CHART PATTERNS

CHART PATTERNS

Recording the Battle between Supply and Demand

The backbone of the Point and Figure analysis is the chart pattern. The beauty of this method is its ability to form simple chart pat- terns that record the battle between supply and demand. The reason this method is so credible is that it is founded on the irrefutable law of supply and demand, which affects our life on a daily basis. Al- though just about everything we come in contact with has some as- sociation with supply and demand, it wasn’t until my first course in college-level economics that I really thought about and came to un- derstand this basic law. Heck, for the previous 22 years, I had sim- ply taken price change at face value—prices changed and that was it. It was that ECON 101 class in college that taught me to appreci- ate the law of supply and demand. You know what? Most people never gain a full understanding of it. This is why I strongly feel that as a requirement for high school graduation every student should take an economics course using the textbook Economics in One Lesson by Hazlett (Random House, 1981). Since it seems unlikely I’ll be elected to any office where I will be able to institute this course of instruction, it will have to remain in the pages of this book. Take it to heart and have your kids learn these basic concepts. They will be well rewarded later in life with clarity of vision others will never have. While many of the concepts I learned in ECON 101 have been improved on over the years, one remains unchanged—

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supply and demand. It is the driving force behind all price changes. If there are more buyers than sellers willing to sell, then the price will rise. If there are more sellers than buyers willing to buy, then the price will decline. This is as true for the price of tomatoes as it is for the price of stocks. It is as simple as knowing why we have lemonade stands in the summer and hot chocolate stands in the winter. Although these price changes affect our lives on a daily basis, we rarely think much about the law that governs these changes. We are currently in an energy crisis. The price of oil is above $70 a barrel as I write this. The American public is up in arms looking to have someone’s head on a platter. Some say it’s the big oil companies that are gouging the retail customer. Others say the government is doing nothing to pass legislation to reduce the price of gasoline at the pumps. Blame is everywhere, but few under- stand what is truly happening. Even our elected officials have not demonstrated one shred or knowledge of economics. It truly amazes me. One idea Congress came up with was to tax the heck out of the big oil companies with a Windfall Profits Tax. If that was to be in- stituted, big oil would simply produce less of what is being taxed more, and the result would be shortages and higher gas prices. What it would do is gain votes for the politicians who proposed it. The votes would most likely come from those who would be most hurt by the legislation. I have not seen anyone explaining to the Ameri- can investor why it takes 800 government permits to build one re- finery. This is not a problem that will be fixed by legislation other than legislation allowing the oil companies to search for more oil and gas. The energy crisis is a topic for a whole book. Suffice it to say, Adam Smith’s “Invisible Hand” is working well.

When I left a hotel in Phoenix, Arizona, on May 6, 2006, the highways were nearly empty. No one was driving. Those who were driving were not driving their SUVs. “The Invisible Hand” was working. High gas prices caused less driving, which caused less demand for gas, which caused the demand for SUVs to de- cline and demand for small cars to increase, and so it is, real life Econ. 101. The problem with television today is no one takes time to educate the public on very important things like energy costs. I have been a regular on both CNBC and FOX business shows. There is only time for sound bites. It’s all about ratings, nothing else. Every time I was on one of those shows, I tried to

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educate the viewers in some way about how the markets worked, but the time was so short, even in a half hour show that I’m afraid I failed at my task. One day I decided to take things into my own hands. We went to a local TV station and began to tape “The James River Talks.” These were hour-long talks about the mar- kets and how we used Point and Figure analysis to help us negoti- ate them. We then turned the tapes into DVDs and offered them to our clients. They received rave reviews, so I decided to take myself off the national TV programs and focus on doing the right thing. All of a sudden the Podcast came into existence. This tech- nology superseded our James River Talks, so we began doing Pod- casts each week. Now you can listen to us each week for free through itunes or www.wallst.net where we are syndicated.

In the stock markets, prices change daily. Buyer and seller bat- tle it out for control of the stock. Eventually, one side wins the battle, and the stock begins to take on a trend. Guess what? The battle between supply and demand was won by demand in oil stocks in 2002. Had investors been able to figure this out, as we did, they could have purchased oil stocks and offset any increase in gasoline along the way. Just think about how astute the Amer- ican public would be if they taught basic economics in high school. I’ll bet you there would be a waiting list for the class. I have taught this method of stock analysis to children in grade schools by using the analogy of a tennis match described in Chap- ter 1. Virtually the same pattern occurs with stocks. Over the near term, stocks seem to move back and forth randomly the same way players may win alternate sets of a tennis match. Even- tually, either demand or supply will win out and establish a trend. In the Point and Figure method, a particular pattern will form sig- naling that either demand or supply has taken control of the stock. We are not interested in making commitments in the stock market on the evidence of the sets. We are only interested in making commitments on the evidence of a completed match.

History Repeats Itself

The usefulness of the Point and Figure chart patterns lies in their repetition. The patterns of a Point and Figure chart tend to repeat

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themselves, and thus provide a high degree of predictability about the future move of the underlying stock. When teaching the im- portance of chart patterns in the Point and Figure Institutes held in Richmond, Virginia, and we also have available the DWA Global Online University, I use this example. To begin the ses- sion, I throw a ball to someone in the audience without the par- ticipants knowing I am going to do it. (At the DWA Global Online University, we discuss the concept of throwing a ball to someone in class.) The person’s reflex is to reach up and catch the ball. Then I throw another ball into the audience, and then another. Even though the participants know what is coming, the natural reflex is the same—they hold up their hands to catch the ball. This is just like a Point and Figure chart; the pattern is repeated. Every time the market throws a Triple Top, or a Bearish Signal Reversed pattern, or a Bearish Triangle pattern at me, I know the action that I must take. More often than not, the action taken was the right one. All too often investors buy stocks that are clearly being controlled by supply simply because they never ven- ture past the fundamentals of the company. Keep in mind there are some very fundamentally sound companies whose stock price move lower. What we try to accomplish is to stack as many odds as possible in our favor before we make a stock commitment. That includes fundamentals and technicals.

While the chart pattern is very important in the decision- making process, other factors should go into any decision. This method is an art, not a science. Many investors think they can simply look at a particular chart pattern with no additional eval- uation and experience instant success. It just doesn’t work like that. You are an integral part of this process. Other things we evaluate along with the chart pattern are overall market, sector, trend, and relative strength. Before we get to those concepts, how- ever, it is essential that you understand the chart patterns of indi- vidual stocks. This is of utmost importance because the markets are made up of individual stocks. The market is like the aggregate of all the fish in the sea. These fish can be broken down into schools of fish and then to individual fish. It is imperative to un- derstand the basics of looking at a stock’s Point and Figure chart before graduating to market indicators, sector indicators, and rel- ative strength.

Chart Patterns 59 Increasing Your Odds of Success

A good friend of mine, the late Jim Yates, used the following anal- ogy when explaining profits and probabilities. Consider a basket- ball game in which one player is dribbling the basketball down the court. Along the way, he receives a personal foul from an op- posing team player. A personal foul simply means the player can go to the foul line and take two shots (free throws) at the basket, unencumbered by the opposing team. Each shot he attempts is in- dependent of the other. Prior to his shooting, the television com- mentator says that this player is a 70 percent free-throw shooter. This means that he will make 7 out of 10 baskets when he at- tempts a free throw. Keep in mind that he has two opportunities to make a basket, each one independent of the other. What is the probability that he makes both shots? When I present this prob- lem at seminars, most people will answer 70 percent, whereas the actual probability of making both shots is 49 percent (0.70 × .70 = .49 percent). What this suggests is this basketball player, over time, will be successful less than half the time at completing two free-throw shots.

You, as an investor, have the same problem. You must per- form two tasks correctly, each one independent of the other. You must buy the stock right and you must sell the stock right. Have you ever bought a stock, had it go up, and—before you sold it— watched it go right back down again? If you haven’t, I have. I have also had the distinct displeasure of buying a stock and having it go right down without the benefit of a rise first. In the latter case, I never even made the first basket. This whole book is designed to help you increase your odds of success and have the greatest prob- ability of making both shots. We outline the whole game plan as we go along.

Right now, let’s deal with chart patterns. Chart patterns are like road maps. They are really not any different from a map you might study to find the best interstate for a vacation trip to New York from Richmond, Virginia. If you were to choose I-95 South instead of I-95 North, it would take you to Key West, Florida, first. Selecting the wrong route is a common mistake most investors make. They set out on a trip to New York from Virginia and choose I-95 South to get them there. They select a fundamentally

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sound stock that is clearly controlled by supply and likely to go down, not up. As a broker, I did this many times simply because I didn’t know any better. My approach was like starting out on a road trip and taking the first road I hit as the direction to my des- tination. What we did back then was simply buy the stocks that research recommended we buy without any other input. We tended to emphasize the “What” question and never considered “When.”

