ascending wedge

Our next ascending wedge is

another textbook pattern.
Figure 45 shows the overall
set-up leading up to the
formation of the wedge:

FIGURE 45
 Oriental Financial’s stock
had doubled in price in 10
months and then started to
form this ascending wedge.
Remember, a reversal pattern
needs something to reverse.
The next chart focuses on the
breakout area:

FIGURE 45.1
 There was a retest of sorts
as prices recovered a bit after
breaking down through the
lower boundary. But this
semi-retest did not come
close to challenging a stop
placed above the high of the
breakdown day.
The rising wedges that
formed in CPFL Energia and
Oriental Financial were truly
textbook examples. But not
all ascending wedges will be
so elegant and clean. The
most difficult aspect of
trading rising wedges is
similar to other patterns with
slanting boundaries like
symmetrical triangles and
H&S patterns with slanting
necklines: dealing with retests
on a sloping boundary. A
normal retest in a rising
wedge could keep prices
below the lower boundary yet
still go higher than the
breakout point. Such a retest
can also trigger our stop-loss
order and still stay under the
wedge’s lower boundary. The
next chart shows how a
possible retest could stay
under the lower boundary
while prices shot higher:

FIGURE 45.2
 I can think of three ways
to deal with such retests.
First, we simply move on
when we are stopped out. If
the rising wedge will not
break down cleanly, then we
are not interested in trading
the pattern again.
Second, we can attempt
one more trade if the stock
closes just under the lower
boundary after stopping us
out. If the stock continues
higher and stops us out for
the second time, then we
move on.
The third option is a
somewhat drastic but not
unreasonable choice: avoid
trading rising wedges. After
all, there are plenty of
textbook patterns with
horizontal or nearly
horizontal boundaries. It is
fine to trade, say, only
rectangles and H&S set-ups.
While I would not
categorically eliminate
patterns with slanting
boundaries, I think being
selective in general is very
good. We must find our
likings and strengths and
stick to then and don’t worry
about what others are doing.
 CHAPTER 14

Descending Wedge

Our next classical chart

pattern is the descending or
falling wedge. A descending
wedge has two descending
boundaries, with the upper
boundary declining more
steeply than the lower
boundary. It is a bullish
pattern that indicates the
stock will likely rise after
breaking out through the
upper boundary.

Owens Illinois: 6-week

descending wedge

Our first descending wedge is

from the chart of Owens
Illinois. Let’s first get an
overall view of the set-up:
FIGURE 46
 The stock rose almost
50% from December 2012 to
March 2013. Then it paused
and traded in the $24 to $28
range for the next 6 weeks.
While a descending wedge is
drawn on the chart, it was not
so clear in mid-April whether
a descending wedge was the
most useful way to interpret
the price action. The more
obvious interpretation seemed
to be a larger H&S top
forming from February to
April 2013:

FIGURE 46.1
 It was not just the price
action strongly suggesting a
possible H&S top. It was not
easy to believe that the stock
would continue to rise after
gaining almost 50% in such a
short period. It was easier to
believe that the strong
uptrend was coming to an end
that this possible H&S top
would reverse the uptrend.
On the other hand, it was also
reasonable to interpret the
price action from mid-March
to mid-April as a bullish
descending wedge.
What now?
As classical chartists, we
should not try to predict the
future. Instead, we should
strive to participate in
trends launched by classical
patterns. So the best thing to
do was to continue to observe
the chart’s evolution.
The next chart shows one
way to trade the price action:
FIGURE 46.2
 If someone asked me what
I thought about the price
action in Owens Illinois from
February to April 2013, I
would have said that it
seemed like a H&S top was
forming. But my opinion was
just that: an opinion. And
other traders had different
opinions. Some of us may
have preferred the descending
wedge interpretation.
Whatever our view of the
chart, there was no reason to
take a position unless there
was a breakout from the H&S
top or the descending wedge.
So while it is fine to have an
opinion, we must not be so
committed and obsessed with
a particular view as to blind
ourselves from the actual
price action. We have to
remain mentally nimble
despite our biases. The best
way to remain flexible is to
believe what we see and not
what we want to believe. This
is easier said than done.
If we were so committed
to the H&S top interpretation,
then we would not have seen
a small pennant develop
within the descending wedge.
We also would have missed a
strong breakout to the upside
from this pennant that
resulted in prices closing
above the upper boundary of
the descending wedge. Don’t
get me wrong: there was no
guarantee that this pennant
and descending wedge would
work as the possible breakout
could reverse at any moment
and the chart evolve into
something completely
different. But keeping an
open mind would have at
least alerted us to a possibly
compelling entry opportunity.
On the other hand, if we
were single-mindedly focused
on a bullish descending
wedge interpretation, then we
were blind to a potentially
powerful H&S top. If the
upside breakout from the
wedge reversed and failed,
yet we had convinced
ourselves that the wedge
pattern “had to work,” then
we were vulnerable to taking
risky and foolish actions,
such as refusing to honor our
stop or even adding to our
losing position as the stock
broke down through the
neckline of the H&S top.
 We might object that the
3-day pennant is too
insignificant a development
to trade on it. I sympathize
with this objection, but I
think it is also important to
look for small edges. And
trading well is about
continuously exploiting small
edges. The pennant need not
carry some deep meaning.
The breakout from the
pennant, if we chose such an
interpretation, was simply a
chance to enter this trade on
favorable terms. In exchange
for risking 2.5% of our
position, we could make far
more if our interpretation
worked. If the breakout from
the pennant turned out to be
nothing and we were stopped
out soon, then we suffered a
minor loss and we would
move on.
Let’s say that we either
did not spot or think
significant the breakout from
the pennant and descending
wedge. We wanted a more
significant signal before
going long or short. Was
another trade setting up?
Recall our brief description of
the H&S top failure pattern
above and then look at the
next chart:

FIGURE 46.3
 Figure 46.3 shows prices
closing above what would
have been the highest point of
the right shoulder in a H&S
top. This close signaled a
completion of a H&S top
failure pattern and was a
chance to buy shares. The
fact that the right-shoulder
high later served as a support
level confirmed that prices
closing above the right
shoulder was a meaningful
event supporting the H&S top
failure interpretation.
We may be overwhelmed
by the multiple interpretations
inherent in almost every
chart. We might be frustrated
at not seeing the alternative
interpretations until too late.
We must not worry. Time and
experience will improve our
ability to spot patterns and
keep an open mind at the
same time. We should take
comfort in the versatility of
chart patterns that allows for
multiple interpretations and
thus multiple entry points.
Having more than one way to
trade a set-up means that we
often have another
opportunity to enter a trade
even if we missed the first
breakout.

Parker Drilling: 10-week

descending wedge

From February to April 2013,

Parker Drilling formed the
following textbook
descending wedge:

FIGURE 47
 While the wedge had
textbook form, it required
much patience in several
ways to trade it well.
First, patience and
discipline were required to
stay out of this trade until the
dust settled from the earnings
release. The stock closed
above the upper boundary of
the wedge four days before
the earnings release. It was
tempting to enter the trade
then and rationalize this
entirely unpredictable gamble
by thinking, “the stock must
know that the earnings report
will be good since it closed
above the boundary just days
before the earnings
announcement.” This is
groundless and dangerous
reasoning.
If the market reacts
favorably to the earnings
report and pushes prices up
beyond our reach, then so be
it. We move on to the many
other set-ups that we can
trade. If the market reacts
negatively to earnings and
crashes the price down
through the upper and lower
boundaries of the wedge, then
we move on knowing that we
did the right thing by staying
out regardless of the market’s
reaction to earnings.
What is interesting is how
often the market gives us
enough time to enter a trade
rather than putting the trade
out of reach with an explosive
move. Here, the day after the
earnings announcement, the
stock traded within the same
narrow range as it did on
earnings day. Also, with the
immediate uncertainty of the
earnings release out of the
way, we had a logical entry
and exit strategy. We could
buy shares around the closing
price of the day after the
earnings release and set our
stop at a reasonable distance
away that still kept us well
under our maximum risk. The
rationale for this trade is that
the earnings report did not
cause prices to undo the
breakout from the pattern.
The breakout was still valid
and we had an attractive entry
point.
That said, the inherent
trickiness in trading a pattern
with slanting boundaries
remained. While prices
reacted calmly to the earnings
report, prices could still retest
the upper boundary and
trigger our stop-loss order yet
stay above the boundary.
Given the inherent difficulty
of trading a pattern with a
slanting boundary, I would
move on if stopped out and
not attempt another trade.
Here, the stock jumped
9% two days after the
earnings release. But the
stock did everything but go
straight up. Much patience
was again required. The stock
traded within the $4.20 and
$4.90 range for the next six
weeks. Six weeks of prices
going sideways and nowhere.
Only in hindsight is it easy to
say holding patiently was the
right thing to do for a big
gain. We have heard it before
and we must hear it again: it
is impossible to stay patient
and give a set-up time to
work (or fail) unless we turn
our attention to other charts
and other interests. My
general rule is that I try my
very best to give a trade time
to work itself out as long as
my position is sitting on any
kind of profit or is only
slightly in the red.
Patience is perhaps the
most important trait of a good
trader. But, and there is
always an exception, infinite
patience may not be always
appropriate. There will be
other set-ups that never look
back after breaking out. So
another general rule I follow
is that I may reduce my
position size, say, to half of
my original position, to free
up capital for other trades if
the stalling sideways price
action continues for more
than three weeks and a
continuation pattern does not
seem to be forming. If there
are truly promising set-ups in
other stocks, I may exit my
entire position.
In Parker Drilling, the
month-long sideways action
following the early-May
breakout would have tried my
patience. The sharp decline
into early June would be
frustrating for many traders.
But difficult moments often
offer important clues. Notice
how the early-June decline
held above the $4.10 level
and did not trade or close
below our possible initial
entry point. Prices staying
above this crucial support
level supported the view that
the early-May breakout had
continuing significance and
that there were buyers when
the stock returned to the
breakout price. The stock
started to surge a week after it
successfully stayed above this
level. If the stock failed to
hold this support level, then
not only would I have been
stopped out but I would not
have tried to trade this set-up
again. I had given the pattern
plenty of time to work and a
crucial support level had
failed. It would be time to
move on.

Stifel Financial: 10-week

descending wedge

Our last descending wedge

combined a textbook shape
with a tricky breakout:
FIGURE 48
 Prices broke out of the
descending wedge five days
before the earnings release.
Was it worth buying a
position here? We certainly
don’t have to, but if we are
looking for a quick trade, an
entry here could be
worthwhile because a stock
may run up quite a bit in the
days leading up to the
earnings report. Prices
increased by 5% in the four
days between breakout and
earnings. If we entered this
quick trade, we should sell
our shares before the earnings
release.
It is always interesting to
watch the stock’s reaction to
the earnings report.
Sometimes a stock trades as if
nothing happened by trading
with less volatility than
normal. Other times, a stock
makes a huge gap up or gap
down. And sometimes an
earnings release will lead to
great initial volatility that
settles down and clarifies the
picture. In Figure 48, the
earnings report led to a gap
down in price. However, the
stock reversed the downward
momentum by the end of the
day. The stock was still down
3% for the day, but the
momentum seemed to be to
the upside as the stock closed
near the high of the day. Had
we gambled by staying in our
position through earnings, it
was likely that we got scared
and sold near the low of the
day or simply got stopped out
for a loss. If we did not trade
through earnings, and we
should not have, then we now
had the opportunity to enter
on much more favorable
terms and with the immediate
volatility and utter
unpredictability of the
earnings report behind us. We
could buy shares around the
closing price of the day and
place our stop-loss order just
below the low.
Finally, note again the
patience required to ride the
big moves. The stock initially
surged after the earnings-day
reversal. Then it traded within
the $34 and $37 range for the
next month before breaking
through.
 CHAPTER 15

Flags and Channels

A descending flag looks like

a down-sloping
parallelogram. Flags that are
anywhere from several days
to three to four weeks in
duration are similar to
continuation pennants in that
they are often form after big
runs. Breakouts from flags
often start another strong
move that continues the
previous trend.
Descending flags usually
form after a strong move up
and are usually down-slanting
or horizontal and indicate the
possible continuation of the
uptrend. Ascending flags
form after a decline and are
usually up-slanting or straight
and indicate the possible
continuation of the
downtrend.
Edwards & Magee
specified that true flags
should not form for more than
2-3 weeks. It has been my
experience that small flags
ranging from several days to
two weeks are often the best
trades. However, I have also
found success with much
larger flags, sometimes
months in duration. Every
classical pattern has countless
variations. We can study the
following charts, learn some
of the many possibilities, and
pick the trading style that we
like. Which pattern we trade
is far less important than that
we trade each set-up using
prudent risk management.

Clearwater Paper: 7-week

descending flag

Our first flag launched a

breakout from a yearlong
rectangle. Figure 49 provides
an overall view of the set-up:

FIGURE 49
 The next chart focuses on
the breakout:

FIGURE 49.1
 Note the failed breakout
after prices traded just under
the upper-boundary resistance
level for a month. This failure
suggested that there were
many sellers at that level. So
many, in fact, that gathering
momentum for a month was
not enough to break through
resistance. Then the stock
formed a down-slanting flag.
One possible interpretation of
the price action was that the
stock was again gathering
momentum to break through
resistance. Here, a decisive
breakout from the flag also
led to a decisive breakout
from the yearlong rectangle
pattern.
There are several
takeaways with this setup.
First, a small pattern
within a larger pattern can
initiate the overall breakout
and start a big move.
Second, we must not
underestimate old resistance
and support levels. Resistance
and support levels formed
months, years, and even
decades ago can have force
today. Here, the March 2013
high served as powerful
resistance almost a year later.
Third, breakouts
sometimes succeed only after
several attempts, especially
when the breakout must
surmount a longstanding
resistance or support level. If
we have been stopped out a
couple of times due to failed
breakouts, then we may be
hesitant to try again. And it is
perfectly fine to move on.
There will be many set-ups
that will break out cleanly on
the first attempt. Here, there
were six failed breakouts in
the two months leading up to
the real breakout. Prices
traded above but failed to
close decisively above the
pattern boundary during these
failed breakouts. The real
breakout, in contrast, was
unmistakable. So another
lesson is to wait for the
unmistakable breakout
(which can still fail). The
advantage of waiting is that
the situation clarifies. While a
powerful breakout can make
entering the trade too risky, in
my experience more often
than not charts provide a
favorable spot to enter even
after a decisive breakout. And
if it is too risky to chase, then
we must have the discipline
to move on.

Cts Corp.: 6-week descending

flag

Our next flag formed after the

stock gained 50% in three
months. The following chart
provides a big-picture view of
the set-up:

FIGURE 50
 Next, the close-up of the
pattern and breakout:

FIGURE 50.1
 Let’s first note that CTS
often had very low daily-
trading volume. I always use
a smaller position with thinly-
traded stocks like CTS. Also,
the declining volume during
the formation of the flag
supported the pattern
interpretation.
The breakout was
decisive, but the follow-
through was not. There were
two retests in the next 10
days.
The first retest was a hard
retest that came the day after
breakout and led to the stock
closing below the upper
boundary. Prices did not close
below the boundary by much
but the hard retest would have
triggered a stop-loss order
placed just below the low of
the breakout day given that
the breakout day had very
little trading within the
pattern boundary. In such a
case, it is prudent to set our
stop farther away from the
boundary.
The second retest came a
week after the breakout.
While it did not touch the
upper boundary, it
nonetheless would have been
discouraging to a trader who
was impatiently waiting for a
strong uptrend and who was
anxiously watching the price
action. As always, the correct
thing to do is to enter, set our
stop, and turn our energy and
attention elsewhere. Had we
turned to other charts and
projects and forgotten about
this trade, then we would find
that the stock had broken
through the post-breakout
congestion two weeks later
and made large gains.

Patrick Industries: 10-week

descending flag

Our next descending flag

formed in another low-
volume stock:

FIGURE 51
 Some classical chartists
may argue that this pattern is
not a true flag because it is
too long in duration. We
noted that Edwards & Magee
defined flags as rather small
patterns that last no longer
than two to three weeks. I still
trade large “flags” because I
think of them as variations to
the standard small flag. More
important than the pattern’s
label is whether we can find
an advantageous entry point
and logical stop-loss point.
And I think this large
descending flag provided a
favorable trade set-up.
The next chart focuses on
the breakout:

FIGURE 51.1
 We could buy shares as
soon as prices closed above
the upper boundary or wait
for a more decisive breakout,
which came the next day. As
Patrick Industries is another
low-volume stock, we would
use a smaller position to
further limit risk. Using a
smaller position allows us to
set our stop at a reasonable
distance from the upper
boundary and still remain
below our maximum risk.

Federated Investors: 3-month

descending flag

Our next large descending

flag is one of my favorites.
Volume declined during
pattern formation and
increased during the breakout
and the strong follow
through:

FIGURE 52
Altisource Portfolio
Solutions: 5-month
descending flag

Our next flag might be called

a giant descending flag:

FIGURE 53
 We have seen how
quarterly earnings reports
affect our trading. Here, the
stock broke out and closed
above the upper boundary on
earnings news. With the
immediate volatility caused
by the earnings release
behind us, we might consider
buying shares around the
closing price. Because the
stock was up 7% on the
breakout day, we would
likely buy a smaller position
to stay within our risk
parameter. Another reason to
buy a smaller position is the
fact that Altisource Portfolio
is a relatively volatile low-
volume stock. We must
always use extra caution
when trading a thinly-traded
stock. We may be tempted to
use a large position or rashly
go all-in with thin stocks
because we think about how
fast they can move and
produce big profits. But fast-
moving stocks don’t always
move in our favor. Fast
moves go in both directions.
By the way, the giant flag
is my own label. Edwards &
Magee would likely identify
Figure 53 as a descending
channel. They wrote that the
breaking of a channel line is
not a trade signal as it may
signal only a change in the
technical situation rather than
a definite change in the trend.
They argued that traders
should wait until a classical
pattern forms after the
breaking of a channel line. I
agree mostly with Edwards &
Magee’s analysis and
prescription. Channels by
definition have slanting
boundaries and thus are
subject to all the additional
difficulties associated with
trading patterns with non-
horizontal boundaries. Also,
large channels, despite my
labeling them “giant flags,”
reflect an entirely different
price action compared to the
compact flags that Edwards
& Mage had in mind. Flags
are relatively brief rest
periods within a narrow
trading range. They usually
form after a stock has made a
strong run. In contrast,
channels, or giant flags, cover
a much larger trading range
and do not form after a strong
run.
 I will at least consider
trading channel breaks
because I have seen fast
moves come from them. As
long as I manage my risk and
stay within my comfort zone
on every trade, I am
comfortable trading patterns
in a way that the founders of
classical charting may not
have envisioned. It is fine for
us to develop our own trading
style that still follows most of
the fundamental rules of
classical charting. I consider
trading giant flags as a
relatively minor extension of
classical charting principles.
Classical charting offers us
choices. As we learn and gain
experience, we will develop
our own trading style. We
should take advantage of the
fact that classical charting
principles are flexible and
allow for personalization.
While I am open to trading
breakouts from channels, I
would much prefer to trade
breakouts from flags. I have
found it more difficult to
trade channel breakouts
compared to flag breakouts.
Thus, I move on if there is no
immediate and decisive
follow through after the
breakout from the channel.
Patience is vital in trading,
but I give less leeway to
certain set-ups. Channels are
such instances.
Cray Inc.: 4-month
descending flag

Here’s another giant

descending flag:

FIGURE 54
 The breakout day from
this 4-month channel in Cray
Inc. was an ideal spot to buy
shares. While the stock
clearly closed above the
channel’s upper boundary, it
did not do so by such a large
margin as to make entering
the trade too risky. Indeed,
the stock was up a modest
1.1% on the breakout day and
thus allowed us to risk no
more than 2% of our position
if we chose to buy shares
around the closing price of
the breakout day and set our
stop just below the low price.
It turned out that the breakout
day was not just a good day
but perhaps the last day to
buy shares as the stock
jumped almost 10% the next
day.
Is it too late to buy shares
after the 10% jump? I think
reasonable minds can differ.
Some will argue that the
initial “breakout” was not
decisive enough, that this
10% gain was the real
breakout and the better trade
signal. Others will argue that
risking close to 12% of our
position, even a reduced
position, in a single trade is
simply too much. I would
have passed on this trade if I
had not bought shares at the
initial breakout. Again,
reasonable minds will differ.
If we decide to buy shares
after the 10% jump, then we
must significantly reduce our
position size to stay under our
maximum risk.
Cray made strong gains
after the breakout,
culminating in a 39% gain on
earnings news. Before we say
“see, that’s why it’s worth
gambling on earnings
releases,” we have to
remember that the large gain
could just as easily have been
a huge loss.
Olin Corp.: 7-month
descending flag

As in Figure 54, our next

descending giant flag pattern
featured a modest but clear
breakout followed by strong
gains:

FIGURE 55
 There was a retest a week
after breakout but the retest
did not threaten a stop placed
below the breakout day’s low.