Many stockbrokers and investors buy a stock on the funda- mentals because it is usually the only form of analysis they un- derstand, and there is plenty of this type of research around. I’ll bet most of you get unsolicited stock hype research reports in your mail every day. I know I get them. This type of fundamental research is everywhere. Never forget, someone has a reason for sending it to you. That reason is not to help you become indepen- dently wealthy. It’s probably to unload some stock on you. These stories catch the investors’ interest because they are all hype. I’m in no way suggesting fundamental analysis isn’t important. It is essential in answering the question what stock to buy; it is the first line of defense. It is our preferred method of analysis to cre- ate our inventories. Fundamentals, however, provide only half the equation. Once the stock has been selected and is determined to be fundamentally sound, the next task is to determine whether it has a high probability of going up or down. This is the point where technical analysis comes into play. When I was a stockbro- ker, technical analysis was never used. It was considered black magic even though it had been around in the United States for over 100 years. We sold the sizzle on the steak. That’s what cus- tomers wanted to hear, and that is what we sold. Had my firm in- cluded technical analysis along with fundamental analysis and trained us to understand and use it, what a difference that would have made. It would have been like the Fourth of July for both brokers and customers. Today most broker dealers have given up on tactically managing portfolios. They have gone to Strategic Asset Allocation where a computer decides, after a risk analysis is done and an investment policy statement is drawn up, how an investor should populate his Strategic Allocation Pie. Then twice a year the computer “rebalances” the portfolio. This means the stocks that have done well in the portfolio are trimmed and this

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money is placed in the stocks that have done poorly. To me this is the best way to put the brakes on a portfolio. I must also add there are many firms that provide DWA research to their brokers. Over the past 20 years, we have had a major impact in the way techni- cal analysis is used on Wall Street. Many advisors utilizing our work will use the Strategic Asset Allocation as the base from which to build and then add the Point and Figure work to tacti- cally manage the portfolios.

The best results in investing are achieved by using fundamen- tal and technical analysis together. At DWA, we look at several sources of fundamental recommendations to answer the “what” question. There are many excellent sources of fundamental infor- mation. Value Line and Standard & Poor’s both produce fantastic rating systems that are easy to use. And for a little over a dollar a day, you can get some great earnings numbers right out of In- vestors Business Daily newspaper. These numbers coupled with Point and Figure analysis are very powerful. Most of the tradi- tional brokerage houses also publish reports now available to all investors with their fundamental stock picks. The Internet has fundamental information everywhere you turn. It’s virtually everywhere and free on the Internet. In fact, on our web site I keep several portfolios of fundamentally sound stocks that I work from. What I then do with those fundamentally sound portfolios is bring the technical side into the equation. Technical analysis is more difficult to find than fundamental but most of the time this step in the investment process truly determines whether an in- vestment is successful. Technical analysis is different from fun- damentals. Fundamentals simply deal with the same things everyone had in accounting 101 and 102, period, end of story. Chartered Financial Analysts all look at the same ratios like PEs, Cash Flow, and so on. Technicians are a diverse group. There are many methods that are used like Fibonacci numbers, waves, Gann angles, cycles, astrology, candlestick charts, line graphs, bar charts, and Point and Figure. This is the reason why many con- sider technical analysis black magic. I took the easy approach to it. I knew that the last part of the equation before prices change is the irrefutable law of supply and demand. No matter what method of analysis you subscribe to, there must be an imbalance between supply and demand to cause the price change. If this is

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the case and it is then you have arrived at the Holy Grail. As I dis- cussed earlier, the Point and Figure method was developed by Charles Dow as a simple, logical, organized, way to view this bat- tle between supply and demand, nothing else. So why not go di- rectly to the source rather than learning something that is many steps removed? You are reading this book so that you can take control of the technical research yourself. There is no one who will watch over your own investments more diligently than you.

The reason technical research is so important is that it an- swers the question when to buy. All too often, investors and stockbrokers buy a stock because it is a great company, but great companies don’t always make great stocks. In fact, I recently got a call from a broker client of ours asking what my opinion was on a stock named Integrated Devices. He related to me how the com- pany just had an extended news release talking about how their earnings were going up 50 percent and how things were just won- derful. His question to me concerned how the stock could move down on that news by $5. I looked at the chart and 30 points higher the stock was screaming at anyone who would listen, to “get out.” The supply-and-demand relationship was already sug- gesting supply was in control. This broker never went past the fundamental roses and was totally perplexed that he had lost his clients $5 in one day. The stock went on to lose quite a bit. If I created a balance sheet of technical indicators for that stock, it would be extremely heavy on the debit side. You need to know when a great company is also a great stock. That is where this broker went wrong. He should have listened to the fundamentals and then put the stock name in a drawer of “things to do later.” Once the technicals came around to positive and the fundamen- tals were still positive, it would be a “go.”

Here’s another interesting story. General Electric has been a great company over the years. It is the only original stock left in the Dow Jones Industrial Average. The earnings had been going straight up for 10 years but in 2000 the stock topped out and began a long decline from $60 to $22. The fundamentals had not changed only investor sentiment changed. Investors decided they did not want to own GE for whatever reason. Supply overtook de- mand, optimism turned to pessimism, and the stock collapsed. Warren Buffett said something interesting. He in essence said there was a time to own the stock and a time to own the com-

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pany. In the GE example, with the fundamentals intact but the technicals suggesting a decline in price, it was time to own GE, not GE’s stock. Our problem is we are not like Warren Buffett who has the ability to buy whole companies. We are relegated to the stock market. In times when supply is clearly in control, our only play is to avoid the stock or mitigate the risk of holding it in some way.

The power of the computer has made this process much easier than it use to be. In those days before computers became a com- modity, we would literally page through chart books looking up the symbols of fundamentally sound companies that had strong chart patterns. Today, we enter those fundamentally sound port- folios into our web site (www.dorseywright.com) and then use the Search/Sort function to filter out those stocks that meet our tech- nical requirements for a stock we expect to rise in price. It is this combination of fundamental and technical analysis that is so powerful. The computer reduces to a matter of seconds the time- consuming task of looking at hundreds of stocks to come up with a small basket of actionable names. The computer can never re- place the analysis of a specific issue, but it can help narrow down the list of those to evaluate to a reasonable number based on some basic technical attributes we feel are important. One of those technical attributes is the chart pattern of the stock.

Chart Patterns

If you wait for the right chart pattern to form before making a stock commitment, you dramatically increase your probabilities of success. In our day-to-day operation evaluating and trading the markets, we have found that when the market is supporting higher prices (we cover these indicators in later chapters), stick- ing to the bullish chart patterns when going long stock usually produces superior results. Conversely, we have found that when the market is not supporting higher prices, sticking to the bearish chart patterns when shorting a stock usually produces superior results. If the market is not supporting higher prices, the odds of success in buying a stock with a bullish chart pattern is like try- ing to swim against the current. You may make some headway but not nearly as much as if you just wait for the tide to change so

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you can swim with the current. Think for a second about the salmon. Remember the pictures you have seen where they swim upstream to spawn each year? That’s what it is like trying to make headway in the market with long positions when the pre- vailing market is bearish. I’ll bet if you could interview a salmon you would find it would prefer to swim downstream to spawn if possible.

While I cover chart patterns as one of the first concepts in this method of stock market analysis, other indicators must be added to the equation before you can decide what to buy. The tendency of those new to the Point and Figure process is to focus only on patterns when evaluating an individual equity. This is a very im- portant step in the process, but not the whole process. That hav- ing been said, let’s delve right into covering the Point and Figure chart patterns.

Had I known about this during my broker years, I would have been able to save a lot of heartache for both my clients and me. We always tried to recommend stocks that were fundamentally sound, but we never knew if we were on I-95 North or South. It is such a simple concept, yet most brokers and investors never get a handle on it. I remember a time I put on a trade for a client with- out paying much attention to the underlying stock. This good client of mine called to discuss some possible trades in the mar- ket. I had just learned about an option strategy called “covered writing” that involves buying a stock and simultaneously selling a call option against the position. The client and I talked at length about the stock. We discussed how Burlington Industries was a great company (the leader in the textile business at the time). He liked the covered-writing concept, so we did the trade, bought the stock, and sold the call option against the position. I sold it as a conservative strategy. I was really thrilled that I had been able to explain the concept of a covered write on the phone.

After the close of business, I went with my broker buddies to the Bull and Bear Club, as we did every evening, to have a beer and discuss the day’s business. I mentioned to them that I had done a covered-write trade that day and the underlying stock was Burlington Northern. One of the fellows responded, “oh, the rail- road.” I broke out in a cold sweat. I said no, I had bought the tex- tile company, not the railroad.

Chart Patterns 65

As it turned out, I had in fact bought the client Burlington Northern, the railroad, despite discussing the merits of Burling- ton Industries, the textile company. The names Burlington Northern and Burlington Industries are close, right? Well, the names might be close but their businesses are like the North and South Poles. The trade turned out fine, and I was probably better off with the railroad than I would have been with the textile com- pany. In fact, Burlington Industries didn’t even have listed options at that time. Talk about stacking the odds in your favor—I shut my eyes and took a shot in the dark. I wasn’t sure what coast the stock was on, much less what interstate and what direction. This happens more often than you can imagine, but in most cases it doesn’t turn out as well.