Hilltop Holdings: 5-month

descending flag

We have another textbook

channel:

FIGURE 56
 The breakout was very
decisive – up almost 5% on
the day. This strong gain
meant that some of us,
depending on our risk
tolerance, would have bought
a smaller position to trade the
breakout. I would have used
my regular position size
because I thought the set-up
and breakout were very
promising. First, the upper
boundary had clearly been
acting as a strong resistance
level as it rejected at least five
attempts to break above it.
Second, the breakout was
decisive on volume that was
much higher than on previous
days. Third, because the
earnings report led to the
breakout, entering around the
closing price of the day and
after earnings had been
released meant that we did
not have to deal with the
immediate volatility of
earnings news. Lastly, the
breakout from the channel
also meant a breakout from a
small H&S bottom within the
channel. I am more confident,
though never certain, about a
trade when a smaller pattern
launches a breakout from a
larger pattern.
Buying shares around the
closing price of the breakout
day and placing a stop below
the low price meant risking
about 5% of our position.
Five percent may be the
upper limit of our maximum
risk for a single trade. We
may feel more comfortable
buying a smaller-than-usual
position. As I said, I give less
leeway when trading channel
breakouts. If they don’t start
working immediately, then
I’m out and looking for other
set-ups. Whether or not we
decide to trade channel
breakouts, we can benefit by
looking for smaller patterns
that can launch breakouts
from larger patterns.

Companhia Siderurgica
Nacional: 4-month
descending flag

The last giant flag we’ll look

at is a set-up that I think
Edwards & Magee would be
interested in because it had a
textbook classical pattern that
formed after the breaking of
the channel boundary. The
next chart shows SID, a
Brazilian steel maker,
forming an intriguing double-
pattern set-up:

FIGURE 57
 The eventual H&S
bottom’s left shoulder and
half of the head formed inside
the channel. The rest of the
H&S bottom formed after
prices broke above the upper
boundary of the channel.
Prices first closed above the
neckline of the H&S bottom
by the smallest of margins.
After this hesitant breakout,
prices seemed to gain
momentum in the next two
days to possibly start a strong
run. Instead, three days after
the indecisive breakout,
prices plunged but did not
close below the neckline in a
difficult retest.
On the breakout day, there
was very little trading below
the neckline. Strictly applying
the last day rule meant
placing a stop just below the
breakout day low, very close
to the neckline and likely to
be triggered by a hard retest
or even normal volatility. In
fact, the hard retest here
triggered such a stop-loss
order. So the specificities of
this set-up and breakout
called for modifying the last
day rule to place our stop
lower, say, somewhere below
the closing price of the day
before the breakout. Doing so
still meant that we were
risking only about 3% to
3.5% of our position to trade
a very promising pattern. The
next chart zooms in on the
retest area:

FIGURE 57.1
 Let’s say we were stopped
out by the hard retest. Should
we consider re-entering the
trade? I think so. While prices
plunged below the neckline at
the beginning of the trading
session, they decisively
closed above the neckline at
the end of the retest day. That
prices closed above the
neckline suggested the
possibility that the pattern
and breakout were still valid.
It is important to understand
that prices staying above the
neckline did not guarantee
anything as prices could
plunge the next day. But the
important thing was that this
development provided a
logical entry and exit set-up.
We could buy shares around
the closing price of the retest
day and set our stop below
the lowest reach of the hard
retest. Again, there was no
guarantee that another retest
would not go farther below
the first retest. But entering at
this spot meant that our risk
was defined and likely
limited while the possible
upside was greater. The stock
made strong gains in the
weeks and months following
the hard retest.
 CHAPTER 16

H&S Top Failure

As we started to discuss in
Chapter 11, a H&S top failure
pattern is when a stock forms
a possible H&S top but rather
than breaking down through
the neckline it instead goes up
and closes above the high of
the right shoulder. A decisive
close above the right shoulder
can provide a buying
opportunity.

Avago Technologies: 3-
month H&S top failure

Let’s first get a big-picture

view of our next set-up. The
next chart is a weekly chart
that shows Avago
Technologies doubling in
price from the spring of 2010
to the spring of 2011 and then
pausing and trading between
the $30 and $40 range for the
next two years:

FIGURE 58
 Avago Technologies
formed a giant 14-month
symmetrical triangle during
the second half of this range-
bound period. Let’s now look
at the daily chart that focuses
on the breakout from the
symmetrical triangle:

FIGURE 58.1
 As we have learned, some
breakouts are so powerful
that they are untradeable, at
least until another tradable
pattern, such as a
continuation pennant, forms.
Here, the quarterly earnings
report led to an unpredictable
10% jump and breakout from
the giant symmetrical
triangle. It was a decisive
breakout, but it was not, in
my opinion, a tradable
breakout. I would not have
bought shares even after the
volatility surrounding the
earnings release had passed
because entering after the
breakout meant risking close
to 10% of my position. As of
now, the set-up and breakout
did not provide a favorable
entry spot. And, as we know,
we should not buy shares
before the earnings release
and hope that the market will
react positively to the
earnings news. This 10%
increase could have been a
10%, 20%, or larger crash.
Nobody knows how the
market will react to earnings.
We must wait and see how
the chart plays out after the
earnings report.
Two weeks after the
breakout, a retest challenged
but did not penetrate the
upper boundary. Then stock
traded between $35 and $40
for the next two months.
There was no follow through
after the explosive breakout. I
have seen this scenario often
and it is another reason why
we must be very careful if we
decide to chase a breakout. If
we had bought a full-size
position around the closing
price of the breakout day,
then we were likely to
become very frustrated as
prices stalled. We were
susceptible to anxiously
watching every price tick
because we did not want to
lose 10% of our position. As
it is impossible to remain
relaxed and detached while
watching a stock’s every
move for days or weeks (let
alone months), we get tired of
waiting and sell, likely for a
significant loss.
So if we are going to
gamble and chase, we should
use a significantly smaller
position and place our stop-
loss order at a reasonable
distance away from upper
boundary and then forget
about the trade. No amount of
wishing, hoping, and screen-
gazing will make the trade
work. Prices will take their
time to do whatever they
want to do.
Whether we decided to
wait or buy a small position,
we would have found three
months after the breakout that
not only had prices failed to
break out of the congestion
but also that a H&S top
seemed to be forming. What
was happening? How could a
reversal pattern form so soon
after what seemed like a
decisive breakout from a
giant 14-month symmetrical
triangle? Of course patterns
can fail anytime. And this
once-promising set-up was
now not only frustrating but
also potentially very
dangerous for those who were
unwilling to accept the
possibility that the pattern
might fail.
Then we remember: every
H&S top can become a H&S
top failure. Every pattern can
fail. A promising ascending
triangle can fail and prices
plunge down through the
rising lower boundary instead
of breaking through the
horizontal upper boundary.
An upside breakout from a
rectangle can reverse and
prices can shoot down
through the upper boundary
and then even the lower
boundary. And so on. I have
found H&S top and bottom
failures to be particularly
useful trading tools.
More trading opportunities
result from knowing and
being open to different
possibilities. Charting is
about possibilities. If the
H&S top worked and prices
broke down through the
neckline and then the upper
boundary of the giant
symmetrical triangle, then we
would conclude that the
initial breakout was no longer
valid and that the giant
symmetrical triangle failed. If
we had bought shares after
the 10% jump, then we would
be stopped out for a
manageable loss. Whether we
bought shares or not, we
would move on.
Here, the H&S top failed
and became a H&S top
failure pattern when prices
closed above the highest
point of the right shoulder.
An earnings reports led to the
completion of the H&S top
failure pattern just as it led to
the breakout from the giant
symmetrical triangle three
months ago. If we had bought
shares after the breakout from
the symmetrical triangle, then
we would have sold our
shares before the latest
earnings report to watch from
the sidelines. Once the dust
settled from the earnings
release, we found that the
H&S top failure pattern
completed and created a good
opportunity to re-enter the
trade. And of course it was
also a good opportunity to
buy shares for the first time.
We could buy shares around
the closing price of the
breakout and place a stop
somewhere below the low
and risk less than 1% of our
position for a promising chart
development. But, as always,
patience was required. The
stock traded in a very narrow
range just above the right
shoulder for two weeks
before making a powerful
run.
A clue that suggested that
a H&S top failure pattern
could develop was when the
price decline in mid-August
2013 stayed above the
support level established by
the retest in mid-June. A
H&S top pattern was still
possible, but so was a H&S
top failure pattern. Trading is
all about being open to
different possibilities and
trading according to the
actual price action rather than
our wishes or biases. This
chart was undeniably
interesting: the 3-month
congestion after the breakout
from the symmetrical triangle
took the form of a 3-month
H&S top failure pattern,
which finally launched the
post-breakout follow through.
Whatever our initial
approach to this set-up,
patience was the vital
ingredient for trading it well.
We had to be patient while
the giant symmetrical triangle
developed and launched a
breakout. We needed patience
not to chase the initial
breakout. If we chased the
breakout with a small
position, then we needed
patience and discipline to get
out before the next earnings
report. And we needed to be
patient after we entered the
trade upon the H&S top
failure. Be patient.

Crane Co.: 10-week H&S top

failure

Let’s again start with an

overall view of the situation:
FIGURE 59
 Crane Co. made a
powerful run from 2012 into
2013 and then seemed to be
possibly forming a significant
H&S top pattern.
The next chart focuses on
this possible H&S top
pattern:

FIGURE 59.1
 By the middle of April we
saw a well-formed possible
left shoulder and head as well
as a horizontal neckline. By
late April we also had a half-
formed potential right
shoulder. We were justified in
suspecting a possible H&S
top that might reverse the
previous uptrend. But we also
should have kept an open
mind and remembered that
every H&S top could become
a H&S top failure. We had to
stay mentally flexible and be
willing to accept the actual
price action. Such rules seem
commonsensical but are often
difficult to follow. Thus, we
may have been jolted when
prices closed above the
possible right shoulder with a
gap up in price. Not all price
gaps are significant. For
example, some thinly-traded
stocks have price gaps almost
daily. Here, however, the
price gap seemed very
significant because it
occurred in a stock that had
just a few price gaps in the
last four months and it was
the gap up that vaulted the
stock above the right shoulder
high. Thus, this gap up was
very possibly a breakout gap
that completed the H&S top
failure pattern rather than
simply a random price action.
This interpretation was
supported by subsequent
developments. First, prices
made steady gains over the
next three weeks. Second,
prices stayed comfortably
above the right-shoulder high
when prices decline into late
June. It was now reasonable
to conclude that the right-
shoulder high had been a
significant resistance level
before the gap-up breakout
and that now it had become a
support level. Previous
resistance often becomes
support, and prior support
resistance. We’ll further
discuss support and resistance
in Chapter 21.

Facebook, Inc: 10-week H&S

top failure

The next set-up combined a

H&S top failure with an
overlapping H&S pattern,
another pattern that I learned
from Peter L. Brandt:
FIGURE 60
 After making a strong run,
Facebook formed a H&S top
that seemed ready to push
prices down. A decisive
breakdown through the
neckline seemed to complete
the pattern and would have
justified shorting shares. But
the decline lasted only a day
as prices reversed
immediately and closed
above the neckline within two
days. Prices continued to go
up, paused at the level of the
right shoulder high, declined
a bit, then burst through the
right shoulder resistance
level. The stock had
completed a continuation
H&S bottom. Note how the
right shoulder of the H&S top
constituted the left shoulder
and part of the head of the
H&S bottom. Peter L. Brandt
calls this an overlapping H&S
pattern.
This price reversal need
not alarm us. Yes, we would
have lost money if we shorted
Facebook shares upon the
completion of the H&S top
pattern. But our loss was
nothing more than a minor
one if we used prudent money
management. We could have
channeled our mild
disappointment to finding
other set-ups. And a good set-
up could be found on the
same chart less than two
weeks later. In the process of
forming a H&S top failure
pattern, the chart also
produced an overlapping
H&S pattern, which was a
small pattern that was easy to
miss. We cannot and do not
have to find every tradable
pattern. Even if we could, we
cannot and should not trade
every one. Beginners,
especially, should not worry
about missing patterns. We
will get better.
Kindred Healthcare: 6-month
H&S top failure

The next set-up shows why it

is so important yet sometimes
so difficult to believe what
we see rather than what we
want to believe.
The following chart shows
Kindred Healthcare doubling
in price from summer 2012 to
summer 2013 and then
forming a possible H&S top
from May to November 2013:
FIGURE 61
 The next chart focuss on
the possible H&S top that
seemed poised to reverse the
powerful uptrend:

FIGURE 61.1
 A well-defined H&S top
was my first, second, and
third impression. The
symmetry of the left and right
shoulders in duration, size,
and shape was textbook. I
also noticed that the head of
this 5-month H&S top was
itself a successful H&S top. I
am always fascinated by such
a pattern within a pattern. It
was easy and comfortable to
be committed to the H&S top
interpretation. And it is fine
to have an opinion. What is
dangerous and costly is to be
so attached to that opinion as
to blind us from the actual
price action. If we thought
that a textbook H&S top was
forming, then we had to re-
evaluate the situation when
prices decisively closed
above the right shoulder high.
This level was also the
neckline of the small H&S
top that formed the head of
our beloved H&S top
interpretation. It was also the
high of the left shoulder. A
decisive close above this
significant level signaled the
need to re-think our
interpretation and trading
strategy. If we had
preemptively entered a short
position, then we should have
covered our position. If we
were still waiting for the
stock to break down through
the neckline of the H&S top,
then we should consider
buying shares instead.
Experienced traders
understand the importance
of mental flexibility. It helps
them overcome their biases
and accept and trade the
actual price action.
Nimbleness allows them to
recognize that the
disappointing failure of a
potentially textbook H&S top
could mean a profitable trend
in the other direction. Mental
flexibility allows us to take
advantage of a rapidly
changing situation.

Extra Space Storage: 6-month

H&S top failure

The next set-up also made it

easy to believe that a trend
reversal “had to happen.”
First the big-picture view of
the situation:

FIGURE 62
 After doubling in price
over 15 months, Extra Space
Storage seemed to be forming
a large H&S top that could
reverse the uptrend.
The next chart focuses on
the possible H&S top that
was forming:

FIGURE 62.1
 Prices did not break down
through the neckline of the
H&S top. Instead, the
possible right shoulder of this
seeming H&S top turned into
a smaller continuation H&S
bottom that launched another
upswing. This set-up may
also be called an overlapping
H&S pattern.
 CHAPTER 17

Double Bottom

Among the classical patterns,

the double bottom (and
double top) pattern is perhaps
the most carelessly talked
about price action. But
Edwards & Magee laid out
quite specific requirements
for the double bottom and
top, and true double bottoms
and tops are rare.
One requirement is that
the two bottoms be at least a
month apart. Another is that
the price increase between the
first and second bottoms
should be about 20%.
Edwards & Magee said that
the time requirement, that the
bottoms be at least a month
apart, is more important than
the height of the rise and that
most true double bottoms
have bottoms that are two to
three months apart. They also
said that the greater the time
between the two lows (or
highs for a double top), the
less important the
requirement for a significant
price increase (or decrease for
a double top).
These requirements are
not absolute and Edwards &
Magee recognized that there
are many examples that
deviate from the textbook
requirements. That said, we
should try to adhere to the
textbook requirements for
double bottoms and tops as
much as possible given that
they are prone to much
misuse and mislabel. My
personal requirement for
double bottoms and tops is
that the two lows or peaks be
at least two months apart.

NutriSystem: 7-month double

bottom

Our only double bottom is

one of my favoriate patterns
from the last couple of years.
It formed in NutriSystem
from November 2012 to June
2013:

FIGURE 63
 The two bottoms occurred
five months apart, fulfilling
the key requirement specified
by Edwards & Magee. The
price rise between the
bottoms was almost 30%,
meeting another requirement
for a legitimate double
bottom. The breakout was
decisive and was followed the
next day by a gap up.
There were two main
challenges to trading this
pattern well.
First, the wait: five months
between the two bottoms and
another two months until the
breakout. A double bottom by
definition does not form
overnight. Some patterns, like
flags, last only three or four
days before starting a
powerful run. In contrast,
double bottoms reflect an
extended process during
which a stock’s long-term
downtrend reverses as buyers
slowly accumulate shares
from tired and sometimes
demoralized sellers who have
seen the stock lose a lot of its
value over an extended
period. Again, patience is the
trader’s best friend.
Second, diligence. We do
not have to check every hour
the progress of a potential
double bottom. The skills
required are long-term
discipline and diligence:
cycling through our stock list
regularly over weeks and
months as we look for good
set-ups while keeping track of
interesting developments
such as a potential double
bottom forming. We will talk
more about our day-to-day
routine in Chapter 28.
And if we missed the set-
up and breakout? Let it go.
There will always be other
opportunities.
 CHAPTER 18

Horn Bottom

A horn bottom is another

interesting and useful though
rare pattern. Edwards &
Magee did not mention horns
in their book but Richard
Schabacker did in his. And
Peter L. Brandt in his Diary
of a Professional Commodity
Trader specifies the
requirements of a horn
bottom: a major low followed
by two higher lows
intervened by two higher
highs.

Sina Corp.: 7-month horn

bottom

The following chart is a

weekly chart that shows the
overall set-up for our first
horn bottom:

FIGURE 64
 The stock went up more 7-
fold from the financial crisis
low in the spring 2009 to the
spring of 2011, going from
less than $20 a share to above
$140 a share. Then it formed
a 5-month reversal
symmetrical triangle and lost
more than 70% of its value
over the next 20 months and
was trading at about $40 a
share in December 2012.
The next chart focuses on
the horn bottom that formed
after the December 2012 low:

FIGURE 64.1
 We have a major low (#1),
followed by a peak (#2) and
decline to a higher low (#3),
and rally to a higher peak
(#4) and another decline to a
yet another higher low (#5).
A key requirement is that
there must be some overlap
between the decline from #2
to #3 and the decline from #4
to #5. The pattern completed
with a breakout above the
second peak (#4).
 I have found horn bottoms
to be useful analytical and
trading tools despite their
relative rarity. When a stock
is trading in a sort of range
but its bottoms and peaks do
not line up exactly as in a
rectangle, I know that a horn
pattern is an alternative and
perhaps better interpretation.
We must keep an open mind
when analyzing the price
action, and being aware of
different possibilities helps us
stay mentally flexible.

Gollinhas Aereas
Inteligentes: 2-month horn
bottom

Our next horn bottom was

much smaller than our first
but still produced a powerful
trend. The next chart gives us
the big-picture view:

FIGURE 65
 The stock was trading
above $7.50 per share in the
early months of 2013 before
crashing to less than $2.75
per share by early July.
The next chart zooms in
on the horn bottom pattern:

FIGURE 65.1
 Note how this horn bottom
fulfilled the pattern
requirements. Just as
important was the fact that
this horn bottom formed
where and when it was
supposed to: after a long,
disheartening price decline. A
horn bottom is a reversal
pattern. And reversal patterns
need something to reverse,
such as this long price
decline.
 CHAPTER 19

Diamond

The diamond is our next

pattern. Diamonds can be
continuation or reversal
patterns. This versatility
makes sense since the second
half of a diamond pattern is a
symmetrical triangle, and a
symmetrical triangle can be
either a continuation or
reversal pattern.
Figure 66 provides the
overall set-up surrounding a
6-month continuation
diamond pattern in Susser
Holdings:

FIGURE 66
 Note the two-year reversal
symmetrical triangle in the
bottom left of Figure 66 that
launched a big uptrend. After
the stock gained more than
300% over the next two
years, it paused and formed
the following diamond
pattern:

FIGURE 66.1
 The next chart zooms in
on the breakout area:

FIGURE 66.2
 The upper boundary had
five solid touches before
prices finally closed above it.
Buying shares around the
closing price of the breakout
day and placing a stop just
below the low meant risking
about 4% of our position.
There was no immediate
follow through as there was a
hard retest the day after the
breakout and prices traded
near the boundary for a full
week. Patience, as usual, was
required.
Why not just call this set-
up a symmetrical triangle?
We can. After all, we would
trade a breakout from a
diamond in the same way as
we would trade a breakout
from a symmetrical triangle. I
still think there is a good
reason for charting this set-up
as a 6-month diamond rather
than a 3-month symmetrical
triangle. The longer the
consolidation or congestion
period, the more likely it is
that the breakout and ensuing
trend will have staying
power. A pattern’s size is
never a guarantee that a
pattern will work well or
work at all. But it is an
important factor to consider
when we are choosing among
different set-ups. I’d rather tie
up my money in a larger
pattern with a larger
measured price target than in
a smaller pattern.
Diamond patterns are
relatively rare. We will look
at another textbook diamond
pattern in Chapter 29.
 CHAPTER 20

Second and Third

Effort

Sometimes a stock breaks out

only after several failed
attempts. Let’s take a look at
the following ascending
triangle that formed in United
Community Banks:
FIGURE 67
 It is a small but relatively
well-defined ascending
triangle. I think the first
“failed” breakout was just an
out-of-line movement. So far
we have seen so many
textbook patterns with precise
boundaries that it is easy to
think that prices must stay
within the lines we draw. But
this example reminds us that
patterns are not perfect. And
they don’t need to be to be
useful trading tools. We must
allow a certain amount of
leeway as we draw patterns to
make sense of the price
action. Still, it is remarkable
how often prices seem to
respect our lines.
The stock tried to break
out two weeks after the one-
day out-of-line movement but
was turned back. This failure
could have been somewhat
alarming to traders expecting
an upside breakout given that
the breakout failed on heavy
volume. If a breakout could
not be achieved on heavy
volume, then perhaps the
pattern was destined to not
work. Such worrying is
pointless as no one knows
what prices will do. If the
pattern fails, then so be it.
The first failed breakout
shows why it can be
advantageous to wait before
entering a trade. Most
breakouts, even decisive
ones, give traders time to
enter at a favorable spot
towards the end of the
breakout day. The real
breakout here, on the second
attempt (or third attempt if we
treat the out-of-line
movement as a failed
breakout), was decisive and
buying shares around the
closing price and placing a
stop just below the low meant
risking about 2.8% of our
position.
 Stay patient and wait for
the pattern to prove itself.
 CHAPTER 21

Support and
Resistance

If I had describe the essence

of good trading using the
fewest words possible, then I
would say “limit losses.” If I
were given up to five words, I
would add “support and
resistance.”
The boundaries, horizontal
or slanting, of all of the
patterns we have analyzed are
support and resistance levels.
Breakouts go through support
and resistance. Retests re-
challenge support and
resistance. Patterns fail when
existing support and
resistance levels fail. Charts
evolve when new support and
resistance levels form. And
prior resistance often
becomes support while prior
support becomes resistance.
I find it amazing how well
support and resistance levels
perform their function. They
don’t work every time, but
often enough to make
classical charting possible
and worthwhile. I also find it
fascinating how support and
resistance levels established
years ago continue to work
today.
The following examples
show just how resilient
support and resistance can be.

Chicago Bridge & Iron

The next chart is a weekly

chart that shows the overall
situation:

FIGURE 68
 Note the pre-financial
crisis high and how the stock
lost more than 90% of its
value over the next year. The
stock recovered remarkably
over the next four years and
approached the pre-financial
crisis high.
As we see in Figure 68.1,
the stock tried to close above
the old high reached more
than five years ago. But
heavy selling turned back the
stock. Was the remarkable
uptrend over or would the
stock make another attempt to
break above the old high?

FIGURE 68.1
 The old-high-turned-
resistance rejected another
breakout try two months after
the first attempt. And no
tradable pattern seemed to be
forming on the chart. But
after another month, we saw
that a possible symmetrical
triangle was forming. Would
the triangle reverse the 4-year
uptrend or launch another
uptrend?
Let’s discuss how our
emotions and prejudices, that
is, being human, can affect
our analysis and trading of
this set-up. We now know
that this symmetrical triangle
launched another upleg to
continue this incredible run.
But let’s try to get an honest
sense of what our bias would
have been if we were looking
at this chart as it was
developing. I’ll tell you my
bias. Very simply, I wanted
the symmetrical triangle to
reverse the 4-year uptrend
and start a downtrend. I
wanted a breakdown so much
that I convinced myself that a
trend reversal must happen
because it was the right thing
to happen. It was a case of
believing what “had to
happen” rather than the actual
price action.
Why did I want the trend
to reverse?
To be fair to myself, the
stock did have an incredible
run. Surely, I thought, the
stock is too tired to start
another uptrend. It failed
twice, after all, to break
above the all-time high
establish five years ago.
Going down would create a
nice symmetry: two nice
peaks 5 years apart that were
both followed by momentous
price declines. And, finally,
haven’t those lucky investors
and traders in Chicago Bridge
& Iron have had enough
gains?
Let’s examine this
ridiculous yet, if you will
allow, very human sentiment.
Money we did not make is
not money we lost. We will
miss many set-ups that
become big winners, but we
don’t lose money when we
miss a trade. And nobody
knew during unsettled days of
the 2007-2009 financial crisis
that Chicago Bridge & Iron
would gain so much in the
next 5 years. So why might
we, and I’ll shift to “we”
from “I” because I don’t want
to be too harsh on myself,
feel this way? Answer must
be envy, no? We wanted that
14-fold gain. Never mind that
almost everyone was too
scared to go anywhere near
the stock market during the
financial crisis. Never mind
that the company could have
gone bankrupt and wiped out
shareholders. Never mind that
we might not have had the
investing or trading skills
then to take advantage of this
“opportunity.” Wishing we
were part of this huge gain is
like wishing we bought
Microsoft shares in 1986
when the company went
public. In short, it is a silly
and juvenile wallowing in
fantasy.
We must always try to
prevent our emotions from
blinding us from the actual
price action. But we are
human, and thus we have a
remarkable ability to ignore
reality. I did not believe my
eyes when the textbook
symmetrical triangle
produced a decisive breakout
to the upside with immediate
follow through. So I did not
buy the breakout. I watched
the stock go up and up and
waited for the stock to crash
because it “had to” go down.
My hope is that this example
of my strenuous ignorance
will motivate others to always
be on guard against their
emotions. Believe what you
see, not what you want to
believe.
Another lesson is that
sometimes a stock will break
out of a classical pattern
before breaking through a
long-term resistance or
support level. I compare it to
an airplane slowly building
up speed to gather the energy
and momentum to get
airborne. We saw such a
build-up in the flag pattern
formed by Clearwater Paper
Corp., discussed in Chapter
15, that launched a breakout
through multi-month
resistance.

Johnson & Johnson

Here’s another example of

stock gathering momentum
for a breakout. First, let’s
look at the weekly chart to
get an overall sense of the
situation:

FIGURE 69
 The next chart focuses on
the 2-month symmetrical
triangle that formed just
under the resistance level on
the right side of Figure 69:

FIGURE 69.1
 Note the textbook
symmetrical triangle and
breakout. But how to deal
with the looming earnings
release? If we had bought
shares around the closing
price of the breakout day,
then we were sitting on about
a 3% profit the day before the
earnings report. We should
exit our position for a modest
profit and move on. Because
Johnson & Johnson is a
relatively stable stock with a
strong financial position
based on a rock-solid
business, we could argue that
there is a stronger case for
holding a small position
through earnings. Even a
negative market reaction to
earnings probably won’t
crash the stock by much.
However, while Johnson &
Johnson is a solid company,
we must still be prudent and
not gamble on earnings.
 In any event, the lesson
here is not how to trade
through earnings. Our policy
towards earnings remains the
same: do not trade through
earnings, and, if we do, we do
so with a drastically scaled-
down position that will not
hurt us much if the stock
crashes on earnings. The real
takeaway is to look for
patterns that may form near
powerful resistance and
support levels.
Seagate Technology

Our final chart of this chapter

shows again the importance
and ubiquitousness of support
and resistance, and how
previous support can become
resistance and vice versa:

FIGURE 70
 Support and resistance
levels don’t always work, but
they work well enough to be
more than mere coincidence
and to serve as a foundation
of classical charting and
prudent trading. And when
they don’t work, our stop-loss
orders will exit us from the
trade for a minor loss.
Trying to find the perfect
trading system, one that
guarantees that most trades
will make money, can be
irresistible, especially when
we are on a losing streak.
That is the wrong approach
and almost certainly will lead
to bigger losses. Returning to
the basics, such as never
chasing a breakout and
focusing on support and
resistance, is the most fruitful
thing to do when we are
suffering through a losing
streak. We have to remember
and accept the fact that losing
streaks are part of trading. All
traders experience them. But
the best traders trade in a way
that even 20, 30, or more
losses in a row will not drain
their trading account by
much.
 CHAPTER 22

Pattern within a
Pattern

We have already looked at

many pattern-within-pattern
set-ups. I think they are so
interesting and useful that we
should devote a separate
chapter to them.
Boeing

The next chart is a weekly

chart that shows a 15-month
continuation H&S bottom in
Boeing:

FIGURE 71
 Boeing made strong gains
from the second half of 2011
to early 2012. Then it stalled
for 14 months as it could not
break above the $78 level. By
early 2013, it seemed Boeing
had been forming an
intriguing continuation H&S
bottom with an abbreviated
right shoulder.
The next chart is a daily
chart that focuses on right
portion of this possible
continuation H&S bottom:

FIGURE 71.1
 The right shoulder of this
continuation H&S bottom
developed in the form a 2-
month symmetrical triangle.
We had several opportunities
to enter this trade. We could
buy shares as soon as the
stock closed above the upper
boundary of the symmetrical
triangle. Or, we could have
waited until the stock
decisively broke above the
horizontal neckline of the
continuation H&S bottom.
We could have entered even a
day after the breakout
through the neckline.
We should always look for
smaller patterns that can start
the breakout from a larger
pattern. Patterns like this
symmetrical-triangle right
shoulder can help us
understand the overall price
action and even provide an
earlier opportunity to enter
the trade. We have to keep
our minds open with a
creative mindset to take
advantage of these additional
clues.
One of the best ways to
stay mentally flexible is to be
always drawing different
trendlines and boundaries to
see the various ways to make
sense of the price action. Just
as it is crucial to write down
our ideas or risk forgetting
them and lose the chance to
develop them later, drawing
pattern boundaries using our
charting program helps us
understand the price action
and also helps us spot and
keep track of emerging
patterns. This monitoring-
function is very important.
While the initial boundaries
we draw will often need to be
redrawn as patterns evolve,
they can also work from the
beginning. We are less likely
to miss breakouts from the
more modest-sized patterns,
like this two-month
symmetrical triangle, if we
have already framed the price
action with our drawings.

Sabra Healthcare

Here’s our next pattern within

a pattern. First, let’s get a big-
picture view:

FIGURE 72
 After making strong gains
throughout 2012, Sabra
Healthcare took a break from
its strong uptrend and traded
in a relatively tight range
from November to December
2012. This range-bound price
action produced an ascending
triangle and a smaller
symmetrical triangle within
it.
The next chart zooms in
on the patterns:
FIGURE 72.1
 The breakout from the
small symmetrical triangle
led to the breakout from the
larger ascending triangle. The
first breakout did not
guarantee that the ascending
triangle would work. The
breakout could have reversed
and the chart could have
continued to evolve into
something else entirely. The
breakout from the small
symmetrical triangle had no
inherent meaning, did not
represent some universal
truth, and did not guarantee
anything. It is merely one
possible interpretation of the
price action to help us find
advantageous entry and exit
points. We could have bought
shares on the day of the
breakout from the
symmetrical triangle on the
expectation that a breakout
from the larger ascending
triangle would follow. In this
case, that possibility came
true and we were rewarded
for our interpretation of the
price action. If the first
breakout turned out to be a
meaningless price gap and the
pattern failed, then we were
out with a small loss. But we
should not be too
disappointed because we had
made a worthwhile bet. We
move on.
Note that we had another
chance to buy shares even if
we missed both breakouts. If
we patiently refused to chase
the missed breakouts and
monitored the chart over the
next couple of works, we saw
a 2-week ascending triangle
develop. The breakout from
this small continuation
pattern provided another
favorable entry spot. The
lesson: there will always be
more opportunities.

Goodyear Tire & Rubber

Our next example was not the
prettiest pattern but it can still
teach us important lessons.
Figure 73 is a weekly chart
showing the overall set-up:

FIGURE 73
 The next chart is a daily
chart that focuses on the last
five months of this 16-month
symmetrical triangle:

FIGURE 73.1
 A 5-week symmetrical
triangle formed inside the 16-
month symmetrical triangle.
A decisive breakout from this
small triangle led to a
breakout from the larger
triangle.
Note the big advantage
given to traders who bought
shares upon the breakout
from the small triangle. They
risked around 3.5% of their
position and would enjoy
larger profits given their
earlier entry. In contrast, we
had to risk about 7% of our
position when buying shares
after the breakout from the
larger triangle. Quite simply,
in this set-up, if we missed
the breakout from the small
triangle, then we had to risk
more, work harder, and be
more patient to trade the
pattern well. Some of us may
hesitate risking 7% of our
position. Thus, we may
decide to not trade this set-up.
Of course we can use a
smaller position, and that’s
what I would have done had I
missed the first breakout.
Once we decided on the
size of our position, then our
work was just beginning.
Let’s say we bought
shares upon the breakout
from the larger triangle and
set our stop just below the
breakout day’s low. A hard
retest occurred four days later
when the stock penetrated
deep below the upper
boundary but did not close
below it. Another retest
occurred two week later but
this retest did not penetrate
the upper boundary. The most
challenging retest occurred
another two weeks later when
the stock again traded deep
into the pattern. The lowest
reach of this hard retest was
13.89. The low of the
breakout from the
symmetrical triangle was
13.91. If we had set our stop-
loss order at 13.90, a penny
below the breakout day’s low,
then we got stopped out. I
usually give a bit more
leeway to my stop-loss order,
say, in the range of two to
five cents. But it’s possible
that I could have used just a
penny-buffer given that I was
already risking 7% or more of
my position.
Let’s say that this third
retest stopped us out. We
notice that the stock seemed
to just barely close above the
upper boundary at day’s end.
What to do now?
Here are some of our
choices:
First, we can move on. We
bet on a good set-up and
breakout and we got stopped
out by a deep retest. We
move on because we know
there are many more
promising set-ups. Those of
us who like to keep trades on
a short leash will like this
option. We simply move on if
we get stopped out and
almost never re-enter a trade
after getting stopped out.
Second, we can buy shares
around the closing price of
the third retest and set our
stop just below that day’s
low. We are giving this trade
another shot on the rationale
that this third retest could be
the low point of this post-
breakout congestion because
the stock closed above, albeit
only slightly, the upper
boundary of the symmetrical
triangle. Another attempt
meant risking 2.4% of our
position, a very manageable
loss, especially if we were
stopped out on a smaller-
than-usual position.
Another option is to wait
and look for another tradable
classical pattern to develop.
Within a few days of the
third retest we saw that it was
possible to interpret this
entire post-breakout
congestion as a descending
flag. We can buy shares upon
breakout from this
descending flag.
Like all charts, there is no
single correct way to trade
this set-up. Besides the fact
that buying the breakout from
the smaller triangle worked
best and imposed the least
stress on us, our personalities
and trading styles will
determine how, or, even
whether, to trade this set-up.
Managing risk is our top
duty. We shouldn’t be
afraid to pass on a chart
just because the set-up is
intriguing. There will always
be other promising trades. If
we decided to trade this set-
up, then several significant
technical developments (a
pattern within a pattern,
decisive breakouts, and prices
that did not close below the
upper boundary despite hard
retests) suggested that it
could be worthwhile to
devote extra attention to this
set-up.