Many investors simply feel they can’t grasp the nuances of the investment process to become better investors. They believe Wall Street is somehow over their heads. But, I’ve seen it time and again: Brokers and investors who take that first “toe dip” into learning this material are quickly hooked and eventually become true craftsmen at the investment process. It’s like the first time you learned to employ a little strategy in a game of chess or backgam- mon. Before you know it, you are hooked. It’s intoxicating!

The Chart Patterns

Double Top

In Chapter 2, you learned how to maintain your charts. The most basic chart patterns are the Double Top and Double Bottom. The Double Top requires three columns: two columns of X’s and one column of O’s. The key to interpreting the chart patterns is to de- termine where the stock exceeds a point of resistance or support. A feature of Charles Dow’s charts that caught the eye of some as- tute turn-of-the-century investors was the charts’ accurate iden- tification of levels of distribution and accumulation. Distribution corresponds to a top (resistance) and accumulation corresponds to a bottom (support). Resistance is the point at which a stock reaches a particular price and encounters selling pressure. Back to the supply-and-demand scenario. This is the point where supply

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exceeds demand. For example, let’s say that XYZ rises to 60 and meets selling pressure. This selling pressure exceeds the demand at that price, and the stock retreats back a few points. Remember, it requires a three-box reversal to change columns. If the selling pressure was enough to force XYZ back to 57 or lower, the chart would revert to O’s from X’s. In the tennis match analogy, supply would have won one set. The match continues. Let’s say over the next few weeks, demand once again creeps back into the stock at 57 and causes the price to rise to 60 per share. This is another three-box reversal back up into a column of X’s, and XYZ now sits at the same price level that previously found supply.

The question now is whether the sellers that forced the stock back before are still there. I have seen stocks hit resistance nu- merous times over many months until the selling pressure was fi- nally exhausted. The only way to find out if the sellers are still operating at that price is to see how XYZ negotiates that level. If it is again repelled, then the sellers are still there. If it instead is able to move to 61, then we can say that demand has prevailed at this price by exceeding the level where supply was previously in control. By exceeding this level of resistance, the Point and Figure chart gives its most basic buy signal, the Double Top. Naturally, you must consider other things before purchasing the stock but in this most simple pattern, we can say demand is in control. If you could give me no other information on XYZ, my decision would be to buy the stock. By XYZ exceeding that point of resistance, we can say that demand won the match. The chart pattern would look like the one shown in Figure 3.1.

Figure 3.1 The Double Top.

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Figure 3.2 The Double Bottom.

Let’s cover the Double Bottom. In this pattern, supply wins the match. Let’s say instead of XYZ exceeding the previous point of resistance, it instead reversed and exceeded the previous level of support. You can see in Figure 3.2 that the stock declined to 56, at which point demand overtook supply and the stock reversed back up into a column of X’s. At 59, the stock encounters selling pressure that drives XYZ back down the chart to the 56 level where demand previously took the upper hand providing support. This time, however, the buyers are not there as before, and the selling pressure persists until the stock exceeds that level of sup- port. The match is over. Supply wins and the probability is lower prices. The reason supply overtook demand is not important. How the stock reacts to supply and demand is all that matters, for in the end, supply and demand causes stocks to move up and down and nothing else.

You can now see why we call this pattern Double Top and Double Bottom. The stock rises or declines to the same level twice. You can probably already guess what we might call the pat- tern if it rose or declined to the same level three times.

In Figure 3.3, you can see that when the stock rose back to 60, it was repelled for the second time. This clue suggests to us that there is formidable resistance at that level and the sell signal is that much more important. Looking at this chart, we can tell that

Figure 3.3 Double Bottom with resistance.

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Figure 3.4 Double Top with support.

the upside potential is only 60. Naturally, things can and do change, but this is all we have to go with for the time being. Short sellers always want to know points of resistance because a pene- tration of these levels might signal a reversal in trend.

Figure 3.4 shows us that there is good support at 55 simply be- cause that is the price where the stock stopped going down on two separate occasions. For some reason, there are buyers at that level. We consider this a level of accumulation or support. This Double Top buy signal is more important than the previous one because there is more information available with which to make a deci- sion. The stock found support twice at the 55 level suggesting that the stock will hold there in the event it experiences further weak- ness—just a little clue the chart in Figure 3.1 did not have.

The Bullish Signal

We add one more dimension, an added clue, to the pattern this time. In Figure 3.5, notice how the last column of O’s does not ex- tend down as low as the previous column of O’s. We call that a rising bottom. It signifies that supply is becoming less a factor in driving the stock. On the other side of the coin, demand is getting

Figure 3.5 Double Top with a rising bottom.

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stronger as the last column of X’s exceeds the previous column of X’s. The rising bottom provides added guidance when evaluating the supply demand relationship of the underlying stock. Of the three Double Tops discussed thus far, this one is the strongest and would warrant the largest commitment.

The best way to understand these patterns is to take a legal pad and pencil and simply write down in 50 words or less exactly what you see (no different from the composition seven-year-olds sometimes have to write for homework, describing their room). This is what I observe in Figure 3.5:

1. I see a tennis match that only took four sets (columns) to complete.
2. I see two sets where McEnroe won (columns of O’s) and two sets where Connors won (columns of X’s).
3. The last column of X’s exceeded the previous column, giving a Double Top buy signal at 60.
4. The second column of O’s did not decline as low as the previ- ous column of O’s suggesting McEnroe is losing strength.
5. The last column of X’s exceeds a previous column of X’s sug- gesting Connors is gaining strength.Breaking the pattern down to its lowest common denomina-

tor, simplifies analysis.

The Bearish Signal

The Bearish Signal is the opposite of the Bullish Signal. Figure 3.6 shows that demand in this case is becoming less strong as the last column of X’s fails to reach the previous level. Selling pressure

Figure 3.6 Double Bottom with a lower top.

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however is increasing as evidenced by the lower column of O’s. These clues simply suggest demand is losing strength and supply is gaining strength. All too often, investors buy stocks in this condition only to see them erode further.

So far, we have discussed the Double Bottom and Double Top. All other patterns that we cover are expansions of this basic form. By now, you can see how simple this method is to grasp. Let’s go on to the Triple Top buy signal.

Triple Top

The Triple Top is exactly what the name suggests—a chart pat- tern that rises to a certain price level three times. The first two times the stock visits that level, it is repelled by sellers. The third time the stock rises to that level, it forms the Triple Top. The buy signal is given when the stock exceeds the level that pre- viously caused the stock to reverse down. This pattern is shown in Figure 3.7.

There are many reasons a stock will encounter supply at cer- tain levels. Think back to a time when you bought stock thinking it was the bottom, or at least an opportune price level to buy, and instead of rising the stock immediately declined. We have all had one or two experiences like that. The thought that probably crossed your mind as you saw the stock lose value was to get out if the stock got back to even. This is a perfectly normal human re- action. When you place that order to get you out at your break- even point, you are in essence creating supply at that level.

Figure 3.7 The Triple Top.

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If more sellers are willing to sell their stock at that level than buyers are willing to buy, the stock will decline. The only way we know whether the selling pressure has been exhausted at a particular level is by the stock exceeding that price. If the stock is repelled again, the sellers are still there. I have seen stocks bounce off certain prices for as long as 18 months. There have been numerous examples of this over the years. Coca-Cola (KO) from 1992 to 1994 was a trading range with neither supply nor demand winning until finally, in September 1994, demand won and the stock took off. I like to use this example of KO because it was a stock I held in my children’s accounts. The first time I bought KO was in August 1980. My son Thomas was born and that day I opened him a stock account. I didn’t have much money then so I bought him $600 worth of KO and Alcoa (AA). Over the years, KO was a super performer, AA was not. The account was carried by KO. I held that stock for 18 years until the Relative Strength chart turned negative. We got out right at the top. KO has been a dismal performer since. That one stock however made enough money to pay for my son’s college education. If you have not opened a stock account for your young children yet, do so! Another memorable example was Intuit (INTU). This is a stock from back in the wild, wild days of the Internet craze. This stock spent 11 months trading between 23 and 35. Finally, when the stock broke out, it took off like a rocket rallying to 90 in a matter of two months. When a stock trades up to an area of resistance numerous times and then finally breaks out, we refer to that as a “big base breakout” in the office. You know, it sounds a lot like a country song. Yet another big base breakout that comes to mind is Oracle (ORCL). In 1999, this stock traded up to 39 six times. Finally, the stock hit 40 breaking a spread sextuple top and there was nothing but grease between here and the trees for that stock for the next year. The ride down was just as dramatic when the dot-com stocks went bust. Centex in 2004 broke out a large base at 106 (presplit) and in the next eight months had rallied over 65 percent. Then the chart began to change and supply started to come and multiple Double Bottom sell signals were given. It is like that country song, “You gotta know when to hold them and know when to fold them.” That song could have been written about the stock market.