Cheniere Energy

Our next example features a

continuation H&S bottom
within a larger symmetrical
triangle:
FIGURE 74
 The symmetrical triangle
had textbook form, and the
smaller continuation H&S
bottom also had good
structure. The breakout from
the H&S bottom coincided
with the breakout from the
symmetrical triangle. Buying
shares around the closing
price of the breakout day and
placing a stop-loss order just
below the low meant risking
just above 4% for a promising
double breakout. The volume
spike on breakout increased
the likelihood that the
breakout would work. In this
case, the smaller pattern did
not provide an early entry
opportunity.

Tesla Motors

Our next example reminds us

of the thornier aspects of
trading. We must remember
that a decisive breakout from
a promising pattern does not
necessarily provide an
advantageous trade
opportunity. Let’s again see
why.
The next chart is a weekly
chart that shows Tesla
breaking out of a massive 2-
year ascending triangle:

FIGURE 75
 The next chart is a daily
chart focusing on the last part
of this ascending triangle:

FIGURE 75.1
 A 7-week symmetrical
triangle formed at the very
end of the ascending triangle.
We saw in Chapter 21 how a
stock can form a classical
pattern just below a powerful
resistance level in preparation
for a possible breakout. The
horizontal upper boundary of
this giant ascending triangle
was also a multi-year
resistance level that,
unsurprisingly, was not easily
overcome. Traders were
understandably excited when
they spotted this symmetrical
triangle developing just under
resistance. An upside
breakout from this small
symmetrical triangle could
launch a breakout from the
larger ascending triangle and
perhaps even provide an early
opportunity to buy shares.
The breakout was
decisive. So decisive,
jumping 16%, that buying
shares after the breakout was
problematic. What should we
do? Here are some of our
options:
First, we could decide not
to buy shares unless prices
came back down. We wait for
a retest that will provide an
entry that will allow us to risk
less of our position. No
matter how promising the set-
up and how potentially
explosive the uptrend, we
don’t have to trade if we
decide that the nature of the
breakout makes the trade too
risky. Here, the retest brought
down prices exactly to the
upper boundary. Previous
resistance was now support.
We were given a chance to
buy shares at a spot with a
much more favorable reward-
to-risk ratio. Of course
waiting for a retest that might
not have happened meant risk
missing the trade entirely.
But it is perfectly okay to
miss a trade. What is bad is
being obsessed about not
missing a trade. So if there
had been no retest, then we
move on. Never hastily and
recklessly chasing a breakout,
and thus sometimes
“missing” a breakout, is the
price we must happily pay to
not squander our capital on
suboptimal set-ups.
Second, we could buy a
small position that keeps our
potential loss within our
normal risk parameters. If
there is no retest and the
stock surges higher, then we
make money. If there is a
retest, then we might consider
adding to our small position,
still making sure to stay under
our maximum risk.
We always have a choice.
We never have to chase
breakouts. And sometimes
waiting means we get a better
deal.
 CHAPTER 23

Pattern Failures and

Mutations

When we look back at the

charts we have analyzed, we
may justifiably be impressed
with classical charting’s
usefulness as a trading tool.
So useful and intriguing that
we may also be tempted to
think of classical charting as a
mathematical certainty or
science. We must avoid this
mistake. Classical charting is
not an exact science. It does
not and cannot predict or
guarantee anything. Nothing
related to investing or trading
is certain, except risk. The
more fervent the claim of
certainty, the more skeptical
we must be. We must also
have a healthy dose of
skepticism with experts’
opinions, claims, and
predictions. Always
remember that we don’t have
to do anything with our
money just because
somebody says we should.
Nobody, including the
experts, knows much about
future economic and stock
market performance.
Consider the following
instance.
The global financial crisis
starting in 2007 was the most
serious economic challenge
since the Great Depression of
the 1930s. Yet financial
writer Tim Harford points out
that economists as a group
failed to forecast this
economic disaster. In fact, as
late as September 2008, the
expert consensus was that not
a single country among the 77
being examined would be in
recession in 2009. Forty-nine
countries were in a recession
in 2009. America suffered its
deepest economic downturn
since the Great Depression
and many argue that we are
still far from full recovery.
The lesson is that we must
not blindly follow others,
even our mentors. Trading
offers great freedom but
also demands much
responsibility. We must do
our own thinking. In addition
to treating expert
pronouncements with due
caution, we must apply the
same care and prudent
skepticism to our trading.
There are no guarantees in
trading. Patterns fail often.
To emphasize the fact that
patterns are prone to change
and failure and we should
never rely on classical
charting as a precise
forecasting tool, this chapter
will focus on set-ups that did
not work. Looking at the
following failed patterns will
remind us why we must
always use stop-loss orders
and diversify our trades.
Indeed, a trader’s assumption
on every trade should be that
it will fail. No amount of
wishing and fantasizing will
make a trade profitable. We
can only control where we
enter and how much we risk.
And by risking only a small
fraction of our capital on each
trade, we can trade for the
long run.
Texas Industries

Figure 76 shows a H&S top

with a slightly up-sloping
neckline:

FIGURE 76
 We also have a decisive
breakdown through the
neckline. The stock traded in
a narrow range for two
months and then gapped up
13.5% in early December. If
we shorted this stock after the
breakdown through the
neckline, we lost 15% or
more of our position when
price surged up and we were
stopped out.
Several takeaways here.
 First, we must always
diversify our trades. A stock
can crash or jump for any or
no reason. Price gaps happen.
The 13.5% spike here was
unrelated to an earnings
report. Prices just jumped.
Thus, we must never bet our
entire stake on one trade or
even several trades.
Second, we can lose more
than we had planned. If we
shorted this stock after the
breakdown through the
neckline and placed a buy-to-
cover stop-loss order just
above the high of the
breakout day, we meant to
risk about 5% of our position.
But reality can have other
plans, and our loss was three
times greater than what we
were willing to risk.
Third, it is okay to
occasionally lose more than
we had allowed for due to
price gaps and unexpected
news. No amount of careful
risk management can account
for unpredictable price gaps.
But we can and must always
diversify our trades so that a
huge unfavorable price move
remains a very manageable
loss.
Fourth, one could argue
that volume did not support a
H&S top interpretation. The
textbook specifies very heavy
volume at the left shoulder
peak and head. This possible
H&S top did not have such
climatic volume at the peaks.
That said, volume is only one
factor in my analysis, and I
would have shorted the
breakdown through the
neckline given the pattern’s
good form and meaningful
decline through a significant
support level.
Fifth, after breaking down
through the neckline, the
stock traded in a narrow
range for 10 weeks. Is that
too long to wait for a follow
through after the initial
breakout? Hard to say.
Patience is a vital trading
skill. And some set-ups need
time to work. Some traders
use a time-stop along with a
price stop. They exit the trade
even if their stop-loss order
has not been triggered if the
stock does not start working
in their favor within a certain
period.
Lastly, we should stay
nimble and be open to trading
in the opposite direction from
the anticipated breakout.
After the H&S top failed in
Texas Industries, the chart
could evolve and produce
another tradable pattern, such
as a H&S top failure pattern.
But we will miss such an
opportunity if we are
preoccupied with being
disappointed with the failure
of the H&S top. Powerful
trends in the other direction
often come from failed
breakouts. That said, it is
understandable if traders who
suffered a 15% loss on their
short position simply want to
move on to other
opportunities. Mental
flexibility is important, but
more important is clearing
our minds and moving on
from a loss. If we dwell on
the “unfairness” of the price
jump in Texas Industries that
resulted in our losing much
more than we had carefully
allotted for, then we will
dwell on making our money
back from this chart. The
stock, after all, “owes” us. So
we start trading even if there
is no compelling set-up and
we lose more money. The
stock now owes us more
money so we keep trading
and lose more money. The
destructive cycle continues
and we suffer more financial
and psychological pain. As
we know, many life lessons
apply to trading. Moving on
after a setback is one of
them.

Basic Energy Services

Our next example combines a

pattern failure and a pattern
evolution. Figure 77 shows a
failed breakout from a
symmetrical triangle:

FIGURE 77
 In addition to its good
shape, this symmetrical
triangle in Basic Energy also
had a small pennant that
formed just below the upper
boundary that might launch a
powerful breakout from the
larger triangle – the always
interesting pattern within a
pattern. The breakout from
the pennant was initially
powerful. But the upward
momentum died quickly and
the stock decisively closed
below the upper boundary of
the triangle three days later,
which was one day before the
earnings release. The stock
dropped 11% on earnings
news. The bullish breakout
from the symmetrical triangle
failed completely.
So was that it? Should we
move on? Yes, for now. But
we would also periodically
check in on Basic Energy as
part of our regular cycling
through of our charts.
Before examining how the
chart evolved in the following
months, let’s discuss one
more thing about this
symmetrical triangle
interpretation. Was there a
meaningful breakout from the
symmetrical triangle? We
have discussed how some
traders do not consider a
breakout from a symmetrical
triangle or any pattern with a
slanting boundary to be an
entry signal unless the
breakout decisively closes
above a significant high
within the pattern (for a long
trade such as here) or closes
below a significant low (for a
short trade).
The following chart
illustrates this point:

FIGURE 78
 As we discussed, I don’t
think there is a single best
way to trade breakouts from
patterns with slanting
boundaries. Determining
what constitutes an entry
signal will depend on our risk
tolerance, personality, and
trading style. I would have
bought shares upon the
breakout from the
symmetrical triangle but
exited my position when the
breakout could not quickly
close above the horizontal
resistance level. The next
quarterly earnings report was
to be released in three days
and it was better to exit with
little or no loss or even a
small profit rather than hope
that the stock quickly
overcome a strong resistance
level and make a meaningful
run in a mere three days.
Now, let’s discuss the
chart’s evolution after the
failure of the symmetrical
triangle. Two months later,
we saw that the chart was
forming a possible
descending wedge:

FIGURE 78.1
 In addition to the wedge, a
possible descending flag was
forming inside the descending
wedge. As we know that a
small pattern can launch a
breakout from the larger
pattern, we would carefully
watch this chart.
The flag produced a
decisive breakout. I still
would not have bought shares
because the next earnings
report was due four days
later. I would buy shares after
the earnings release and after
a decisive breakout from the
descending wedge, which
occurred on October 29. If we
had bought shares on October
29, we were up by almost
34% by November 8. A great
gain even if we bought only a
small position. And the size
of the descending wedge
indicated that even larger
gains were possible.
Very few breakouts go
straight up or down. And
every set-up presents unique
challenges. Here, sitting on a
34% profit, should we
continue to hold? I wouldn’t
blame anyone for taking at
least partial profits at this
point.
Let’s say that we decide to
take profits on one-third of
our position and hold the rest.
Over the next month we
watched the profits in our
remaining position evaporate
as the stock declined and tried
to retest the upper boundary
of the descending wedge.
This retest shows
perfectly why trading
challenges so much our
mental and physical
strength. We know that
retests are normal and that
all breakouts are subject to
pauses and even outright
failure. We also know that
all we can do is to enter at a
favorable spot, set our stop,
and move aside. But
knowing our limitations is
one thing. Accepting them
to achieve calm and mental
clarity is much more
difficult. We could suspect
that this price decline
indicated that the pattern and
breakout were about to fail.
Many of us are likely to sell
our remaining shares in
frustration at the early
December lows, after all of
our profits have disappeared,
as we don’t want to lose any
more money. So we sell and
stop paying attention to this
chart. We hate the chart
because it didn’t go straight
up. We don’t care whether
the retest is over or how the
chart may evolve in the
coming weeks.
But consider the attitude
of experienced traders who
bought the breakout on
October 29 and used the last
day rule to set their stop-loss
order just below the low of
the breakout day. The price
decline into early December
did not come close to
triggering their stops. The
decline turned out to be a
relatively weak retest that did
not even threaten touching
the upper boundary of the
descending wedge. Of course
no one could know how sharp
the retest would be. All
anyone could do is enter, set
their stop, and move on to
other charts and projects.
They could have been
stopped out and lose all the
profits they were sitting on in
early November plus some
more. There is no way to
preclude this possibility.
Patterns can fail no matter
how decisive the breakout or
beautiful the set-up. Our
profits can evaporate in days
or even seconds. The sooner
we accept this reality of
trading, the quicker we can
start to trade in a calm and
detached manner focusing on
doing the right things rather
than making money. Here,
the early-December lows
turned out to be the lowest
point of the retest. The stock
went on to form and break
out of a 2-month continuation
symmetrical triangle.
The formation of this
textbook symmetrical triangle
shows again why we must
regularly review our charts. A
quick and focused view
couple of times a week would
have alerted us to the forming
of a possible symmetrical
triangle. This triangle gave
another chance to buy shares
if we had missed the breakout
from the descending flag or
descending wedge or if we
sold our position in early
November. Also, those
patiently holding since the
flag breakout could add to
their position and move up
their stops to the breakout
from the symmetrical
triangle. We still had to be
patient even after the decisive
breakout from the textbook
continuation symmetrical
triangle. The stock traded in a
narrow range for 3 weeks
before surging higher.
We should not worry if we
feel a bit overwhelmed by the
many evolutions that the
Basic Energy chart went
through. We do not have to
catch every or even most
intriguing charts. We just
need to trade well a couple of
set-ups. And if we lose on the
few set-ups that we catch,
then we know that there will
always be more set-ups to
come.

Altria Group

Our next example is a 3-

month H&S top that formed
inside an 18-month ascending
wedge:

FIGURE 79
 Both patterns had good
structure. Especially
interesting was how the head
of the H&S top stayed just
below the upper boundary of
the rising wedge. The stock
broke down decisively
through the H&S top’s
neckline. The next day the
stock plunged as the market
reacted negatively to the
quarterly earnings report. In
two more days, the stock
decisively closed below the
lower boundary of the
ascending wedge. Traders
had good reason to consider
shorting shares at this point.
The stock declined a bit
more before pausing and
surging higher to do a hard
retest of the lower boundary.
The stock traded around the
lower boundary of the wedge
for several weeks before
surging higher. It closed
above the neckline of the
H&S top and eventually
broke above the upper
boundary of the ascending
wedge.
A promising set-up that
failed decisively. Why study
failed set-ups? To remind
ourselves that many, if not
most, patterns will fail. We
have looked at many ideal
set-ups with clean breakouts.
And many of our trades will
be like these set-ups and work
well. But many will not.
Many will test us before
working or failing. We must
try our best to remain above
the volatility and focus on
trading well rather than trying
to make money. The best way
to focus on doing what’s right
is to enter at a favorable spot,
set our stop, and move on.
We have no control over
whether a trade works. We
can only manage our risk.
These are blindingly
obvious statements but we
tend to forget these truths
when we bet real money.
Experienced traders have
learned to maintain a calm
state of mind no matter what
happens in the markets. The
best way to try to stay
detached from the gyrations
of the markets is to risk only
a small portion of our account
on any individual trade. If we
do this, even our worst case
scenario will be manageable.
I think this failed
ascending wedge asks an
important question: should
we have traded it at all? Was
the set-up promising to begin
with? This question makes
clear that knowing when not
to trade is just as important
as how we trade.
Let’s examine the set-up
again. The H&S top had good
shape and the breakdown
through the neckline was
decisive. But how tradable
was this breakdown? We
would have been prudent to
not trade it given that the
quarterly earnings report was
released the day after the
stock closed below the
neckline. And as the stock
continued to decline in the
days following the earnings
report, it did not offer a
favorable spot to short shares.
We essentially “missed” the
breakout, by choice, because
of the pending earnings news.
Entering now, so far below
the neckline, meant risking
too much.
Did we have a better spot
to short shares after the stock
closed below the lower
boundary of the ascending
wedge? Perhaps, but we had
to remember the additional
difficulty trading patterns
with slanting boundaries. Due
to the rising lower boundary,
a retest here meant that the
stock could stay under the
lower boundary of the
ascending wedge and still
trigger our stop order. A hard
retest did happen and would
have stopped out our short
position.
Shorting shares upon the
breakdown through the lower
boundary of the ascending
wedge would not have been a
bad trade. My point is that
this set-up was not so ideal
after all, especially since we
did not have a good
opportunity to enter earlier
via the breakdown from the
H&S top. And because of the
drawbacks of this set-up, it
would have been more than
reasonable to simply pass on
this trade no matter how
interesting the pattern-within-
a-pattern set-up. Remember,
not all breakouts are tradable.
We should trade only the
most desirable among the
tradable breakouts. The more
experience I gain in the
markets, the more I find
myself passing on patterns
that I would have traded in
the past. I have learned to be
more patient (don’t get me
wrong – it is a constant
struggle) because experience
has taught me that there
always be more and better
set-ups. Such knowledge
helps me remain calm and
patient more often than not.
 CHAPTER 24

Do Not Gamble on
Earnings Reports

As we have discussed many

times so far, we should avoid
trading through earnings
reports. I almost always exit
my entire position in a stock
that is about to release its
quarterly earnings report.
Only rarely, and only if I’m
sitting on a profit, will I keep
a small position through an
earnings release.
I avoid trading earnings
reports even though I know
that exiting my position can
mean “missing” huge gains if
the market reacts positively to
the earnings news. The
following example shows the
kinds of gains we might
“miss” if we always exit our
position before earnings
announcements:

FIGURE 80
 So then why should we
not hold positions through
earnings reports? We know
the answer. Because stocks
can crash on earnings news as
well:

FIGURE 81
 We analyzed this CETV
chart in Chapter 11. It is
foolish to risk a significant
portion of our capital on a
blind luck of the draw. Such
outright gambling is simply
unnecessary. We study
classical charting because it
allows us to take calculated
risks at only advantageous
spots. And we saw entry
points with highly favorable
reward-to-risk possibilities
where we must risk only
about 2-3% of our position.
Steadily building our capital
is the goal. Overnight
successes are based on
extremely rare luck, and such
luck is often based on
reckless gambles that wiped
out all except the few that we
hear about as overnight
successes.
We are human, and
therefore we are impatient
and greedy. We want money,
preferably a lot of it, today or
at the latest tomorrow. We
are not going to get it. We
know that there is no easy
road to success anywhere; we
just don’t want to believe it.
We should play the long
game while steadily gaining
experience and capital. I
strongly believe that trading
is all about longevity. By
protecting our capital against
large losses, we can trade for
the long run. And long-term
survival greatly increases the
chance that we will make it
simply by virtue of the almost
inevitable coming together of
acquired wisdom and
favorable market conditions.
Sometimes the market will
have very few charts that look
promising. But there will
always be periods when the
market throws us many fat
pitches to choose from. These
ideal pitches and the large
potential profits are the result
of impatient traders who
spent their capital chasing
poor set-ups and treacherous
curveballs. Now they are too
spent, financially and
mentally, to take measured
swings at the fat pitches. But
we can take advantage if we
have carefully preserved our
financial and mental capital
through patience and
discipline.
 CHAPTER 25

Being Out of
Position:
Not Trading No
Matter How
Promising the Set-Up
and Breakout

We know that not all

breakouts are tradable. We
saw some breakouts that are
so powerful that it was too
risky to enter after the
breakout. I call this situation
being out of position. When
we are out of position, we
should not chase, no matter
how tempting and promising
the pattern. If we recklessly
chase, then we must mitigate
the potential damage by using
a much smaller position to
avoid getting caught in a
negative feedback loop of
chasing, losing money,
chasing, and losing more
money.

Flir Systems

The next chart shows Flir

Systems breaking out of a
well-defined symmetrical
triangle:

FIGURE 82
 Note the first time prices
closed above the upper
boundary. While the stock did
not close above the upper
boundary of the symmetrical
triangle by a large margin, it
did so clearly, at least to my
eyes. I would have bought
shares at this point. The fact
that this breakout was
through a boundary with
three good touches would be
a factor in my buying.
Perhaps the most important
factor was that I would be
risking only about 2% of my
position to buy shares at this
point. The potential upside
was great while the downside
was very manageable.
Others will disagree with
my analysis. Some of us will
prefer a more decisive
breakout that closed above
the prior significant high.
Because there was no such
breakthrough here, we may
have decided to wait for a
stronger breakout
confirmation. That decision is
a very reasonable one
regardless of what happened
next.
The next day the stock
jumped more than 6%. If we
didn’t enter the day before,
should we buy shares now?
My opinion is that if we
did not buy shares at the
initial breakout, then we
should not chase this jump
unless prices came back
down and retested the upper
boundary of the triangle to
provide us a much more
favorable entry spot. Entering
after the 6% jump meant
having to risk up to 8-9% of
our position and I think that is
too much.
Prices did come back
down but not enough for me
to enter this trade. Entering
now meant buying shares
when I was clearly out of
position. I still could chase
with a much smaller position
but I prefer not to. And I try
to never chase a breakout
using a full position because
the consequence is almost
always emotional and
financial pain.
But let’s say that we
chased using our regular-size
position after the 6% jump. If
the stock continued to surge
higher, then we got lucky and
made a large profit. But
remember that making money
is very different from trading
well and doing the right
thing. Anybody can get lucky
occasionally. More often we
are not so lucky. The stock
could have reversed just after
we bought shares and decline
all the way down to the
pattern boundary in a
perfectly normal retest. Here,
there was a retest that
declined halfway to the
boundary. If we did not set
our stop low enough after
chasing the 6% jump, then we
would have been stopped out
and would watch as prices
surged higher without us. We
would be frustrated and
angry, and we may chase
again. When we again buy
shares, the stock may pause
and reverse yet again to stop
us out. It is a painful cycle of
financial loss and mental
pain. It gets increasingly
difficult to move on from the
crushing combination of
damaged pride (why couldn’t
I make money on this trade?),
greed (I thought I was going
to be rich soon?), and
frustration (only if I didn’t
miss the breakout or did this
or did that …).
As much as we know that
we should not to chase a
stock if we missed the
breakout or we are out of
position, we will still chase
sometimes. And I don’t think
we learn until we have chased
and suffered financially and
mentally. I’m sure there are a
few traders out there who
have never chased a trade.
But chances are we are not
one of them. I certainly was
not.

Gamestop Corp.

Let’s examine another tricky

breakout:
FIGURE 83
 Gamestop Corp. formed a
well-defined 3-month
symmetrical triangle from
December 2012 to March
2013. On March 26, the stock
closed above the upper
boundary. But I would not
have bought shares because
the next quarterly earnings
report was to be released two
days later. I would wait and
see where prices settle after
the earnings report. The stock
jumped 6% on earnings news.
How should we trade this
breakout? Should we trade it
at all?
Buying shares around the
closing price of the 6% day
would mean entering at a spot
where the reward-to-risk ratio
is unfavorable. We would be
risking about 8% of our
position if we were to use the
last day rule to place our
stop-loss order. Only in
hindsight do we know that
there was no difficult retest
and the stock gained more
than 100% in the next six
months. The decisive
breakout could have failed
decisively and produced a
quick 8% loss on our
position.
If we were to enter this
trade after the 6% jump, I
think we should buy a
smaller-than-normal position
so that an 8% loss (remember
that it is always possible that
we lose more if there is a
downward price gap) on our
position still keeps our loss to
less than 1% of our total
capital. Even if we use a
smaller position, we are still
chasing. And when I chase,
my rule is to not attempt
another trade if I get stopped
out. I have found that
chasing, even with a smaller
position, always creates
negative emotions. I get
anxious about the trade rather
than staying detached and
doing other things. Anxiety
throws off our mental game
and increases the likelihood
that we will do the wrong
things, such as not honoring
our stops or chasing again
and entering at increasingly
unfavorable and riskier spots.
So, we should do our best
not to chase. If we chase, we
should do so with a small
position. And we must move
on if we are stopped out.
ShoreTel, Inc.

Here’s another breakout that,

depending on our risk
tolerance and trading style,
may have been untradeable:

FIGURE 84
 We have a textbook
symmetrical triangle with a
decisive breakout on the day
of the quarterly earnings
release. The breakout was
strong: up more than 7% on
the day. Entering around the
closing price of the breakout
day meant risking more than
7% of our position. If we had
bought shares earlier during
the breakout day when prices
were higher, we were risking
more than 10%. If we did not
want to risk around 10% of a
normal-size or even smaller
position, then we could wait
and observe. Doing nothing
is always an option. A quick
and focused glance once a
day would inform us of new
chart developments that may
create a more favorable entry
spot.
The next day, we saw a
retest that dropped the stock
2.2%. If we chose to buy
shares now, we would be
risking less than 5% rather
than more than 7% of our
position, a big difference.
Let’s say we decided to wait
for an even more favorable
entry spot. Or, we may have
simply missed this decline.
Perhaps there would be a hard
retest that drops prices all the
way down to the upper
boundary of the symmetrical
triangle. There was no hard
retest, but instead of being
disappointed, we would be
wise to continue to monitor
the chart. And our diligence
would alert us to a possible 2-
week continuation pennant
developing just above the
pattern boundary. A decisive
breakout from this pennant
gave us another chance to buy
shares while risking just over
5% of our position.
In addition to providing a
more favorable reward-to-risk
possibility than the initial
breakout, this pennant had
another favorable attribute:
greater likelihood of
producing an immediate
follow through. I have found
that breakouts from small
pennants and flags have a
high success rate. I would
buy shares on the day of the
breakout from the pennant
and set my stop using the last
day rule. If the breakout was
to reverse and the pennant
fail, then I would simply
move on. I have found that it
is easier to move on after
getting stopped out of a
position I entered at an
advantageous spot compared
to after getting stopped out
from chasing an unfavorable
trade. Why? I think there is a
significant satisfaction
knowing that I lost a very
manageable amount of my
capital to make a bet with a
favorable reward-to-risk
possibility. It is about trading
correctly regardless of the
outcome. If a promising
pennant fails, I accept it, and
I think about how I focused
on doing the right things,
such as waiting for a more
favorable entry spot. Trading
well is so much about our
mental state. A losing trade
can increase our confidence
if we know that we traded
the set-up well. We look
forward to applying our
knowledge and exercising our
discipline on the next
promising set-up. We know
that have no control over
whether our next trade will be
profitable. But we also know
that we have full control over
how we trade and that if we
trade correctly then even a
losing streak will keep our
losses small.
 CHAPTER 26

Taking Profits

So far we have focused, with

very good reason, on how to
enter trades at favorable spots
and how to place stop-loss
orders to limit possible losses.
We can make money only if
we have money to bet on
promising set-ups. Preserving
our trading capital requires
strict money management. It
is far better to miss a
breakout and not make
money than to chase and lose
money. Focusing on limiting
losses is proper and
productive.
Once we understand the
foundational importance of
protecting our trading capital,
we also need to learn how to
take profits. We discussed
how to estimate the possible
price target of a pattern
breakout by projecting up or
down the height of the pattern
at its widest from the point of
breakout. This projection is
called the measured price
target. It is only a general
guideline. Breakouts can
reverse and fail any time. Or
a pattern breakout may fail to
reach the measured price
target even though it made a
strong run and produced a
significant profit. Or prices
may continue to surge higher
or lower well past the price
targets. We should not be
disappointed in the lack of
certainty. Looking for
guarantees in the financial
markets is asking for
confusion, frustration, and
pain.
Instead, we can use the
very unscientific nature of the
measured price target “rule”
to help manage risk and make
money. I almost always take
profits on my entire position
if a price target is hit. Also, I
often take profits on part of
my position if a breakout has
reached the halfway mark to
the price target. Sometimes I
will do so with the intention
of adding to my position if
there is a retest and prices
return to the pattern
boundary. Because patterns
can fail anytime, I don’t mind
erring on the side of having
taken profits “too soon.” I
tend to take profits when
there are profits to be taken,
especially at or around the
price target.
That said, I don’t think we
should exit a position the
moment it is sitting on a
profit. Ironically, taking
profits too quickly can lead to
a destructive cycle.
If we seem to be exiting
many positions with only a
tiny profit, then we are likely
watching our screens too
much. We are watching
nervously every price tick
and getting scared every time
the price action is
unfavorable. We cannot trade
well and do the right things
with such an anxious state of
mind. We will be mentally
exhausted and lacking
discipline, which lead to large
losses.
If we have done our
homework, identified a
promising breakout, and
entered at a favorable spot
with a very manageable
possible loss, we should give
our position time to work
(make significant progress
toward the price target) or fail
(trigger our stop). If we are
unable to let go after entering
a trade, if we cannot stand
taking even a small loss, then
we must not trade stocks or
any financial instrument.
There is absolutely nothing
wrong with deciding that we
have no interest in trading.
We all have different
interests, personalities, and
aptitudes. And we don’t have
to prove anything to anyone,
especially in the markets. If
we are not willing to take
many small losses as the
regular and expected part
of trading, then we are
almost guaranteed to suffer
large losses. Let’s see how
this disaster can happen.
 Say that we bought shares
after a strong breakout. We
are sitting on a nice profit as
prices surge higher. Then
prices reverse and our profits
have almost entirely
disappeared. We think about
exiting with a small gain but
we “want to make back our
profits that we had only days
ago.” But prices continue to
decline and we are now
sitting on a loss. A small loss,
but we are annoyed. We
“want our money back.” So
we wait and stay in our
position even when prices
continue to decline and reach
our stop-loss level. Instead of
allowing our stop-loss order
to take us out of our position
for a still minor loss, we
cancel our stop-loss order and
stay in. Prices are now
crashing. We still don’t get
out because we want to get
out when we are respectably
close to breaking even. The
stock continues to decline and
our losses grow. We
eventually exit with a huge
loss.
And things don’t
necessarily get better. We are
embarrassed. And angry. The
market owes us. So we trade
ill-defined patterns and poor
set-ups. We continue to lose
money. We are now on what
can only be called the cycle
of pain and greed. There is a
way off this satanic treadmill.
Exit our positions, step away
from our screen, and take a
break for several days or even
weeks. Muster the courage to
think about why we made
these mistakes. Reflect on
how we can improve. Affirm
that we can do better. Realize
that there will always be more
opportunities. Calm down.
Forgive ourselves. Focus on
doing the right things. Return
to the basics.
Too dramatic?
Unfortunately, no. I think all
of us will (must?) take at least
one ride on this treadmill of
pain. It seems sometimes
experiencing pain is the only
way we learn.
To avoid this destructive
cycle, I try to stay in a trade
until it is resolved either by
prices hitting or having made
significant progress to the
price target or getting stopped
out. Meanwhile, I try to
ignore my positions and stay
away from the screens as
much as possible during
market hours. I remind
myself that I am bigger than
my positions. We are bigger
than the small losses we will
take. We are also bigger than
the large profits we could
make. As in life, self-respect
is necessary before success in
trading.

Mechel Steel Group

Mechel Steel formed a
textbook ascending triangle
from June to September
2013:

FIGURE 85
 The breakout was decisive
and the follow through
immediate. The price target
was hit two days after the
breakout. At this point, I
would have taken profits on
at least two-thirds of my
position. Why not sell the
entire position? I should, and
I usually do. But there is
always the temptation to keep
my position to make more
money if the uptrend
continues. Also, the breakout
and price target were
achieved in three days while
the ascending triangle formed
for three months. There is
something unsatisfactory
about diligently tracking a
pattern for months and even
years and then see the price
target reached in less than a
week. We want more. We
want to ride the money train
for at least several weeks. In
addition, a continuation
pattern might form after the
price target is hit so we’ll just
stay with our position instead
of risk missing a fast breakout
from a pennant or flag.
But there are also good
reasons to exit once the price
target is hit. The measured
price target is just a
possibility, and prices could
have stopped well short of the
target. Also, an immediate
follow through after a
breakout is a good thing as
we don’t have to deal with
retests. This 3-day trek to the
price target may not seem like
much of a move on the chart
but that is an almost 18%
gain. It is a big gain in such a
short time and it will build
our capital. Finally, we gain
confidence in our ability to
trade while managing risk.
So what to do when the
price target is hit? I see three
options.
First, get out completely
and move on.
Second, take profits on
most of our position and let
the remainder ride. If the
stock continues to surge then
fine but we won’t add to our
position unless there is a
compelling continuation
pattern that provides an
advantageous entry spot. If
prices reverse and we get
stopped out on the position
we kept, then that’s it and we
move on.
 Third, keep our entire
position even when the price
target is hit. But we’re done if
we get stopped out at our
original stop-loss level.
I almost always choose the
first or second option and I
think most of us should as
well. If we choose the third
option and get stopped out
after prices reverse, then we
have to remember that we had
prepared for this loss. Try not
to think of the evaporated
profits as money we lost.
Instead, focus on having
entered at a favorable spot
and consider taking profits
earlier next time.
Here, selling our shares at
the price target turned out
well. Of course we had no
way of knowing the optimal
strategy. The stock paused
after hitting the price target
and traded in a narrow range
for 7 days. It was reasonable
to think that a possible
continuation pennant or flag
was forming. But instead of a
fast uptrend out of a pennant
or flag, prices dropped to the
upper boundary of the
ascending triangle.
Some scenarios to
consider:
If we sold our position at
the price target or missed the
breakout, then it was worth
considering whether we
should buy a position when
prices returned to the upper
boundary. I do not usually re-
enter a position on a chart
where prices have hit the
measured target and then
returned to the breakout level.
My reasoning is that the chart
pattern that launched the
successful move has served
its purpose. But support and
resistance levels are often
enduring. The upper
boundary of the ascending
triangle was resistance prior
to breakout and it may now
be effective support. So we
may decide to buy a position
just above the upper
boundary of the ascending
triangle with a relatively tight
stop. If we get stopped out,
then we move on. If the
boundary holds up against
retests and pushes prices back
up, then fine.
As we see in Figure 85,
the upper boundary held as
support over four days of
retests. But the stock closed
below the upper boundary on
the fifth day and then
decisively closed deep inside
the pattern over the next
several days. If we had
bought shares during the
retests, we were stopped out
with a small loss. At this
point, for a while at least, I
was no longer interested in
trading this chart. The
ascending triangle had served
its purpose by hitting its price
target and then also became
invalid when the upper
boundary failed as a support
level. There was no tradable
classical pattern on the chart.
Of course Mechel Steel’s
chart will continue to evolve
and perhaps form another
tradable classical pattern, but
that possibility was probably
months away.
Let’s discuss another
scenario from this chart. Let’s
say we held on to our position
even when the price target
was met. We were counting
on a continuation flag or
pennant forming and riding
another powerful uptrend.
Instead, prices declined to the
upper boundary. We were
disappointed when our profits
disappeared but we hoped for
the upper boundary to hold as
support and push prices up.
Then we were stopped out
when the upper boundary
failed to hold as support.
What we must do now is
move on knowing that we
took a reasonable risk by not
selling at the price target and
counting on a continuation
flag or pennant to develop.
We must also remember that
we lost only a very small
slice of our trading account.
Indeed, we expected to lose
this modest sum when we
entered this trade and set our
stop. Again, we must not
count the profits that
disappeared as a loss. But
what is absolutely the worst
thing we can do is to re-enter
this trade to get our money
back. By early October, this
chart is “broken.” There is
simply no tradable pattern. In
mid-November, the stock
dropped 30% in one day
before closing the day down
23%.
The overall lesson is that
we must accept the fact that
there is no trading method
that maximizes our profit in
all situations. The wise
decision is to adopt a strategy
that manages our risk in all
market conditions. It means
sometimes selling at the price
target and then watching the
stock explode higher. It
means sometimes watching
prices trigger our stop and
then immediately turn around
and take off without us. We
must accept these
disappointments with
maturity and calm because
we understand that protecting
our capital, not making
money, is our priority.
 CHAPTER 27

Why We Must
Diversify Our Trades

As we gain experience and

have some winning trades, we
can get overconfident and
forget that the reason we are
finding success is because we
have been focused on the
fundamentals, namely,
limiting losses and managing
risk. Overconfidence can lead
to taking a large position in a
single stock. Why go for only
steady gains when we can
make a lot on one trade? The
following chart shows why
we must always diversify our
trades, especially when things
are going well and we are
most vulnerable to
overconfidence, and never bet
it all on a single position:
FIGURE 86
 In July 2013, NQ Mobile
broke out of a giant
descending flag or channel
that had been forming for
over four months. Prices
nearly tripled over the next
three months. The breakout
and follow through were so
strong that the stock had only
a couple of down days during
the month following the
breakout. If we had taken
profits on two-thirds of our
position in, say, late July or
early August, and decided to
hold onto the rest, we saw
NQ Mobile form a textbook
uptrend channel from August
to October 2013 that
continued to push prices
higher. We are human, so we
may regret getting out “so
early” instead of focusing on
how we kept a portion of our
original position. At this
point, there is one thing that
we must not do: buy more
shares, and, driven by the
frustration over selling
earlier, perhaps go all in on
this stock. We should not
dismiss this possibility. We
are very capable of buying
shares at the September or
October highs even though
there was no tradable pattern
with an advantageous entry
spot. The only classical
trading principle that could
guide us in September and
October was the rising
channel, but it, like all
patterns, had multiple
possible interpretations. A
bullish rising channel could
just as easily be seen as a
bearish giant rising flag.
Whatever our interpretation,
our overall conclusion should
have been that there was no
favorable entry spot with a
compelling reward-to-risk
possibility. Therefore, I don’t
think we had a compelling
reason to add to our position
or start a new position at
these price levels. If anything,
we should have been
considering selling our
remaining position.
Then in late October, the
stock dropped 47% in one
day. Even this disaster did not
hurt us if we took partial
profits in July or August and
did not recklessly add to our
remaining position or initiate
a new position in August,
September, or October. If we
took profits, we still earned a
small or even significant
profit. But if we chased and
bought shares anytime from
August to October, then we
lost nearly half of our
position or account if we
went all in.
This crash was unrelated
to an earnings report. And the
cause does not matter because
such unpredictable events can
happen anytime to any stock.
We simply have no control
over unexpected news that
crashes a stock. We can
control how much we bet on
a stock. I usually commit at
most no more than 7-8% of
my account to a single
position. By always
diversifying our trades and
entering only when there is a
compelling opportunity, we
can reduce our risk to very
manageable levels and
survive even market crashes.
One more thing about the
August to October price
action. Some people will
prefer to interpret it as a
powerful uptrend within a
well-defined rising channel.
Others will like to see it as a
giant bearish flag. As we
discussed, it is fine to have an
opinion but we must be
mentally flexible and honest
enough to at least recognize
that there is an alternative
interpretation. If we only saw
a powerful uptrend within a
textbook rising channel and
ignored all contrary
interpretations, then we were
closing our eyes to risk, and
such willful blindness is
always costly. If we preferred
the bullish rising channel
view and bought shares
toward the lower boundary of
the channel, but we also
recognized the opposite and
potentially dangerous bearish
rising flag possibility, then
we were much more likely to
use an appropriate position
size that would have reduced
our losses to a manageable
amount.
 CHAPTER 28

The Trader’s
Routine:
Continuous Patience
and Diligence

Winners have systems.