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Expansions on the Triple Top are merely patterns that take longer to complete. Patterns like the Quadruple Top or Quintuple Top are rare. The more tops a pattern has, the more bullish; and the faster the pattern develops the more bullish. The more times a stock bounces off a resistance level, the stronger the breakout will be when it comes. It was said years ago that the degree to which a stock will rise is in exact proportion to the time the stock took in preparation for that move. In other words, the wider the base from which a stock breaks out, the higher the stock will rise. In our 20 years of experience at DWA, we have found that a good strategy to use with the Triple Top or greater breakout is to buy partial positions on the breakout and then average in on a pullback. Half of the time, a stock will pull back after the Triple Top breakout.

Triple Bottom Sell Signal

The Triple Bottom sell signal, like the Triple Top, has a high de- gree of reliability. When I teach seminars on this subject, I use Fig- ure 3.8 as an example of how dangerous it can be for investors to exclude technical analysis when buying a stock. Consider an in- vestor who buys this stock at 31 per share and then leaves on va- cation for one month. He checks the Internet frequently and notices that his stock is still around the price he paid for it, only down a point. Not bad for a market that had been volatile for the past month he thinks, and he continues to feel comfortable with the stock. The fundamentals are all in place. What is he missing in this puzzle? What he is missing is that a whole tennis match

Figure 3.8 The Triple Bottom.

Chart Patterns 73

between supply and demand has been completed with supply win- ning the match. By not watching the match, he is unaware of it.

The probability of lower prices is very high. The Triple Bot- tom does not mean that the stock will cave in immediately; it suggests that the risk in that position has increased tremen- dously. Whether this investor chooses to do anything about the signal or not, he should at least be aware of it. If the investor does nothing other than increase his awareness of a potential decline, he is far ahead of the investor who holds the same position with- out any warning. Other considerations, such as Relative Strength, sector bullish percent, overall market condition, and trend lines, are discussed in later chapters.

In analyzing the Triple Bottom pattern, keep a close watch for declining tops. Think back to the Double Top formations. When the stock declined but was unable to decline as far as it previously did, it implied that selling pressure was drying up. Conversely, if the tops or columns of X’s are making lower tops, it suggests that demand is drying up. These two clues make the chart more bullish or bearish, respectively. This will hold true with any chart pattern.

Keep in mind that other factors must be taken into considera- tion when evaluating a chart. We put it all together in the chap- ters ahead.

The Bullish and Bearish Catapult Formation

The Bullish Catapult (Figure 3.9) is simply a combination of the Triple Top and the Double Top. This pattern is a confidence builder. The Bullish Catapult comprises a Triple Top buy signal

Figure 3.9 The Bullish Catapult formation.

74 Learn the Point and Figure Methodology

followed by a pullback producing a rising bottom. Following the pullback, the stock resumes the trend giving a Double Top buy signal. Take a look at the pattern in Figure 3.9. Notice the Triple Top buy signal followed by the pullback into a column of O’s. No- tice how the column produces a higher bottom. The resumption of trend completes the Bullish Catapult by giving a Double Top buy signal.

Let’s look at the Bullish Catapult in pieces to better understand what it is saying to us. The Triple Top is saying that the stock has a very high probability of rising in price, assuming the market is in a bullish mode. In fact, this type of pattern has a success probabil- ity of 87.5 percent in bull markets. The subsequent reversal pro- ducing a higher bottom suggests that supply is beginning to dry up or becoming a less significant factor. The resumption of trend and subsequent Double Top buy signal simply confirms the Triple Top. The Bullish Catapult is a confidence builder. This is one pattern that you can be more aggressive with when the overall markets are in a bullish mode, the underlying sector is in a bullish mode, and the fundamentals are superior in the stock.

The steps involved in stock selection resemble the steps in- volved in taking the trip from Virginia to New York City. Before you begin the trip, you need to gas the car up, check the oil, and check the water in the radiator. Then you must select the most direct route to New York (I-95 North). Gassing the car, checking the oil, and so on are similar to checking the fundamentals of the underlying stock. Selecting the proper interstate to embark on is similar to evaluating the technical (supply and demand) picture of the underlying stock. Many investors are diligent in doing the fundamental work on a stock they want to buy but ignore evalu- ating the probability of it rising in price. Buying a fundamentally sound stock that has just completed a chart pattern that suggests lower—not higher—prices is like making all the preparations for a trip to New York, then embarking south on Interstate 95 toward Florida. The idea is to stack as many odds in your favor before you begin the journey. There still isn’t any guarantee. As much as people try to make investing a science, it remains an art.

In teaching this subject to grade school children, I have ob- served it takes only 30 minutes of instruction for them to make the right selection when evaluating a bearish and bullish chart to-

Chart Patterns 75

gether. The beauty about teaching children is that you don’t have to deprogram them. Adults have preconceived ideas about how the market is supposed to work, mostly derived from watching TV programs about finance. All we are trying to ascertain with these chart patterns is whether supply or demand is in control of the un- derlying stock. If you go any farther than that, you’ve gone too far. Keep it simple. The law of supply and demand causes prices to change whether it’s in the supermarket or the stock market.

Trading Tactics Using the Catapult

The Bullish Catapult is a confirmation pattern—the final Double Top that completes the Bullish Catapult simply confirms the pre- vious Triple Top. It’s a confirmation that demand is in control at this point in the stock’s trend. The first part of the pattern is the basic Triple Top. In the last 15 years, buying on the pullback, or re- action from breakouts, offers a higher probability of success in the trade. Once a Triple Top exceeds the previous column of X’s and then pulls back, the potential for a Bullish Catapult exists. In- vestors might consider buying half their position on the three-box reversal from the Triple Top. This gives them a good entry point for the first portion of the position and gets them in close to their stop point. Let’s talk about the stop for a second. At what point will investors have to stop out of the position if they are wrong in their assumption that the stock will rise? In this case, with the only information being the chart pattern, the only logical stop would be the Triple Bottom. At that level, the pattern would sug- gest that supply was in control. If the stock is selected using strong fundamentals, has strong Relative Strength, and is trading above the Bullish Support Line, the probability of a failure in this pattern is low. Still, investors must consider what to do when things go wrong. There needs to be a plan of action if the trade be- gins to go sour. Remember, this is not an exact science, it’s an art.

Once half the position is bought on the three-box reversal and the mental stop is in place, investors can begin to execute the plan to buy the other half of the position on completion of the Bullish Catapult. Traders can then raise their stop to the new Double Bottom sell signal that is formed when the stock reverses

76 Learn the Point and Figure Methodology

back up to complete the Bullish Catapult. Long-term investors will keep their stop on the violation of the Bullish Support Line, otherwise known as the trend line. In Figure 3.10, we would have to assume that supply had taken control if the stock violated the trend line and simultaneously gave a Double Bottom sell signal. The stop-loss point would come at the 42 level once the Bullish Catapult formation was complete. Just keep in mind that as long as a stock trades above the Bullish Support Line, we consider it bullish. Long-term investors will only stop out on violations of the trend line. Traders will be more apt than investors to take the sell signals above the trend line.

So far on our order entry using the Bullish Catapult, we have bought one half the intended position on the pullback to 43 and entered a mental stop-loss point at 40. Now, for the second half of our intended position, we enter an order called a “Good until Cancel” (GTC) order. The GTC order simply allows you to select a price you are willing to pay for your stock, and your order re- mains on the specialist’s books until the stock reaches that price. In this case, you would place an order to buy the remainder of your position at 47, the level where the Bullish Catapult forma- tion will be completed.

You can now see where you bought the second half of your in- tended position. Notice how the stop has risen now to the new Double Bottom sell signal that has formed at 42. This new stop allows us to protect profits should supply suddenly take control of the stock. It is important that long-term investors only use the trend line to stop out of a position. Traders are much shorter term in nature and may select a percentage of the entry price as their

Figure 3.10 Knowing where to set the stop.

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Figure 3.11 Trading with the Bullish Catapult formation.

stop. A. W. Cohen, one of the pioneers in this method of analysis, always suggested that investors risk no more than 10 percent in a stock. In today’s more volatile markets, a 10 percent decline can happen fast. We find it more useful to carefully select our entry point and then give the stock some room to perform.

By looking at the Bullish Catapult formation, you can see many other combinations of entry points that you can use (see Figure 3.11). The key is you have an organized and logical guide to assist you in finding entry and exit points when investing. No other charts that I am aware of can do this. The Point and Figure charts are, without a doubt, the best and most accurate guides an investor can use.

Bearish Catapult Formation

The Bearish Catapult formation can be interpreted exactly oppo- site the Bullish Catapult formation and is particularly useful in timing short sales. Entry and exit points would be selected the same way we did with the Bullish Catapult. Stop points are par- ticularly important in selling short. The risks in short selling are theoretically unlimited. In reality, that is not probable, but I have seen situations where stocks received buyout offers that significantly increased their price. The problem with being short in these unusual situations is that the stock stops trading and opens at a higher price without anyone being able to get out. These situations, however, are few and far between. It is very important to plan your entry point so you have a palatable stop

78 Learn the Point and Figure Methodology

price. A short seller might plan to sell half his intended position short on the first reversal back up in the chart pattern following the Triple Bottom sell signal. This will allow him to initiate the short relatively close to his stop point. Trend lines are even more important in short selling. The second half of his intended short position can be initiated when the stock reverses back down and completes the Bearish Catapult formation. Let’s look at Figure 3.12.