Scott Adams
 We need not, indeed, must
not, spend 13 hours a day
staring at charts. However,
we must be diligent in doing
our homework by regularly
monitoring our charts. A
quick, focused, and efficient
glance at a chart every several
days to every couple of weeks
will allow us to identify,
monitor, and trade many
interesting classical patterns.
Some exceptions are the fast-
forming and fast-moving
small flags and pennants that
can last as few as three days
or so. But since many flags
and pennants form after
breaking out of much larger
patterns that are easier to spot
and track, we can create a list
of stocks that justify more
frequent, such as daily,
check-ins. We cannot and
should not try to catch and
trade every classical pattern
that forms in the markets.
Several promising patterns
are enough.
Since most patterns take
many weeks and months to
form, I would describe the
skill and attitude needed to be
a good trader as one of long-
term patience and diligence.
Let’s say we have about 700
to 800 stocks on our watch
list and we usually take about
a week or two to review
them. If we spot an
interesting chart, we can save
it in one of several folders
categorized by the urgency of
the set-up. For example, we
can have a folder for charts
that have already formed an
identifiable classical pattern
and may be close to a
breakout. Another folder can
be for patterns where the
breakout does not seem
imminent. Yet another folder
can be for set-ups that may be
in the process of forming a
classical pattern but no clear
pattern can be identified yet.
And another folder can be for
charts that have potential,
such as those that show clear
resistance and support levels.
So we can cycle through our
stock list about every two
weeks while checking in on
our urgent folders more
regularly and perhaps even
daily.
Let’s see how this trading
process might work in real
life using the following set-
ups.

Matrix Service Co.

FIGURE 87
 It is late February 2013.
We start to go through our
stock list and see nothing
interesting about the chart of
Matrix Service Co.
We cycle through our list
over two weeks and come
back to Matrix Service in
mid-March. Again, nothing
noteworthy. We come back to
it in early April and still don’t
see any identifiable classical
pattern.
 But by late April it seems
that prices are coiling and
forming a possible
symmetrical triangle. We put
this chart in one of our more
urgent folders and review it
every day.
There is a decisive
breakout in early May and a
strong follow through into
mid-May. Let’s say we
bought shares around the
closing price of the breakout
day and set our stop-loss
order just below the low. We
are happy about the strong
follow through but we try not
to get too excited and instead
we move on and continue to
cycle through our stock list.
Two weeks later in early June
we see that the stock has
declined from the May highs.
We consider this decline
normal as no stock goes
straight up and we know that
we have to expect retests.
Another two weeks later, in
the middle of June, prices are
essentially unchanged.
But there are somewhat
disappointing developments
when we come back to the
chart in late June. The stock
has dropped further and is
now trading at about the level
where we would have placed
our stop-loss order. If our
stop-loss order was triggered,
then we were out with a small
loss. No big deal. There was
nothing to get angry about.
Small losses are part of
trading. At this point, we had
no urgent interest in this
chart. But that did not mean
we would ignore this chart
forever. We would review
this chart every couple of
weeks as part of our regular
search for trade set-ups.
In mid-July, we saw that
the stock had bounced up
nicely from the lows of late
June. But, and this point is
crucial, we do nothing
because there was nothing to
do: we did not see a tradable
classical pattern with a
compelling entry opportunity.
So we continue to cycle
through our stock list. In
early August we saw that this
stock was trading in a range
and was perhaps forming a
descending triangle since the
highs of mid-May. We put
this stock in our folder for
medium-urgency set-ups and
check in every several days or
so. By mid-August a
descending triangle did seem
to be forming and an
imminent downward breakout
seemed possible. We move
this chart into our folder for
the most urgent set-ups and
check it daily. Still, we must
not get fixated on a single
possibility and instead we
must keep our minds open
and flexible. We know that
patterns can fail and evolve
into a very different look.
 It is now late August. It is
still possible that a
descending triangle in
forming. But we see another,
perhaps more compelling,
possibility: a symmetrical
triangle. The strongest clue
that a symmetrical rather than
a descending triangle was
forming was the rising lower
boundary of a possible
symmetrical triangle. This
rising lower boundary was
not evident in the middle of
August but had six or seven
solid price touches by late
August and even more by
early September. Since
symmetrical triangles can
break up or down, we
continue to stay mentally
nimble. We check the chart
daily and catch the breakout a
few days later. We decide to
buy shares around the closing
price of the breakout day and
set our stop just below the
low. Then we move on and
continue our routine of
cycling through our stock list
while also checking more
frequently our more urgent
set-ups.
This multi-month routine
we described is the ideal, but
it is still a reasonable and
reachable goal for us. It is
within our power to do
everything that was
described.
Let’s discuss an
interesting event from this
pattern. When prices declined
to the breakout level in late
June, did the pattern fail? I
say no. It is true that prices
returned to the breakout level
without reaching the
measured price target. But,
again, the target is only a
possibility and the breakout
did launch a significant
uptrend. And prices could
still reach the price target.
Was there are any reason
to expect the late-June lows
to hold and possibly reverse
the downtrend? Notice how if
we extend a horizontal line
from the apex of the triangle
(the pointed end), that level
held as support during the
late-June lows. Prices briefly
traded a bit below the apex
level but did not close below
it. Edwards & Magee wrote
more than 50 years ago that
the apex level of a
symmetrical triangle can be a
support level. Here, this
principle worked as the apex
level supported prices for the
next two months and was the
basis of a textbook and
powerful symmetrical
triangle.
Should we trade bounces
off of apex-based support? I
will consider trading any
pattern or situation that has a
clearly defined and favorable
reward-to-risk scenario. For
example, here I can buy
shares around the apex
support level and place my
stop just below a recent low. I
am risking a fraction of a
percent of my position on a
clearly-defined situation: I
can make significant gains if
support holds and prices go
up while I will lose a small
fraction of my position if
support fails (barring a big
downward price gap). As
with any trade, a favorable
entry spot is key. If an apex
level serves as powerful
support and quickly reverses
a downtrend, then the bounce
off support may be so strong
as to force me to chase the
rebound and enter at a spot
where I must risk more than
prudent.
Lastly, let’s return to the
topic of this chapter, and,
really this book: patience and
diligence. Almost two months
passed from the breakout
from the first symmetrical
triangle to the retest of the
apex-level support in late
June. And it was another 10
weeks until the breakout from
the second symmetrical
triangle. We needed
discipline to regularly check
the chart to spot important
developments. We needed
patience to give the pattern
time to evolve knowing that
there was no guarantee that
the chart would form a
tradable pattern despite our
vigilance over many months.
There are also the inevitable
boredom and anxiety
associated with such
permanent uncertainty. Only
in hindsight does it seem
“obvious” that a symmetrical
triangle was forming. Only
now does it seem like it was
easy to wait the almost four
months it took for the second
symmetrical triangle to form.
We must not think that ideal
set-ups will present
themselves to us whenever
we feel like looking at some
charts. Taking advantage of
compelling set-ups requires
following a regular and
diligent routine over many
months, and the process must
never stop if we are to trade
well over the long run.
In short, I think it is
impossible to be a successful
classical chartist over the
long-run without being
substantially at peace with
ourselves before we start to
trade. We simply will not
have the patience, composure,
and calm to diligently apply a
systematic trading process
over many weeks, months,
and years if we are looking
for personal validation and
quick riches in the markets. I
don’t mean that being at
peace will spare us from a
steep and challenging
learning curve. I am saying
we will be much more likely
to survive the difficult trading
periods that we will
experience if we commit
ourselves to being grateful
and reflective regardless of
our trading results.

Ryland Group

Our next chart is another

example of the necessity and
rewards of diligently applying
a systematic trading process
over months and years:
FIGURE 88
 In early July, we did not
see anything interesting on
Ryland Group’s chart. So we
move on. A few weeks later,
we see something
noteworthy. In late July, we
see prices were turned back
right around a high
established several weeks
ago. We draw a horizontal
line just above the two peaks
to signify a possibly
significant resistance level. If
this level does turn out to be
an important resistance, then
a breakout through this zone
will be important and perhaps
a trading opportunity. For
now, we do not see a classical
pattern so we just wait for
further chart development.
But we know that patterns
can form quickly and how
seemingly meaningless price
action can be the beginning of
a textbook pattern, so we put
this chart in our medium-
urgency folder for more
frequent check-ins, say, every
3 to 4 days vs. every 7-to-10
days.
Two more weeks pass and
it is early August, and we
don’t see anything
interesting. But there is
something interesting in
another two weeks. Our
preliminary horizontal line
indicating a possible
resistance level has again
turned back prices. Two
touches can be just
coincidence, but three or
more touches on a potential
pattern boundary are
noteworthy. And there was
another development: a
possible rising lower
boundary with 4 or 5 touches.
We now put this chart in our
urgent folder for daily review.
If an ascending triangle was
forming and if the lower
boundary had already been
established, then a breakout
could happen soon. But
everything is only a
possibility before the pattern
completion and breakout.
Prices could plunge below
our preliminary lower
boundary and the chart could
continue to evolve for weeks
or months into nothing. We
will check the chart daily but
we will not do anything
unless there is an actionable
development that provides a
compelling trade.
 On the last day of trading
in August, the stock made a
strong upward move and
closed just under the upper
boundary of this potential
ascending triangle. A
breakout could be imminent.
Or the chart could continue to
evolve for a while. So we
watch rather than jump in.
The next day stock broke
through and closed decisively
above the upper boundary.
The stock was up 2.35% on
the day so buying around the
closing price and setting a
stop just below the breakout
day low meant risking a very
reasonable amount of our
position for a promising
pattern and breakout. Then
we immediately face a
challenge. The following day
prices decline by 1.24% and,
perhaps more ominously,
close slightly below the upper
boundary.
Should we sell our
position? Were we tricked by
the “breakout” that was in
fact a nasty bull trap or just
an insignificant out-of-line
price movement? It was
possible that the breakout was
a false move. It was also
possible that the 1.24%
decline was a normal hard
retest. Nobody could know.
My opinion is that we should
stay in our position until there
is a resolution to the trade. If
prices continued to decline,
then we were stopped out for
a minor loss and we move on
to other set-ups. If the 1.24%
decline turns out to be a
normal retest after which
prices increase, then fine.
Such composure is our
goal. It is not that we should
not care. That is impossible.
We should care. We should
take great care to enter only at
compelling spots. But we
have no control over prices.
Obsessing after we enter only
causes anxiety and can undo
the patient work we did to
identify and enter a
compelling set-up. If we did
our homework before
entering a trade, then we have
to learn to let go. Since we
will use strict money
management and risk only a
fraction of our trading
account on any single trade,
we are not bothered too much
about the prospect of getting
stopped out. We can stay
detached and give the pattern
time to work.
Here, we did our
homework before entering
and bought shares after a
clear breakout that provided a
compelling entry spot. We
did all we can and thus we do
not obsess over the outcome.
Several days later we saw that
the pattern survived the hard
retest and launched a strong
follow through that reached
the price target. We sell our
shares for a nice profit at the
measured price target. And
for now, we move on from
this chart. We will review the
chart as part of our regular
cycling through of our stock
list rather than checking it
daily. We don’t see any
compelling set-ups on this
chart for the next two months.
We know that continuous
patience and diligence are
necessary to identify
promising patterns so we
continue to review the chart
every couple of weeks or so.
By late November we see a
descending resistance line
that could possibly form the
boundary of a tradable
pattern. We put this chart in
our folder for more frequent
reviews and check in every
several days. By early
December we see an
ascending support line that
could be the lower boundary
of a possible symmetrical
triangle. Now we move this
chart into our urgent folder
for daily review to maximize
our chances of catching a
potential breakout. Several
days later prices break out of
the 5-week symmetrical
triangle. After a hard retest,
prices moved quickly up.
We will never know when
or whether the charts we are
monitoring will produce a
tradable pattern. But the only
way we will spot compelling
setups and decisive breakouts
is to always do our homework
by cycling through our stock
list, drawing and redrawing
possible boundaries, and
staying patient. There is no
other way. If we are
beginners and just started to
look at charts, we may not
find a tradable pattern for
weeks or even months. The
market is not required to give
us a welcome basket full of
compelling chart set-ups just
because we decided to trade.
We have to be patient. We
must not be so eager to trade
and make money that we
waste our capital by trading
weak set-ups and non-
patterns.
Lastly, a five-week
symmetrical triangle is a
relatively small pattern. It
was easy to miss this pattern
even if we examined the price
action daily in late
November. Many patterns are
much easier to spot when
framed by boundaries.
Therefore, we should always
tirelessly draw and redraw
preliminary pattern
boundaries for an evolving
chart. Boundaries frame and
focus our view and help us
spot and track meaningful
price developments.

Xerium Technologies

Our next chart is a great

example of the rewards of
patience and how turning our
attention elsewhere after
entering a trade is often the
best and only thing we can
do:

FIGURE 89
 A 14-week symmetrical
triangle. We did not see
anything resembling a
classical pattern from July to
early September. Only by late
September did we see a rising
support level from the mid-
August low. With four solid
touches, this ascending
boundary was potentially
significant and thus we put
this chart in our folder for set-
ups requiring more frequent
review. In early October, we
saw that the rising support
line successfully supported
two more price touches. We
continue to check in every
several days and stay patient.
In late October, we see that
the rising support line has
earned another price touch
and that a possible upper
boundary of a potential
symmetrical triangle has been
established. The pattern
seems to be maturing so we
check it daily. We should
always find out as soon as
possible the release date of
the next quarterly earnings
report. We find that Xerium
Technologies is due to release
its earnings report in about a
week, in early November. We
wait and watch. Prices
decisively break out from the
symmetrical triangle on
earnings news. The breakout
is powerful: up 8.78% for the
day.
 Given this powerful
breakout, we can decide to
buy a smaller position.
Another and more important
reason is that Xerium is a
very thin stock. All stocks are
subject to fast moves and
large price gaps, but very
low-volume stocks are more
vulnerable. In fact, we should
generally avoid trading such
low-volume stocks unless we
do so with a significantly
reduced position and only if
there is a compelling reason
to trade. Here, the breakout
was decisive and on heavy
volume and closed above a
significant prior high. That
said, risk management, not
making money, must be our
focus and priority so we
should use a much smaller
position or avoid trading this
kind of set-up.
We decide to buy a small
position, set our stop just
below the low of the breakout
day, and move on. We have
done all we can for this chart.
We continue to cycle through
our stock list to spot
promising set-ups on other
charts. While such
detachment is easier said than
done, it must be our goal if
we are to achieve long-term
success. We do our
homework before we enter a
trade. Afterwards, we should
be indifferent toward our
positions.
 A carefree attitude focused
on other tasks after entering a
position will always be
beneficial, as it was here.
After breaking out, prices
traded in a narrow range just
above the pattern boundary
for a month. Also, there were
two hard retests that traded
below the upper boundary of
the symmetrical triangle.
Prices broke above the
trading range a month after
breakout. Then prices traded
in another narrow range for
two weeks before starting a
sustained uptrend. So prices
essentially went nowhere for
six weeks after a decisive
breakout. If we had watched
every price tick or even if we
checked the post-breakout
progress only every day or so,
we were almost certain to
lose patience and sell our
position.
As we discussed, there are
reasonable arguments against
waiting six weeks for a
breakout to reach a
resolution. Here, only in
hindsight do we know that a
powerful uptrend started six
weeks after breakout. Some
traders look for trades to
work almost immediately in
their favor. Otherwise, even if
their position is sitting on a
small profit, they will exit
their position and move on
because their valuable capital
and time can be deployed in
other set-ups. Others give
more time for a pattern to
work.
I think there are
reasonable arguments in favor
of moving on after a couple
of weeks of waiting. We
should consider these
arguments and adopt them if
they fit our personality and
trading style. But even if we
decide to give our trades less
leeway, we still must avoid
following too closely the
price action after we enter
trades because
micromanaging trades is the
path to a destructive negative
feedback loop.
Micromanagement is so bad
precisely because it
sometimes works and rewards
us for our bad behavior.
For example, let’s say that
we bought a position in
Xerium Technologies after
the breakout. We anxiously
watch the post-breakout
action as prices, rather than
surging up, are hugging the
upper boundary of the
symmetrical triangle. When
there is a hard retest in mid-
November, we have had
enough. We sell our shares.
Then let’s assume that prices,
instead of eventually surging
upwards in mid-December,
continued to decline and that
the pattern failed. We were
feeling brilliant instead of
merely lucky for
“anticipating” the pattern
failure. We tell ourselves that
we knew the pattern was
bound to fail. Besides
humorous and dangerous self-
deception, what have we
gained? True, we saved a bit
of money by selling at a
higher price than we would
have had our stop-loss order
been triggered at the lower
price. But because our
position size was appropriate
to begin with, selling at the
stop-loss price would still
have meant a very small loss.
The only “reward” was that
we were rewarded for our bad
trading behavior.
In fact, the money we
“saved” is inconsequential
compared to what we have
lost. We spent our most
valuable possessions, time
and energy, obsessing about
the price action, which we
have zero control over. Why
do we act as if prices will
obey our wishes if we watch
them closely? Having spent
our energy on a futile task,
we are more tired than we
need to be. And fatigue
makes it much more likely
that we will trade badly and
make mistakes. Fatigue
means more anxiety and less
patience. We find it difficult
to stay patient and calm.
Instead, we are prone to
chasing breakouts and
entering where there is no
compelling trade. Worse,
what if, instead of the pattern
failing as in our hypothetical,
we sold our position a week
before prices finally surged
upwards? We might kick
ourselves for being so
impatient. So we chase the
breakout, perhaps with a too-
big position. When prices
inevitably pause and decline,
we get stopped out for a large
loss. We are angry and
anxious to make back our
money the market “owes” us.
So we chase again and again
with larger positions and the
losses mount. It is the
familiar cycle of great pain
and frustration.
The way to avoid this
negative loop is simple: we
must be bigger than our
trading results. And we are.
Stop obsessing over a trade
and let go. Be like Han Solo:
cool, calm, and nonchalant.
The foundation of such
detachment is risk
management: trading only
compelling set-ups and
risking only a fraction of our
trading account on any given
trade, we are indifferent to the
outcome.

TRW Automotive Holdings

Our next set-up emphasizes

again the need for and the
benefits of sustained
diligence.
First, the weekly chart:

FIGURE 90
 A 14-month symmetrical
triangle formed after a 2-year
rally from the 2009 lows.
Before we examine the daily
chart, let’s talk about any
biases we may have had with
this set-up. I’ll tell you what
my bias was. I thought surely
this possible symmetrical
triangle will be a reversal
pattern. I had a difficult time
accepting even the possibility
that the stock could continue
to go up after rising 43-fold
from March 2009 to March
2011.
But, of course, prices
could continue to go up.
There is something
irresistible about picking the
tops and bottoms of a price
move. With TRW having
risen so much over several
years, we liked the idea of
shorting shares at possibly the
very end of a multi-year
uptrend. We missed the
gigantic uptrend from the
depths of the 2007-2009
financial crisis, but we sure
won’t miss the crash from the
top. This is exactly the wrong
mindset. If we are so focused
on a particular result, then we
will fight the trend and lose
money and miss a profitable
trade. We must continuously
fight our biases and wishes to
keep our eyes open and
accept the actual price action.
Let’s return to analyzing
the chart of TRW. We saw
nothing resembling a classical
pattern during the first year of
the construction of this
symmetrical triangle. Only by
continuously checking the
chart as part of our regular
browsing process, and also by
occasionally checking the
weekly chart to get a big-
picture view of the price
action, could we spot this
pattern. And despite the
pattern’s large size and well-
formed shape, it was not easy
to spot it. Part of the reason is
that the six significant highs
and lows that touch the upper
and lower boundaries are
spread over 14 months.
Again, constantly drawing
and redrawing preliminary
pattern boundaries made
spotting and tracking the
pattern much easier
because boundaries frame
and focus our view of the
price action. They also alert
us to the need to redraw our
preliminary lines when prices
overshoot them. And they
also confirm the significance
of a boundary by staying
within them.
Now let’s focus on the
breakout using a daily chart:

FIGURE 90.1
 By early August 2013, we
saw that a possible significant
low had been established in
late July and that this possible
symmetrical triangle now had
at least four solid touches
framing it. As a continuation
symmetrical triangle can
launch a breakout after four
touches, we know that a
possible breakout could
happen soon. So we put this
chart in one of our more
urgent folders for more
frequent check-ins. In mid-
August, prices touched the
upper boundary but was
turned back. This price action
was significant because it was
the fourth touch on the upper
boundary and it also
supported the interpretation
that our upper boundary was
a meaningful boundary and
resistance. Perhaps prices
would make another attempt
at overcoming and closing
above the upper boundary.
Or, prices could fail to break
above the upper boundary
and instead drop through the
lower boundary and complete
a reversal symmetrical
triangle. Or the chart could
evolve into something
entirely different. These are
all possibilities that we have
to be open to while we wait
for a compelling reason to
enter this set-up.
By late August and early
September, we saw a possible
3-week symmetrical triangle
forming just under the upper
boundary. This small pattern
had the potential to launch a
powerful upward breakout or
a downtrend. The situation
was resolved when prices
decisively shot up from the
small triangle and the larger
14-month triangle on
September 6. Prices went up
4.5% on the breakout day and
so we could enter around the
closing price and set our stop
just below the day’s low.
Prices moved higher for a
week before pausing and
reversing for a hard retest
where prices traded below the
upper boundary. Depending
on where we placed out stop-
loss order, this hard retest
could have triggered our stop.
Let’s say we were stopped
out and disappointed, but we
continued to focus and
evaluate the chart. We
thought it was significant that
during the retest prices traded
but did not close below the
boundary. This fact,
combined with the initial
decisive breakout from a
significant pattern, suggested
that we should continue to
monitor this set-up.
In fact, some of us may
decide to re-enter very soon
after being stopped out. We
could enter around the
closing price of the hard
retest day and set our stop
just below the low. The
rationale for this second trade
is that the upper pattern
boundary kept prices from
closing below it and thus the
pattern and breakout were
still valid. We also had a
clearly defined and, in my
opinion, favorable reward-to-
risk scenario. If the retest was
over, then prices would
rebound. If prices continued
to decline, then we got
stopped out for a likely 1.4%
loss on our second entry.
If we saw no compelling
reason to re-enter so soon
after the hard retest, then we
could wait and continue to
monitor the chart. We saw
prices jump almost 8% three
days after the hard retest. Did
we make a mistake by staying
out? No. Waiting for a more
compelling entry spot was a
reasonable decision. Most
importantly, we absolutely
must not chase. If prices had
continued to streak up after
the 8% jump, then we have to
accept it and let it go. Let it
go. We did not do anything
wrong. And, let’s say it
together: there will always be
other and more compelling
set-ups to trade.
As it happened, prices
stalled again at around the
previous significant high and
generally declined as the next
quarterly earnings report
approached. If we had bought
shares after the hard retest,
then we should sell our
shares. If we had not re-
entered this trade after getting
stopped out, then we would
wait until the earnings report
is released and see how the
chart looks afterwards. The
earnings announcement in
late October caused prices to
rise modestly but there was
no reason to buy shares.
There was no continuation
pattern that presented a good
entry spot.
So far we had the initial
breakout from the giant
symmetrical triangle, which
was tradable, a hard retest,
which likely stopped us out
and could be seen as a
relatively attractive re-entry
point, and range-bound
trading before and after the
earnings report. Since we
now had no compelling
pattern to trade, we would
wait and continue to watch
the chart.
One thing we noticed was
that the post-earnings rise in
early November was turned
back at exactly the prior high
reached in early October. We
had a potentially significant
resistance level that could
form the boundary of a
classical pattern yet to be
formed. Prices declined into
mid-November before
reversing and going up.
Prices turned up just above a
preliminary rising support
boundary we had drawn and
therefore we conclude that an
ascending triangle was
possibly forming. We check
daily the chart and see prices
breaking out decisively from
the ascending triangle in late
November. Now we had a
clear breakout from a
textbook classical pattern and
a compelling reason to enter a
trade at a spot with a
favorable reward-to-risk ratio.
What were the key
ingredients to spotting and
trading this entry signal?
Consistent patience and
diligence. The breakout from
the 7-week continuation
ascending triangle came
almost three months after the
initial and exciting breakout
from the 14-month
symmetrical triangle. When
the initial breakout fizzled
and stopped us out, we were
disappointed and inclined to
forget this chart and move on.
And it is important not to
dwell pointlessly on why
there was no powerful and
immediate follow through.
But an even better approach
is to have the courage,
patience, and diligence to
periodically check back to see
if the chart was evolving to
form another trade
opportunity. Why courage?
We all get discouraged,
especially when a promising
set-up does not work in our
favor. Our natural inclination
is to trash the chart and never
look at it again. Instead, we
could periodically glance at
the chart to spot interesting
price action.
Trading well is never
about forcing meaning onto a
chart. We can never make
things happen by being
anxious and impatient. We
can only participate in price
moves launched by classical
patterns. And we need
continuous diligence and
patience to spot compelling
set-ups.

General Dynamics

Let’s finish this chapter with

one of my favorite charts
from the past couple of years.
Here is a weekly chart of a
27-month symmetrical
triangle:
FIGURE 91
 A perfect giant
symmetrical triangle. It is
tempting to think that all we
had to do to make money was
buy shares at the breakout.
But remember that we are
looking at this pattern in
hindsight. Trading in real
time is challenging, even with
a giant pattern staring at us.
What was required to
trade this set-up well? Again,
we needed patience and
diligence to spot, track, and
trade this symmetrical
triangle. Of course we would
not look daily at this chart for
twenty-seven months. There
was nothing to make sense of
when the pattern started to
form in early 2011. Even well
into 2012, we would not have
known what, if any, classical
pattern was forming. It was
only in late 2012 and early
2013 that we saw that prices
were coiling and forming a
symmetrical triangle.
While we did not have to
check this chart every day,
we still had to monitor it on a
regular basis, say every
several weeks or so. And
even such intermittent
vigilance is not so easy for
those of us, especially
beginners, who are not used
to systematically going
through our charts even when
nothing interesting or tradable
seems to be developing.
Continuous diligence can be
burdensome for experienced
traders too. We could be
single-mindedly and unwisely
focused on a potentially
explosive set-up or a post-
breakout action while
ignoring our basic job as
classical chartists: to look at
charts.
That said, missing this set-
up was not a disaster. We
may see this chart for the first
time only after the breakout.
Or we may have been
viewing this chart every two
weeks or so, but, because we
did not draw any preliminary
boundaries that framed the
price action, we did not spot
the coiling triangle. Or
perhaps we were busy
focused on other compelling
set-ups and breakouts. Or, we
may get lucky and spot this
set-up for the first time just as
it is nearing a breakout. My
point is that we must accept
the fact that we will miss
many setups, including giant
patterns such as this
symmetrical triangle. We are
not perfect, and we don’t
need to be. In fact, we must
not pursue perfection given
the inherently highly
imperfect nature of chart
trading, including the
necessity of taking many
small losses. We find some
and we miss some. And even
when we miss a breakout, the
set-up will often give us
second and third chances to
enter through retests or
continuation patterns.
Let’s now look at the daily
chart to focus on the
breakout:

FIGURE 92
 Prices closed above the
upper boundary on earnings
news. With the immediate
volatility of the earnings
release out of the way, we
could buy shares around the
closing price and set our stop
just below the breakout day
low. We had a good
opportunity to buy shares for
the next several days as prices
did not immediately jump up
and force us to risk more than
prudent. Then prices
gradually increased for the
next 3 weeks and the stock
was up about 10% since
breakout. Everything was
going well: clean breakout,
good follow-through, and no
difficult retest. Then came the
challenges. In late May,
prices stalled and started to
trade in a narrow range.
Everytime prices seemed
ready to make a run, they
would reverse and decline
before turning up again
before stalling yet again.
This situation captures one
of the dilemmas and mental
challenges of trading: we
have a 10% profit on our
position and we want more
given the decisiveness of the
breakout from a massive
textbook pattern, but we also
don’t want to lose the profit
we are sitting on. It is easy to
say now that we should just
wait patiently, that we should
do other things and check
back in several weeks to see
what happened. If we got
stopped out, then so be it.
Only in hindsight do we
know that prices eventually
broke out from this trading
range and went higher and
higher. Don’t get me wrong:
we should direct our energy
elsewhere after entering a
trade. But the reality is that it
is difficult to be so detached
from a trade given our
emotions.
One way to achieve some
detachment is to take profits
on a portion of our position,
say, one-third or so, and let
the rest ride the price action. I
like this option. It
acknowledges our emotions.
It also accounts for the
possibility that the breakout
can fail and prices crash
down through the pattern
boundary. Still, I think it is a
worthy goal to try to stay
with our full position until a
resolution. After all, we know
that if prices decline and we
get stopped out, we will
suffer a small loss that was
accounted for and even
expected in exchange for
making a worthwhile bet on a
compelling breakout.
The choice is ours. We
must choose a trading style
after considering our
personality, capacity for
detachment, and preferences.
No single trading strategy
will produce the best outcome
in all scenarios. Instead, we
must choose a trading style
that suits our temperament
and gives us the best chance
for long-term success.
Let’s return to the General
Dynamics chart. Let’s assume
that we we missed the initial
breakout. We were
disappointed but it is a
mistake to banish a chart to
the trash bin out of
frustration. Instead, we will
revisit this chart as part of our
regular cycling through of our
stock list. Perhaps in a week
or two there will be a retest
that brings prices back down
to the pattern’s upper
boundary and create another
entry opportunity. Or perhaps
a continuation pattern will
form and provide a good
entry spot.
Two weeks pass and it is
early May. Prices are steadily
climbing. There is no reason
for us to enter and chase. By
late May prices seems to be
trading in a narrow range.
Prices are still trading in a
range in the middle of June.
We notice that the price dip
into early June was reversed
at the exact level where a
price decline in mid-May was
reversed. We now have a
potentially significant support
level and we draw a
horizontal line. If prices close
decisively below this support,
then we know that a hard
retest or even a pattern failure
is a possibility. Another
possibility is that this support
can form the lower boundary
of a continuation pattern that
pushes prices higher. These
are simply possibilities for
now and we continue to wait
and observe because we have
no reason to enter the trade.
Two more weeks pass and
now it is late June. We see
that our preliminary support
level bounced another price
dip in mid-June. We also
notice that a possible
resistance level turned back
two breakout attempts in June
and so we draw an upper
boundary. We now have well-
established support and
resistance boundaries. Was a
rectangle forming? If so,
would it be a continuation or
reversal rectangle? No need
to rush to judgment. We’ll
wait and observe and enter
only if we have a clear price
signal and a compelling entry
spot.
It is now early July. Prices
are making another run to our
upper border. This time prices
close above the resistance.
We have a clear breakout and
an attractive reward-to-risk
scenario. We buy shares
around the closing price of
the breakout day and set our
stop just below the low. Then
we move on and continue to
cycle through our charts.
What if we also missed the
breakout from this
continuation rectangle?
Disappointed, and that’s
understandable. But we
should never despair and
never chase. We won’t and
don’t have to catch every
pattern and breakout. And
new patterns are forming all
the time. We need to continue
to look at charts to find new
set-ups. So we calmly move
on and look at the General
Dynamics chart five or six
times in the next three months
as we cycle through our
charts. We don’t see any
patterns developing. The only
thing that jolts us is the
steady rise in prices that we
missed. Again, it is okay to
be mildly disappointed but
we must control our emotions
and never chase. Berating
ourselves over missed
trades is completely
unnecessary as there will
always be more set-ups. We
should use our modest
disappointment as
motivation to be patient and
do our homework. Nobody
said consistently trading well
would be easy.
Four months pass since
the breakout from the
continuation rectangle and it
is now early November. We
notice that prices coiling and
forming a possible
symmetrical triangle. We
draw preliminary boundaries
to help us monitor this
development. And we put this
chart in our urgent folder for
regular, perhaps daily, check-
ins. A week passes and we
see that the price fluctuations
have continued to narrow: a
symmetrical triangle was
definitely a possibility. We
also notice that we can draw
the possible boundaries of a
larger symmetrical triangle
that engulfs the smaller
triangle: the always
interesting pattern-within-a-
pattern phenomenon. We
monitor daily this chart and
see a breakout from the
smaller symmetrical triangle
on November 14, 2013. We
decide to buy shares around
the closing price of this
breakout and set our stop-loss
order just below the low. We
are risking just above 1% of
our position to enter this
intriguing breakout, which
may also launch the breakout
from the larger symmetrical
triangle. Indeed, the next day
prices decisively close above
the upper boundary of the
larger triangle. Buying shares
around the closing price of
this second breakout still
meant risking just 2% of our
position.
We have to continue to
cycle through our charts and
hunt for set-ups in all market
conditions. Long-term
diligence is just as important
when we are on a winning
streak. We will grow and,
more fundamentally,
preserve, our capital only if
we continue to trade well, and
we can trade well only if we
are continuously spotting
favorable set-ups. If, instead,
we get confident and neglect
to do our homework, we will
bet on weak setups. Our gains
will quickly become large
losses and lead us to a
destructive cycle of financial
loss, frustration, pain, and
more loss.
 CHAPTER 29

Trading the Market

Indexes,
and A Lesson in
Stubbornness

As traders, we look at
individual set-ups. We would
not buy the shares of a
company at a random spot
just because the market is
exploding higher. Nor would
we short the shares of a
company just because the
market is declining. However,
most stocks move with the
overall market. That means
we should trade mostly long
set-ups in a rising market and
mostly short set-ups in a
declining market.
So if we find a compelling
upside breakout from a
textbook classical pattern
amid a declining overall
market, we may trade this set-
up but do so as an exception
to the overall declining trend.
Edwards & Magee stress the
importance of trading mostly
in the direction of the overall
market and how short trades
in a rising market and long
trades in a declining market
should be undertaken sparely
and only as partial insurance
against the bulk of our trades
being in the same direction as
the overall market. Long-term
trends do not usually reverse
overnight. Trends continue
longer than traders and
investors expect. Remember,
classical chartists seek to
participate in, rather than
predict or anticipate, the price
trends that start from patterns.
There are times when the
direction of the overall
market and the price action of
individual charts give a
mixed signal. For example,
we may find that the overall
market as measured by the
major market averages is
either trading in a range or in
a general uptrend while we
see many short set-ups on
individual charts. What
should we do? The most
important rule is to remember
that we do not have to do
anything. There is no rule
requiring us to trade for any
reason. I have learned that
trading as few times as
possible often pays off the
best, even when there are
some promising set-ups and
breakouts. Sitting still and
watching and waiting for the
most compelling set-ups
where the reward-to-risk ratio
is overwhelmingly in our
favor is perhaps the best way
to ensure longevity and
profitability in the markets.
And nobody prevents us from
waiting for these fat pitches
… except ourselves. We will
always be our own worst
enemy.
Individual charts are prone
to false break outs in a
choppy market. When the
major market indices are
trading in a range, I often see
breakouts from textbook
patterns reverse quickly and
lead to pattern failure. Then
these formerly-ideal patterns
will often evolve into nothing
or a different classical
pattern. Therefore, I try to
trade as little as possible in a
range-bound market. If I do
trade in a sideways market, I
tend to trade only the major
market indices using ETFs
such as the QQQ (Nasdaq
100), SPY (S&P 500), IWM
(Russell 2000), and DIA
(Dow Jones Industrial
Average). Regardless of how
often we trade the indices, we
must pay close attention to
them as most stocks will
move with them most of the
time.
Let’s see how we could
have traded the indices in the
first half of 2014.