You can see that this pattern is the exact opposite from the Bullish Catapult. Watch carefully for this pattern as it clearly sug- gests lower prices in the underlying stock. Whether you under- stood Point and Figure charting or not, if you looked at two fundamentally sound stocks, both in the same group, one with a Bearish Catapult formation and one with a Bullish Catapult for- mation, it wouldn’t take long for you to determine which stock you wanted to buy.

These same patterns are used to assist the investor in using the options market. I have always looked at puts or calls as being surrogates for the underlying stock. We only use in-the-money calls or puts because the delta (the amount the option will move in relation to a 1-point move in the underlying stock) is much closer to 1 for 1. If an in-the-money long call is used as a substitute for buying the underlying stock, then use the same entry and exit points that you would use if you were buying the underlying stock. The same goes for put purchases as substitutes for outright short selling. Another school of thought in options buying is to let the premium be your stop. If you use this strategy, never buy more options than you would otherwise have an appetite for round lots

Figure 3.12 The Bearish Catapult formation.

Chart Patterns 79

of the underlying stock, either long or short. If you were normally a 300-share buyer, then only buy three options. If you allow the premium to be your stop, then you have the staying power to hang in the position until expiration. I have seen numerous times where a stock declines substantially early in the trade only to come back strong a few months later. We could devote a whole book to this subject, but let it suffice for now that Point and Fig- ure chart patterns can be very useful in assisting the investor with entry and exit points for options trading as well as stock trading.

The Triangle Formation

The Triangle formation is a combination of patterns we have seen before. The key to understanding chart patterns is being able to sit down with a pencil and paper and write down exactly what you see. Don’t look at the whole pattern and try to decipher it. Evalu- ate the parts making up the pattern, and you will then understand the pattern in total. In Figure 3.13, you can readily see the rising bottoms and lower tops in the pattern. To qualify as a Triangle, the pattern must have five vertical columns. The rising bottoms suggest that supply is drying up. You will also see the series of lower tops. The lower tops suggest that demand is becoming less of a factor in driving the stock. In our tennis analogy, the two play- ers are getting more tired after each set, and the players have equal ability. Eventually, something will have to give. One player or the other will get a second wind or begin to take the upper hand. It is

Figure 3.13 The Triangle formations.

80 Learn the Point and Figure Methodology

at this point that we want to make a commitment in the underly- ing stock. There is nothing to do but wait and watch the match. If the pattern resolves itself on the upside, it will give a Double Top buy signal. The Double Top buy signal simply suggests that de- mand has won the match and the probability is higher prices in the stock. Now look at the Bearish Triangle in Figure 3.13. Notice how the match is won by supply. The Double Bottom sell signal suggests that the probability is lower prices in the stock. These patterns are simply road maps. They are not crystal balls.

There are a couple of other things that we want to point out about the Triangle pattern. First, usually a stock in an uptrend will resolve the triangle on the upside (i.e., a Bullish Triangle). Similarly, a stock in a downtrend will usually resolve the triangle on the downside (i.e., a Bearish Triangle). Second, it is usually feast or famine with the Triangle pattern. We will either see very few triangles forming, or we will see a whole host of them devel- oping. Most of the time when we see quite a few triangles form- ing, it is during a choppy or sideways market and supply and demand are battling it out for control. Third, breakouts from the Triangle pattern typically result in quick, explosive moves so it behooves you to be ready to act when the signal is given. Look at the chart pattern in Figure 3.14. The stock in this graphic is form- ing a Triangle pattern right at the Bullish Support Line. A move to 55 would break a Double Top and complete the Bullish Trian-

Figure 3.14 Planning the trade with a Triangle pattern.

Chart Patterns 81

gle pattern and long positions could be taken. On the other hand, if the stock hits 49 it would not only complete a Bearish Triangle but also violate the Bullish Support Line. The stock could be shorted at 49. On our Internet site, we have premade reports that allow you to see the charts of all stocks breaking out of a Bullish Triangle, Bearish Triangle, and all the other different patterns.

Variations on the Triple Top

I usually call this pattern the Diagonal Triple Top, but I hesitate to use the name because it sounds too difficult. Possibly a better name would be a Bullish Signal. I have said many times if investing gets too difficult for a seventh grader to understand, the system is needlessly complex. It is important to keep it simple, especially in technical analysis. We don’t usually use this pattern as a Triple Top, but older publications classify it as one. This variation is sim- ply two Double Top buy signals, one right after the other. This is the sign of a good strong uptrend. A stock in a strong uptrend will produce rising bottoms and rising tops, and that is exactly what this pattern demonstrates. Notice in Figure 3.15 that you simply have two consecutive Double Tops with rising bottoms.

Variations on the Triple Bottom

This pattern is simply the reverse of the Diagonal Triple Top or Bullish Signal. We can simply call this the Bearish Signal. It has a series of lower tops followed by lower bottoms. Just looking at

Figure 3.15 The Diagonalized Triple Top.

82 Learn the Point and Figure Methodology

Figure 3.16 The Diagonalized Triple Bottom.

Figure 3.16 suggests that supply is in control. This is all you want your chart pattern to alert you to. Another way to look at it is two consecutive Double Bottom sell signals. We almost never evalu- ate this pattern as a Triple Bottom although A. W. Cohen clearly classifies it as such.

The Spread Triple Top and Bottom

This pattern is simply a Triple Top that takes a little more space on the chart to complete. Notice the gaps between the tops in Fig- ure 3.17. This is where the spread comes in. The normal Triple Top has no gaps between the tops. The same philosophy applies

Figure 3.17 The Spread Triple Top and Bottom formation.

Chart Patterns 83

in this pattern as in the Triple Top. In each case, the stock rises to a certain price level and is repelled two times. The third attempt at that price is successful by the stock moving through the level shown by a column of X’s exceeding the point of resistance. Since the stock was repelled twice at that same level, there are appar- ently sell orders there. The reason is not important. What is im- portant is that there are sellers at that particular level. The only way to know if demand can overtake the selling pressure is to see how the stock negotiates the level again. Simply stated, if the stock is repelled again at this level of resistance, the sellers are still there. You need not know any more. If the stock exceeds that level, then demand has overcome the supply that previously caused it to reverse. This is why we always wait for a particular level to be exceeded before we make a long or short commitment in the stock. In the 1980s, we typically just bought or sold the breakouts. Starting in the 1990s, we found out that it was best to buy on the pullbacks. For most of the 1980s, stocks went up. From the 1990s forward to 2000, stocks continued their rise. Then in March 2000, something major happened. The technical balance sheet on the Nasdaq turned decidedly negative while the technical balance sheet on the NYSE turned positive—one door of opportunity closes while another one opens. For the rest of 2000 to the third quarter of 2002, tech stocks were virtually decimated. During that time though, there was money to be made in other sectors like utilities, builders, REITs, and healthcare just to name a few. For the past six years it has been a stock picker’s environ- ment and likely to remain so for the foreseeable future. Figure 3.17 shows what the pattern looks like for both the Spread Triple Top and the Spread Triple Bottom.

Notice that in these two patterns, the stocks are trading at the same price. Consider that both stocks are fundamentally sound and each is being recommended by a major firm on Wall Street. Both stocks are in the same industry group and pay about the same dividend. You have studied the fundamentals of the two stocks and are now trying to determine which stock to buy. It’s the moment of truth. Which stock do you select?

Without the chart patterns shown here, you would be in a quandary. Looking at the fundamental data alone, both stocks are equal, therefore both stocks should do about as well in the future.

84 Learn the Point and Figure Methodology

Not so. If you had the benefit of evaluating the Point and Figure charts in Figure 3.17, the selection process would become much easier. With the information I have just given you, which stock do you select? It doesn’t take an in-depth understanding of this method to determine stock A is in an uptrend with the probabil- ity of higher prices and stock B is in a downtrend with lower prices likely.

This simple exercise shows why charts are so important and why you can achieve the best results in the market when you use both fundamental and technical analysis. The fundamental work answers the question what, and the technical side of the equation answers the question when. Both are equally important. The first question, what, is easily answered because fundamental research is everywhere on Wall Street and the Internet. Anyone doing busi- ness with a broker of a major firm on Wall Street, either through their Internet online system or direct through a broker, has access to all the fundamental ideas that the firm produces along with its related research. Technical analysis is much harder to come by, but with the information in this book, you will be perfectly capa- ble of performing that task yourself.

The market and sector represent 75 percent of the risk in any particular stock. The problem most investors have is that they concentrate 75 percent of their effort on evaluating the funda- mentals. It is extremely important to buy stocks when you are in possession of the football (the market is in a bullish mode). We cover the market indicators in later chapters. We started this book with the discussion on individual chart patterns because these patterns make up the market indicators.