QQQ: Continuation diamond

pattern

While I did not trade it well,

this set-up was one of my
favorite patterns of 2014
because it reaffirmed the
value of classical charting.
Let’s first get a big-picture
view of the situation:

FIGURE 93
 A textbook diamond
pattern. Looking at it now,
the pattern seems so obvious.
It may also seem obvious that
it would continue the multi-
year uptrend. Surely every
trader who was paying even
modest attention must have
made money on this set-up,
yes? That’s what I would
think too if I saw this chart
for the first time months after
the pattern had launched a
breakout and reached its price
target.
But remember that we
have trade in real time and
not in hindsight. If I sound
condescending, then please
know that condescension is
not my intent. My intention is
to warn us that these
hindsight judgments are
misleading and simply
wrong. Again, we trade in
real time, and in real time the
market was very choppy and
imposing great frustration and
losses on traders. The perfect
boundaries we see now
included much volatility and
uncertainty. I am not saying
that we needed to decode
random price movements or
get lucky predicting the
future to trade this set-up
well. To put it bluntly, all we
had to do was wait and allow
the chart to declare its likely
intention. And waiting is
what is so difficult for all of
us. Much patience and
discipline were required to
observe the evolution of the
chart over several months.
Then, just as important, we
needed courage and nerve to
enter the trade upon breakout.
Let’s start in early
December of 2013. Here is
the QQQ chart from late 2013
onwards:

FIGURE 93.1
 The stock market had been
on an incredible run
throughout 2013 and it
seemed nothing would derail
its historic rise. There was
some choppiness in
December but the QQQ was
still up for the month. The
QQQ continued to rise
through mid-January before
suffering a 6% drop into the
February low. Then the QQQ
reversed and went up for two
weeks straight. Prices stalled
in early March before
declining into the early April
lows.
So the market was
volatile, but the market is
always volatile. Prices
sometimes go up and
sometimes go down. Amid
the ever-present uncertainty,
was there a way to make
sense of this price action? We
will find that returning to the
most basic fundamentals of
classical charting, and we
cannot get more basic than
support and resistance, will
always be productive and
enlightening. Notice that the
February and April lows
traded but did not close below
the support level dating back
to November 2013. In fact,
prices bounced strongly off of
this support.
Another way to help us
frame the price action is to
always draw preliminary and
possible boundaries. Notice
that a rising resistance line
from December 2013 to
March 2014 has about 10
solid touches. Just as
intriguing was how a
declining support line from
December 2013 to the April
2014 low got three solid
touches. And there was also
the fact that a declining
resistance line from the
March 2014 highs also had
multiple solid touches. Was it
possible that a diamond
pattern was forming? If so,
would it be a continuation or
a reversal diamond pattern?
So far we have not
discussed whether these price
developments presented any
trading opportunities. As a
classical chartist, we trade
decisive breakouts from
classical patterns. We might
also trade standalone support
and resistance levels if they
also present a clearly defined
and favorable reward-to-risk
scenario. Here, we could have
traded the bounce off of the
support level dating back to
November 2013.
What about the possible
diamond that was forming?
Was there a compelling early
entry point for the possible
diamond pattern?
I thought there were
intriguing developments that
suggested, to me at least, that
this possible diamond would
be a reversal pattern that
would start a significant
decline in the markets.
First, there was a well-
formed mini-diamond pattern
that formed at the very top of
the possible larger diamond.
Second, there was also a
possible horn top that formed
soon after the breakdown
from the mini-diamond. I
looked at the mini diamond
and horn top as promising
early entry points before a
possible breakdown from the
diamond. A potential pattern-
within-a-pattern is always
interesting, and now I thought
I was looking at an even more
intriguing two smaller
patterns within a larger
pattern that could start a
powerful downtrend.
So I had an opinion and
also traded on what I thought
were compelling entry
opportunities. Having an
opinion and trading on logical
entry points are not
problematic. What is
problematic is being so
attached to any one possible
scenario. And I made this
mistake. I was so excited
about this multiple-pattern
set-up starting a big
downtrend that I closed my
mind to alternative outcomes.
For my multiple-pattern
scenario to become reality,
the mini-diamond and horn
top patterns had to be the
catalysts of a significant
downtrend and nothing less. I
so wanted the chart to play
out according to my opinion.
By being so stubborn and
inflexible, I was of course
ignoring an alternative
scenario: that the mini-
diamond and horn top could
both work by producing
modest price declines
reflecting their small sizes but
that afterwards prices may
still break to the upside out of
the possible diamond pattern.
And the chart offered ample
clues that an upside breakout
was a real possibility when an
ascending triangle seemed to
be forming in the last part of
this possible diamond pattern.
You may be asking why I
failed to see this ascending
triangle. My answer is that I
did see it. But seeing
something and accepting it
are different things. If I may
say so, I think we have a
large capacity to ignore
reality and instead believe
what we want to believe. And
I wanted my original opinion,
that the diamond would be a
reversal pattern, to become
reality.
So strong was my bias that
I came up with many excuses
to justify not changing my
mind and buying shares when
prices broke out to the upside
from both the ascending
triangle and the continuation
diamond.
Why was I so stubborn? I
wanted the multiple-patterns-
within-a-pattern scenario to
work and not waste the
textbook mini-diamond and
horn top that had formed. But
the reality is that the small
topping patterns did work.
What also worked was the
ascending triangle that
formed immediately after
these small topping patterns. I
was too close-minded to
accept the possibility that
they were part of the
construction and evolution of
the continuation diamond
pattern.
A trading principle that
I have found to be very
valuable is that traders
should wait until a pattern
proves itself. That is, we
should not jump to
conclusions and predict.
Instead, we should simply
participate in the trend.
There was nothing deceitful
about the breakout from the
diamond pattern. We had
plenty of time to buy shares
while risking a very
reasonable amount of our
position. All we had to do
was wait, observe, and let the
chart declare its intention.
This is why early entries,
even based on logical entry
points, must be used with
care: they can make us
inflexible and lead us to miss
the real breakout. It is crucial
to always have an open mind
and consider opposite
scenarios, especially when we
have entered in anticipation.
It would not be an
overstatement to say that the
skills needed to successfully
trade this breakout from the
continuation diamond were
the ability to draw lines and
to understand the direction of
the breakout. Drawing and
knowing up from down. We
learned to do these things in
kindergarten but along the
way we also learned how to
over think and pursue
personal glory.

SPY

Now let’s see how the other

major stock indices were
doing. The major indexes will
almost always move together
so we would expect the SPY
ETF that tracks the S&P 500
index to be in an uptrend in
this period as well. And
indeed SPY was trending up
from May to July 2014:

FIGURE 94
DIA

Let’s now look at the DIA

ETF that tracks the Dow
Jones Industrial Average:

FIGURE 95
 DIA was also in an
uptrend from May to July
2014.

SPY vs. DIA: which should

we trade?

The stock market was rising

during this time and the three
ETFs tracking the three major
indices all reflected this
uptrend. Does that mean we
could have used any one of
the three ETFs to trade this
trend? Remember that we
would not buy any stock at a
random price just because the
overall market is rising. We
would look to enter only if
there was a compelling set-up
with a clearly-defined and
favorable reward-to-risk
possibility. The diamond
pattern and the breakout from
it provided a favorable entry
spot in QQQ. Was there a
well-defined pattern on
SPY’s chart that provided a
compelling entry point? Yes,
in the form of a continuation
H&S bottom as shown on
Figure 96:

FIGURE 96
 What about DIA: did its
chart produce a classical
pattern? No, in my opinion, it
did not. So while QQQ went
up after forming a textbook 5-
month continuation diamond
and SPY went up after a 2.5
month continuation H&S
bottom, DIA simply went up
without forming a tradable
pattern. This absence doesn’t
negate the fact that DIA was
going up. But from a classical
chartist’s perspective, that
omission meant we did not
have a compelling trade on
the DIA chart.
There is a saying that it is
hard to make money in a
rising market. Even the
strongest bull markets have
periods of declining prices.
Investors who buy rising
stocks just before the market
begins a decline are prone to
selling just before the market
resumes its uptrend. Patience
is still very much necessary
even and especially in a
raging bull market.
Traders are even more
vulnerable to losing money in
a bull market. A rising market
lulls traders into thinking that
making money is easy and
they do not have to be careful
in choosing chart set-ups. So
they start to enter early and
make anticipatory trades and
hope that a rising market will
forgive their haste. The
results are large losses, and
even more damaging, mental
pain and loss of confidence.
The frustration of losing
money in a bull market is a
uniquely painful experience.
Our best defense is to be even
more patient and careful
when trading during a bull
market. We have to continue
to do our homework and trade
only the best set-ups. Big
losses are guaranteed the
moment we get
overconfident.
The fact that most stocks
move with the overall market
most of the time leads us to a
vital implication: we should
save most of our financial and
mental capital for times when
the market is trending
strongly. If the overall market
is trading in a range, then it is
likely that there will be
relatively few decisive
breakouts from individual
charts. Individual stocks will
also likely be range-bound
and perhaps methodically
constructing but not yet
breaking out of classical
patterns. And there is a higher
likelihood that individual
breakouts may turn out to be
false breakouts that lead to
further chart evolution before
the real move. Of course
there will be individual set-
ups that break out and
strongly trend even when the
overall market is stuck in a
range and we should always
make trading decisions based
on each set-up. But I think it
is better to deploy the bulk of
our trading capital when the
major indices are breaking
out of trading ranges and
possibly starting a run. Thus,
we need to look closely at
SPY, QQQ, and DIA to
understand what the overall
market is doing.
Looking back at my first
couple of years of trading, I
realize that concentrating my
focus and capital to trending
periods would have been the
single best thing I could have
done to dramatically improve
my trading results. I would be
up 20% to 30% when the
market was trending but lose
much of it or more during
range-bound periods when I
got stopped out trade after
trade. Instead of stepping
back and realizing that the
market was choppy and not
trending, I would trade
increasingly unfavorable set-
ups trying to recover my
losses. More losses led to
more frustration and more
chasing of bad set-ups and yet
more losses. I had entered the
cycle of pain, and I could
blame only myself.
We need not fall into this
trap. By observing the major
indices and having the
discipline to wait for trending
periods, we can reduce our
losses and increase the
likelihood that we keep our
profits. Time and time again I
am struck by how much of
trading comes down to
patience. If we get only one
thing out of this book, I hope
we learn that the market will
give patient traders many
compelling set-ups at some
point. The trick is that we do
not know when that time will
be. But the set-ups will be
there. We need patience.
Surely the market can
demand patience in exchange
for giving us the opportunity
to learn about ourselves,
exercise discipline, and
perhaps even make some
money.
 CHAPTER 30

50-day and 200-day

Simple Moving
Averages

I use only two indicators: the

50-day and 200-day simple
moving averages. I use them
as supplemental but not
controlling references. These
two moving averages are the
only visual data displayed on
my screen other than price
and volume. A good charting
program will allow us to
display the moving average
of our choice. Ask customer
support if you need help
setting up moving averages
on your charts.
Why these two moving
averages instead of, say, the
10-day or 100-day or any
other period? The 50-day and
the 200-day moving averages
are some of the most referred
to indicators among traders
and investors. I have found
the 50-day and 200-day
averages to be effective
support and resistance levels
often enough to warrant
observation but not be the
final determinant of my
trading. Prices and breakouts
are still the most important
factors in my trading
decisions. As a trader, I am a
chart purist.
Others may feel that
different moving averages,
say, the 30-day and 100-day,
are better secondary reference
points.
We have to be cautious,
though, when choosing and
using moving averages. Just
as there is no single entry and
exit strategy that will produce
the best outcome in every
situation, there is no moving
average that will always be
the ideal reference point for
every chart. Because we can
display any moving average
we wish, the danger is that we
choose the moving average
that confirms our wishes or
“explains” the price action in
our favor.

How not to use moving

averages

Let’s say that we have a

breakout from a descending
triangle. The lower horizontal
boundary is at the $17.50
level. Prices decline to $17
then reverse and the pattern
fails. We ask why the price
bounced up from the $17
level instead of continuing to
go down. We don’t see any
previous support or resistance
levels at $17. The 50-day and
200-day moving averages are
nowhere near the price action.
So we start charting different
moving averages to fit the
price action. After trying the
10-day, 13-day, 17-day, and
etc., we find that the “35-day”
moving average was just
under $17. So we conclude
that the 35-day moving
average formed a support
level and was the reason why
prices failed to decline farther
and the pattern failed and,
worse, resolve to buy shares
when prices return to the 35-
day moving average.
Such tweaking of the
moving average to “explain”
the price action in hindsight is
very misleading and
dangerous. We have stopped
being disciplined classical
chartists trading only decisive
breakouts from textbook
patterns and instead have
started to trade randomly.
There is likely no reason
other than coincidence why
prices reversed at the $17
level and the 35-day moving
average happened to be at
that level as well.

How moving averages can

help

Let’s look at an example

where the 50-day and 200-
day moving averages
functioned as powerful
resistance. The following
chart shows a possible H&S
bottom that formed in Mechel
Steel Group from February to
June 2014:
FIGURE 97
 A decisive breakout in
early June seemed to confirm
the pattern. We notice,
though, that the breakout
stopped just under the 200-
day. Prices then traded in a
narrow range for several
days. It was possible that
prices were forming a bullish
flag or pennant that would
propel them through the 200-
day resistance. Instead, prices
quickly reversed after briefly
trading above the 200-day
and closed decisively below
the neckline of the H&S
bottom. Prices failed to close
above the neckline again and
the pattern failed over the
next several days.
In my view, the key
question is not whether we
should buy shares given the
fact that the breakout failed to
close above the 200-day, but
whether there was a
compelling entry opportunity
after the breakout – the basic
and most important question
we must ask for every set-up.
That the breakout stopped
just under the 200-day is an
interesting but a secondary
concern for me. Whether I
enter this trade will depend
on whether there was an
advantageous entry spot after
the breakout, and here there
was none. Why? The
breakout, despite being
stopped by the 200-day, was
powerful: up 13.2% on the
day. I would not have used a
buy-stop order in anticipation
of a possible breakout
because MTL is a relatively
low-volume and high-
volatility stock. That meant
that I would have to decide
whether to buy shares after
the powerful surge. And it
was clear that I was out of
position after the breakout: I
did not want to risk more than
13% of even a small position
to trade this breakout.
Would I have bought
shares if the breakout was
more modest, say, rising only
3-4% on the breakout day
instead of more than 13%?
Yes, because I saw a decisive
breakout from a promising
pattern despite the fact that
the potential resistance of the
200-day was overhead. I trade
breakouts from classical
patterns and not moving
averages. I have found that
even when the 50-day and
200-day averages function as
effective support or
resistance, they only rarely
affect my entry and exit
plans. In contrast, an
upcoming earnings release
will always change or halt our
trading. If one of these
moving averages overlaps a
pattern boundary, then we
may conclude that the
boundary’s resistance or
support potential may be
stronger than otherwise. But
this possibility does not
significantly affect my
trading since we are looking
for a decisive breakout
through the pattern boundary
whether or not the 50-day or
200-day is nearby. A
breakout through a key
boundary and the 50-day or
200-day makes the breakout
more credible. But our trade
decision still rests on whether
we have a favorable entry
spot.
 PART III

CONCLUSION
 CHAPTER 31

Life and Trading

Nothing can bring you peace

but yourself.
Nothing can bring you peace
but the triumph of principles.

Ralph Waldo Emerson

As we said at the beginning,
trading is speculating. With
its lure of quick profits,
speculation seems uniquely
well equipped to bring out the
worst in ourselves. But we
simply cannot succeed in
trading with a get-rich-quick
mentality or any short cut.
Trading well means doing our
homework, being patient,
limiting risk, moving on after
setbacks, pursuing diverse
interests, living life, and
recognizing that our lives are
bigger than trading. Again
and again. Informed and
prudent trading, far from
requiring a gambler’s
lifestyle, is based on a
continuous affirmation of
worthy values.
Remember that we do not
have to prove anything in the
markets to anyone. We do not
have to trade to secure our
financial future. Thrift and
living within our means are
always available and effective
ways to build a solid
foundation for ourselves. If
we choose to trade, we should
do so with discipline and
caution, always remembering
that protecting our capital, not
making money, is our
priority. If we apply these
truths to our trading, we will
find that trading can be a
source of wisdom, self-
discovery, and yes, even
excitement.
I plan to publish a book of
instructive and recent chart
patterns on a regular basis. I
am sure there will be many
interesting classical patterns
to choose from for the next
volume of this book. Some
are forming now, some will
form later, and some are
breaking out as I write these
last sentences.
The patterns will be there.
We must bring the patience,
discipline, and perspective.
I wish you the best.
Farewell for now.
 CHAPTER 32

Suggested Reading

Here are some books that I

enjoyed and offer
fundamental knowledge on
trading, investing, and the
financial markets. We should
take time to learn before
committing our time, energy,
and money to the market.

“Technical Analysis of Stock

Trends” by Robert D.
Edwards & John Magee

I use the 5th edition (1966)

for my daily reference. I also
have the 4th (1957) edition.
The 4th edition is essentially
the same as the 5th, but the
charts in the 4th are not as
clearly drawn as the charts in
the 5th. I bought my pre-
owned 5th edition from
Amazon.

“Technical Analysis and

Stock Market Profits” by
Richard Schabacker
(Harriman House 2005)

While Edwards & Magee

deserve praise for their work,
they acknowledge
Schabacker as the original
founder of classical charting.
You don’t need to buy both
Schabacker and Edwards &
Magee. Either book will
suffice.

“Market Wizards: Interviews

with Top Traders” by Jack D.
Schwager (Wiley 2012)

Informative and fun

interviews with prominent
traders. The book is not about
specific trading strategies.
The value of this book comes
from learning timeless
principles (e.g., cut your
losses quickly) and the
importance of the mental
game.

“A Random Walk Down

Wall Street” by Burton G.
Malkiel (W. W. Norton 2003)

A good introduction to the

stock market. Malkiel argues
that chart traders and
fundamental investors’ efforts
to beat the market are futile.
Instead, he urges everyone to
use low-cost index funds to
invest in the stock market.
Traders must be open to
opposing ideas and different
possibilities, and this book is
as far from classical charting
as you can get. If you agree
with the message of this
book, then you should not
trade.

“The Intelligent Investor” by

Benjamin Graham (Collins
2006)

A book on picking stocks

using the value investing
approach. Ironically, one of
the main messages of the
book is that we should just
invest in low-cost index funds
rather than pick individual
stocks. The book is ultimately
a cautionary tale about the
stock market. Before we
decide to trade or invest, we
should learn what we are up
against.
 ABOUT THE
AUTHOR

Brian studied at the

University of California at
Berkeley and at Harvard Law
School. He is a student of
economic history and the
financial markets. As a
Harvard Law School Post-
Graduate Research Fellow,
Brian researched the
relationship between equity
returns and national politics.
He has authored articles on
economic issues in
publications such as the
Harvard Journal on
Legislation.

Brian is a writer, investor,

trader, and trading coach.

You can follow Brian at

portfoliocareerist.blogspot.com
and on Twitter:
@PortfolioBrian.

Brian can also be reached at

brian.b.kim@gmail.com.
 DISCLAIMER

Everything in this book is for

informational, educational,
and entertainment purposes
only and is not to be
considered professional
advice of any kind. All
statements and opinions in
this book are not meant to be
a solicitation or
recommendation to buy, sell,
or hold securities. Trading
and investing involve risk and
may result in financial loss.
All trading and investment
decisions you make are your
own.