Once again, stack as many odds in your favor as possible be- fore you make a commitment in the stock market. I don’t know how many times acquaintances have come up to me and asked what I think about a stock tip they just got from a friend. They usually say it’s a very reliable source. My answer is always the same: If it’s inside information, you won’t have it. The second you have it, it’s outside information and those who are really in the know have already acted on it. In almost every case, you can look back on the Point and Figure chart and see clearly where the in- siders were operating. Once you get the handle on this method, which has remained true to form for over 120 years, you will see

Chart Patterns 85

why the Point and Figure chart is as good as inside information. We have a four-step game plan that we follow, and this is the se- quence of events you should follow before you make a stock com- mitment. Step 1 is to evaluate the overall market; Step 2 is to evaluate the sector you are investing in; Step 3 is to answer the question of “what to buy” (the fundamentals); and finally Step 4 encompasses stock selection, which answers the question of “when to buy.”

Bullish Shakeout Formation

This is one of my favorite patterns. We keep a strong eye out for this pattern because it has a high degree of reliability. The Shake- out is a relatively new pattern; we’ve only been watching this one for the past 25 years or so, but we have found it very useful in real-life application. It is called the Shakeout because the pattern easily deceives investors when the sell signal is given.

There is a big difference between the chartist and the techni- cian: Many chartists operate on chart patterns alone without any other input, whereas technicians use other indicators to as- sist them in evaluating stocks. Don’t forget there are other con- siderations besides just the chart pattern when making a stock selection. The chart patterns should be used to determine whether supply or demand is in control of the underlying invest- ment vehicle. Because so much risk is associated with the mar- ket and sector, it is imperative to thoroughly evaluate both factors before considering the underlying stock. If you are buy- ing stocks in a down market, you will surely lose money. If you are selling stocks short in an up market, you will surely lose money. We want to drive home this point, because the Shakeout pattern works best in strong bull markets. We have not had much success, as you might imagine, using this pattern in a bearish market.

With that caveat, let’s look at the six attributes of a Shakeout formation:

1. The stock and market should be in a strong uptrend.
2. The stock should be trading above the Bullish Support Line.

86 Learn the Point and Figure Methodology

3. The stock must rise to a level where it forms two tops at the same price. Note this says “forms” two tops, not breaking the Double Top.
4. The subsequent reversal of the stock from these two tops must give a Double Bottom sell signal.
5. This sell signal should be the first in this uptrend.
6. The Relative Strength chart must be on a buy signal or at leastin a column of X’s.

   Sounds like a lot doesn’t it? It’s not really. In our day-to-day

operations, we fudge these parameters a little, but in general the Shakeout has these characteristics. Remember, the whole idea in using chart patterns is to determine whether supply or demand is in control. Don’t forget that, and don’t read too much into it be- cause you will usually over think the position, which in turn re- sults in losses. The best machine is the one with the fewest moving parts.

The Shakeout pattern shown in Figure 3.18 is also great for trading. Because the stock must be in a strong uptrend to qualify for the Shakeout pattern, you very well may already have an ex- isting position in the stock. The Shakeout can provide you with an opportunity to add to that strong position or if you aren’t al- ready long, it can provide an opportunity to get in a dip.

The Shakeout begins by giving the Double Bottom sell sig- nal. We never know what level the sell signal will carry the stock down to so our action point for entry into this stock is on the first three-box reversal back up the chart (see Figure 3.19). This is the only point where we know demand is back in con-

Figure 3.18 The Shakeout formation.

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Figure 3.19 Action point on the Shakeout.

trol. Once the stock reverses back up into a column of X’s, the position can be taken.

The next consideration is, what to do if things go wrong? Where is the stop-loss point? We always use the Double Bottom that is formed when the stock reverses back up as our exit point. Nor- mally, this is 4 points’ risk. Remember that the reliability of this pattern, and any other bullish pattern, diminishes when the overall market is in a bearish mode and your stop-loss point has a higher probability of being hit. Look at Figure 3.20 to see how entry and exit points are established. If the trade was established at the action point, and the stock immediately reversed, the stop point would be the first sell signal the stock gives. The stop is at 151⁄2.

The Long Tail Down

This is one of our favorite bottom-fishing patterns. To qualify for a Long Tail Down, the stock must have declined 20 or more boxes without a reversal. After such a decline, the first reversal

Figure 3.20 Stop loss on the Shakeout.

88 Learn the Point and Figure Methodology

up usually provides a good trading opportunity. We use to see the 20-box-down movement only in stocks that were already in strong downtrends and that move was the final capitulation. However, with increased volatility in stocks, like technology in 2000, some of the Oil and Non-Ferrous Metals stocks in 2005 to 2006, we have now seen stocks in uptrends pull back 20 boxes— just above strong support areas. Of course, this begs the question, “Do you really have the risk tolerance to buy a stock that can move 20 points in one day?” Nonetheless, this pattern can be a good trading pattern.

I remember a time we thought the pattern was infallible. It had worked for a string of trades, so we decided to pound the table on the next one we came across. It seems that Murphy is always hanging around when you alert the world to a particu- larly lucrative situation (you know Murphy’s Law: If anything can go wrong it will). One day we came across a Long Tail Down in Apple Computer. Apple is a great trading stock as the volatility is high and it seems everyone has played it at some- time or other. Apple had just gone through one of these 20-box down patterns. We knew we had a winner. This time we pounded the table with the recommendation to buy on the first three-box reversal back up the chart. I mean we pounded the table. When the reversal came, I think most of our customers took the trade and many of our customers are large institutions. You guessed it, the stock struggled up a point or so and then caved in. It was the first one in many moons that didn’t work. It always seems to work out like that. The one you get everyone to buy, fakes you out. Apple did it again in 2000. The stock came with less than expected earnings and “bang” down 50 per- cent and over 20 boxes. The stock reversed up a few days, only to reverse down again. It did that two more times. But in 2005 Chicken Little had his revenge. Apple came out with the iPod and that stock became as hot as a firecracker. Things always seem to come full circle.

On balance, this is a good trading pattern. The idea is simple. When a stock has declined 20 boxes or more, you take the first three-box reversal back up the chart as your action point. The stop-loss point is the Double Bottom sell signal that is set up when the stock reverses up into a column of X’s. The longer it

Chart Patterns 89

takes for the stock to decline 20 boxes, the less reliable the pat- tern is. This is for trading purposes only and not for investors. A stock that has declined 20 boxes or more usually has something wrong with the fundamentals. One of the better ways to play the trade is through the call market. This will give you staying power to expiration, and you need not worry about your stop point being hit. If the stock rises from your entry point, you can raise your stop to each subsequent sell signal that forms. This will allow you to get the full ride if no sell signals are given. It also prevents you from taking a profit too quickly. Always allow your profits to run as much as possible and take as much subjectivity out of the equa- tion as possible. Figure 3.21 shows the Long Tail Down pattern.

The same philosophy can be applied to a long run of X’s up but with a much smaller degree of success. As a stock rises, the fundamentals are coming to fruition and there are no dissatisfied investors. For this reason, we just don’t see enough selling pres- sure to warrant a trading commitment in a stock that rises 20 boxes without a reversal. Pullbacks in strong stocks like these appear as opportunities to buy not to sell and can easily generate

Figure 3.21 The Long Tail Down.

90 Learn the Point and Figure Methodology

demand. Remember, there are no dissatisfied investors at tops. Still the very nimble can take advantage of it. I usually don’t. I am much more apt to attempt a trade on a 20-box down move. However, the three-box reversal down from a run up of 20 boxes or more can be very useful in providing a stop-loss point for traders to take profits or a place for an investor to take partial po- sitions off the table.

The High Pole Warning Formation

This pattern was pioneered by the late Earl Blumenthal. We have seldom taken action on this pattern; however, we have al- ways used it as a warning. This pattern is most reliable in bear- configured markets. To qualify for a High Pole, the Point and Figure chart must have exceeded a previous column of X’s by at least three boxes. Following the rise in X’s, the stock must pull back more than 50 percent of that last up thrust on the chart. The thought behind the formation is that there must be some- thing wrong with the supply demand relationship if the stock subsequently gave up 50 percent of the last move up. It’s a warn- ing that supply might be taking control of the stock. I will usu- ally give the stock some room and place more emphasis on the trend line as my guide for a potential stop for stocks. The High Pole does, however, increase my awareness of a potential change in the supply demand relationship of the underlying stock espe- cially in bear-configured markets. Figure 3.22 is an example of a

Figure 3.22 The High Pole Warning formation.

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High Pole Warning formation. Over the years this pattern has become less useful to us. Often, the pullback is just that, kind of an exhale for the stock.

The Low Pole Formation

I find this pattern more useful than the High Pole simply because investors are more apt to make a commitment in a stock that ap- pears to be a bargain than to sell a stock that has done well for them. The Low Pole simply means the selling pressure that had been driving the stock down is probably over to a great degree. This does not mean that you jump on the stock with unbridled enthusiasm. The company probably still has problems. Remem- ber, you want to buy stocks that are fundamentally sound. That is your first line of defense. Traders, on the other hand, can at- tempt to make money on a bottom-fishing expedition. The trader’s best play is to wait for a pullback following the Low Pole and enter the stock there (see Figure 3.23). Buying on the pull- back will establish the entry point closer to the stop level. It also sets up the potential for a nice Double Top buy signal on the next reversal back up the chart. It is usually best to allow the stock to come to you if possible.

We use the High Pole and Low Pole Warnings with some of our bond indicators and the Advance-Decline indexes. Therefore, it will be important to understand the pattern when we discuss

Figure 3.23 The Low Pole Warning formation.

92 Learn the Point and Figure Methodology
these two indicators later in the book. In everyday practice, we

rarely use the two patterns with individual stocks.

The Broadening Top Formation

The Broadening Top formation is simply a variation on the Shake- out formation. The primary difference between the two is that the Broadening Top gives a buy signal prior to the sell signal being given. Let’s look back for a moment. If you don’t have the Shake- out firmly in mind go back and look at the pattern (Figures 3.18 to 3.20). You will see that the underlying stock has risen up to a cer- tain level two times but was unable to exceed that level the sec- ond time. The stock in essence formed a Double Top. Subsequently, it reversed and gave that first sell signal in the up- trend. In the case of the Broadening Top formation, the stock ex- ceeds that previous top the stock made. In other words, it gives a Double Top buy signal. The subsequent reversal gives the sell sig- nal. The combination of the higher top and lower bottom has the appearance of broadening the pattern. To complete the pattern, the stock then reverses back up the chart to give another Double Top buy signal (see Figure 3.24). If you look at those two consecu- tive Double Tops, you will see the same pattern as the Diagonal

Figure 3.24 The Broadening Top formation.

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Triple Top described in the section Variations on the Triple Top; the only difference is the sell signal in the pattern. I always think in terms of economics when I evaluate a Point and Figure chart. What is it telling me in economic terms? The forces that cause price changes in anything are supply and demand. Since these pat- terns are nothing more than a logical, organized method of recording supply and demand, the answer must lie in basic eco- nomic principles.

The Broadening Top formation usually takes place after a stock has run up nicely. What the formation is basically saying is that supply and demand had equal power at the point the pattern was broadening out. The Double Top buy signal was suggesting that demand was still in control. The Double Bottom was suggest- ing that supply had taken the helm and the uptrend was in ques- tion. The subsequent buy signal clearly showed that demand was still in control and that the stock had found enough sponsorship to move higher. When that Double Bottom sell signal is given, it alerts us to take a closer look at Relative Strength and the broad market and sector indicators before taking action. If all those things are positive, we will likely give the stock a little latitude.

The Bearish Signal Reversed Formation

We almost always play this pattern. It is seldom seen, but when it is, you should pay close attention. Investors can detect the pat- tern while it forms, which allows them to plan their trade. Often, we will show the pattern and discuss the underlying stock in our report days before the pattern is complete. In this great chess game, it helps tremendously to be able to plan your moves. To qualify for the Bearish Signal Reversed, the pattern must have seven columns in it. Each column of X’s must be lower than the one before and each column of O’s must carry lower than the one prior to it. In the tennis match analogy, the player symbolized by X is underperforming the player symbolized by O. You can easily see this. Remember, keep it simple. Look at the pattern in the context of a tennis match where each column in the pattern rep- resents a set within the match. You can see that when a column of O’s takes control of a set it carries lower than the previous col- umn. Action like this demonstrates supply is getting stronger.

94 Learn the Point and Figure Methodology

Figure 3.25 The Bearish Signal Reversed formation.

When the column of X’s takes control, it is unable to carry up as high as it previously did. By evaluating a pattern in this context, you can easily see supply is stronger than demand and the proba- bility is lower prices. This action is what we characterize as the Bearish Signal. Now let’s look at the Reversed part of the pattern. The reversal up into a column of X’s with the subsequent Double Top buy signal shows a change in this supply demand relation- ship. Something has happened to cause demand not only to win a set by reversing up but to win the match by exceeding a previous top and thus giving a buy signal. What makes this buy signal more important is that it exceeds a series of lower tops. In essence, it breaks the spell. Figure 3.25 shows this pattern.

The reversal is often caused by some sort of news that is not widely disseminated or understood by Wall Street. Insiders are usually operating at this point. Ask yourself a question. Why would such a negative pattern that is being controlled by supply change abruptly midstream? Is it possible that an upcoming earn- ings report is likely to be better than Wall Street expects? Usually there is some fundamental change in the stock that is not widely known. Like the Triangle pattern, the results from this pattern usually happen in a quick, explosive move.

The Bullish Signal Reversed Formation

This pattern is the reverse of the Bearish Signal Reversed. This pattern shows seven columns of rising bottoms and rising tops— the exact opposite of the Bearish cousin (see Figure 3.26). When

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Figure 3.26 The Bullish Signal Reversed formation.

the last top is made in the seventh column, the stock reverses and without a period of distribution declines to give a Double Bottom sell signal as well as break the series of rising bottoms. We have seen this happen in drug companies where FDA approval of a par- ticular drug was not forthcoming. Someone usually knows of this before Wall Street does. There are many other reasons for the quick reversal. It is usually brought on by insiders selling. When I say insiders, I don’t necessarily mean the management of the company. What I mean is simply any investor who has informa- tion that is not widely known on Wall Street. I can truly say that I have never made money on so-called inside information. When anyone calls you with a tip or posts one on an Internet chat board, the whole street usually knows it. Whenever someone gives you a tip, ask yourself what the person had to gain from telling you. In the final analysis, you will find that frequently the reason for clueing you in was that the tipster had stock to sell. This type of action runs rampant on the Internet. So be very careful what chat room you participate in. Most investors are providing free infor- mation that serves their investment objectives, not yours. Re- member, there are no disinterested parties when it comes to investing. Everyone has an ax to grind some way or another. I get e-mails all the time from professional or individual clients who point out the positive fundamentals and technicals of a particular stock. Of course, they are just giving me this information to be nice, right? Wrong! In most cases, they are hoping I will recom- mend it in our report in the hopes we will run the stock up for them. I’ve had people ask me to mention a particular stock on my

96 Learn the Point and Figure Methodology

next CNBC appearance. I would never do that, but it shows you there are no disinterested parties on Wall Street.

I recently saw an interview with a well-known money man- ager. The interviewer asked the manager for some of his best picks, and he generously named some stocks that he thought were great values at current prices. I looked in the back section of the paper for the list of stocks that the mutual funds were buying and selling and, “lo and behold,” his fund was selling a stock he had just recommended for purchase. If this analyst was buying the stock, why would he publish it? So investors could compete with him in the market and possibly drive the price up? Not likely. What is likely is that he had bought the stock earlier at much better prices and was more interested in selling it. Be wary of tips, especially at cocktail parties and Internet chat rooms. Those giving the tips usually have a vested interest.

Before we leave the Bullish Signal Reversed, let’s look at Fig- ure 3.26 and discuss the pattern using the tennis match analogy. The rising tops show that demand is in control of the match. Each time the X wins a set (rises in a column), it does it more convinc- ingly by exceeding the level it previously hit. Each time the O wins a set (declines in a column), it does so less convincingly as it is unable to decline as low as it previously did. Then, without the stock moving back and forth at the top (distribution), it declines in a straight column to give the sell signal and break the series of rising bottoms. In terms of economics, supply has taken control of the stock at 24. This is the point where you could enter a short position, especially if the stock was also violating the Bullish Support Line. It would also be a point at which if you were long, you should begin to examine that stock closer to determine what types of defensive strategies you should take. We could go through all kinds of examples of stops, but in the real world of in- vesting it just isn’t cut and dried. Many factors come into the equation, not the least of which is the investor’s temperament. In most cases, long-term investors will only use the trend lines as stops. Traders have different problems that generally surround trading capital preservation. Watch for this pattern. It won’t show up often but when it does, take action.

You know, one of the most asked questions I get is, “Have you got any back testing done on this method of analysis?” My an- swer is, yes. If you look in the first edition of this book, you will

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see a study done by Purdue University on the probabilities associ- ated with the chart patterns we use. However, I have chosen not to use them in the second or third editions because it suggests this method is a science not an art. You are the most important part of the method. Yes, you! Without you—the well-educated and experienced captain of this ship—it will drift aimlessly. Like anything else in life, the more you practice and use the method, the better you will become with it. The following article explains exactly what it takes to become world class at something.

Are You Color Blind? Flash of Genius

I was cleaning up my desk to start out the new year with a clean desk and I came across an article named “Flash of Genius” from Forbes,* along with some of my commentary. What caught my eye was the sentence “We need to pay much more explicit atten- tion to teaching pattern recognition.” This comment was made by Professor Herbert Simon. The article went on to say, “Simon won a Nobel Prize in Economics in 1978 for theories of decision making that turn on the nature of human expertise. His central finding was that pattern recognition is critical. The more relevant patterns at your disposal, the better your decisions will be.” I found it quite interesting when he discussed chess mastery. Most would think that mastering the game of chess relates to analysis but Dr. Simon suggests that isn’t the case. Success in chess re- lates to pattern recognition. I can picture Bobby Fischer playing Kasparov of Russia in a chess match. Each is seeing patterns on the chessboard just as we would see patterns on a stock chart or a Bullish Percent chart. On Toll Brother’s chart and the chart of the Building sector, it was clear to the trained eye that the stock was making higher long-term bottoms as the broad averages made lower bottoms from 2000 to 2002. The untrained eye would not have picked up on this subtlety, but this pattern spoke volumes about the probable direction of the building sector. Now we are seeing the opposite—lower tops while the indices are making new highs. It’s like a color-blindness test. Have you ever taken one in a doctor’s office? Most people have. The patient looks at a

* Forbes, November 16, 1998.

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card with colored spots on it. The person who is not color-blind can, without difficulty, see the number within the dots. Those who are color-blind cannot. The craftsmen in Point and Figures can see patterns that the uninitiated will never see, and this abil- ity shifts them up to a much higher plane compared with other professionals in the business. By understanding these patterns whether on a chessboard or the big board, the initiated have the confidence to act rather than react.

“What makes a good doctor, lawyer or stock picker?” Simon asks. It all relates to pattern recognition. It relates to experience as well. “Mozart composed for 14 years before he wrote any music you’d regard as world class, . . . you can tell juvenile Mozart from 18 year old Mozart.” He suggests it’s the same in all fields. “Bobby Fischer got to grand master title in chess in just under 10 years, and so did the Polgar girl. Brain power matters but so does experience.” He goes on to suggest that even your doctor has probably diagnosed your problem before you finish telling him all the symptoms. We at DWA often know the answer to portfolio questions asked by our broker clients before they finish illuminating the problem.

What Does It Take to Do World-Class Work?

No matter what profession you are in, there are those who are world class and those who are other than world class. Professor Simon says: “It takes at least 10 years of hard work—say, 40 hours a week for 50 weeks a year—to begin to do world class work. We found it takes eight seconds to learn a pattern for a day, and quite a lot longer to learn it permanently. That takes you to the million pattern estimate, if you allow for certain inefficiencies in learn- ing and also for forgetting.” This is why there are relatively few professionals in the investment business who could be called world class. The term we use for it is craftsman. How long do you think it took a cobbler in the seventeenth century to learn his craft? How about a cooper? I surmise that it would have taken about 10 years. Those who have reached world-class level have seen approximately 1 million patterns. This is exactly why it takes so long to become world class in the investment business.

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So many professionals jump from one thing to the next—they never take the time to do one thing well. To be world class, you must choose something to become a craftsman in. One of our an- alysts, Susan Morrison, calculated that during a 10 year time span when we charted by hand, in charting about 400 stocks per day for 50 weeks a year, she has seen about 1 million stock charts. This is why she has such insight into the Point and Figure Chart patterns of stocks, sectors, and the market. The rest of the ana- lysts at DWA have similar experience. I get asked frequently, “What will happen when everyone is doing Point and Figure analysis.” My response has always been that to become truly good at it one must take years of study, and most people do not have the time or the inclination to become a craftsman at this method of analysis. Only a select few will go the distance. A method becomes self-fulfilling when investors follow a “guru” (e.g., Joe Granville in years past) and simply do what he tells them to do until the inevitable happens. These investors are not inter- ested in becoming well versed in the investment process. They simply want someone to tell them what to do.

Here is what normally happens. A broker reads our report and gravitates to the breakout reports. He looks at one symbol that says Double Top buy signal, buys that stock with no other analy- sis, and gets whacked. He then says this doesn’t work and moves on to the next strategy. Every now and then, a broker will pick up my book Point and Figure Charting and read it. He will then begin to implement the strategy. Somewhere down the road, he will keep a few charts by hand himself. His feel for the subject then increases tremendously. He loves the new confidence he has. He continues to learn and apply the method; years later he looks back and can see a distinct difference between his abilities then and now. His journey has still much further to go to reach world class, but he is on the way. His client retention is now high as is his confidence. He now maintains 200 stocks a day and looks at many more through our Internet system. When he nears the tenth year, he is approaching world class and the number of chart patterns he has viewed is approaching 1 million. He no longer needs to read the financial newspapers, or watch the financial TV shows. Major statements made by Wall Street pundits have no ef- fect on his thought process. He (or she) instinctively knows what

100 Learn the Point and Figure Methodology

to do in various market conditions. He is like a child who has to- tally memorized the multiplication tables, and now instinctively knows 9 times 9 equals 81.

How many of you have been doing this for longer than five years and are now feeling comfortable with this investment pro- cess? You’re on the road to world class. There’s nothing like being world class at something. To get there takes determination, pa- tience, and hard work. There are many other methods of analyz- ing the market that you might choose, from astrology to Gann angles. Whatever you choose, go the distance, become a world- class investor. You only have one life to live.

Stop Loss Points

I saved this until last because it’s something that everyone will decide for themselves what the best method for stopping out los- ing positions is. I remember reading some old manuscripts on Point and Figure and they recommended a simple 8 percent stop if a position went against you. William O’Neil one of the pioneers in technical analysis also recommends 8 percent as the stop point in a stock position. I have a problem with percents. The problem is a simple 8 percent stop may only suggest the stock has taken the “pause that refreshes.” Often times a small pullback of say 2.5 points (8 percent) on a $30 stock is a market related pullback or what I call a healthy exhale. We like to use sell signals that de- velop on stocks we own as our “wake-up call.” Traders who are quick on the trigger and need to preserve their trading capital should take every sell signal that develops. They too will be ready to go right back in on the next buy signal. This type of trading is not for most investors today. It’s interesting to look at some charts of stocks and ask yourself the question: “what if I just held on to the stock until a sell signal was given”? You might be amazed how stocks trend for a very long time without giving the first sell signal. Often it’s hard to stay with stocks that continue to trend up because we inherently want to nail down profits while we have them. Just take some time and look at the charts and develop your plan. In our Money Management Company we use the trend line of the stock as our “wake-up call.” When a

Chart Patterns 101

stock breaks the long-term Bullish Support Line, the stock goes on what we call Death Row. We then decide how we will execute the stock. We might sell some right then on the break and some on the next bounce up. We might consider selling all on the next bounce up. The point is we develop a plan and execute that plan. Conversely short sales would be stopped on a breakout of the Bearish Resistance Line. Another “wake-up” call we use is when the Relative Strength chart gives a sell signal. In situations like this we can easily set stop loss levels, actually put the order in on the exchange, Good Until Cancelled to sell if the stop point is hit. The stop point or escape route will be determined when the trade goes on. Remember I said we must determine what to do if things go right and what to determine if things go wrong from the onset of the trade. Always work from a plan. There are no set rules for stop points. You will intuitively begin to know what works best for you as you develop your skills in this method of analysis. Try to take a longer-term approach to investing and don’t be too quick on the trigger.

POINTS AND FIGURES BY DORSEY, WRIGHT MONEY MANAGEMENT

One of the beauties of Point and Figure analysis is that the only indicator used is price. No volume, no Fibonacci retracements, no waves, no guess- work of any kind. Just pure supply and demand. Often, especially by indi- viduals new to this form of analysis, people think that by “adding” volume or another of a host of “confirming indicators” accuracy might be im- proved. This, I think, is a false hope. Although using only price SEEMS overly simplistic, it is in fact much more robust than supposedly sophisti- cated models.

Here’s an example. The normal correlation between the price of oil and 10-year bond yields has been 75 percent (Steven Wieting, Citigroup econ- omist). That is a very high, positive correlation. Oil up, bond yields up. No doubt some sophisticated hedge fund built a predictive trading model using derivatives and leverage, making us Point and Figure practitioners look like we are back in the Stone Age.

We may still be in the Stone Age, but the hypothetical hedge fund is belly up in a negative equity position, because the correlation between No- vember and June 2004 has become inverse and is now running at −85 per- cent. The new world order is oil up, bond yields down. How did that happen? Who knows? And, it doesn’t matter. We’ll leave that excuse to the economists.

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What IS important is that a Point and Figure analyst wasn’t thrown off at all. Uptrends and breakouts are clearly observable in both oil and bond futures. The Stone Age Point and Figure charts give very accurate and di- rect information about supply and demand in both markets, regardless of what a finance textbook says is supposed to happen. (Come to think of it, Point and Figure charts bear an uncanny resemblance to certain primitive cave etchings. To survive, Cro-Magnon man certainly had to understand relative strength from a hunting standpoint: send out the hunter who has had the most success. Perhaps the extinction of Piltdown [trend] man had something to do with selecting “value” hunters: “Let’s send out Ogg. He hasn’t speared a boar in months!”)

Joking aside, the strength of Point and Figure is its simplicity. Supply and demand is robust. When the world changes, it changes, and can still provide accurate guidance.