Introduction

Jim is struggling.

He is the owner of JCB Superstores, and his competitor across town is beating him up; there is blood all over Jim's ledger. He decides it is time to take off the gloves: JCB goes public. He uses the money from the initial public offering to buy his competitor and add a few more stores around town.

With a growing sales base, Jim's clout allows him to negotiate lower prices for the office supplies he sells. He passes on part of the savings to his customers, while watching his margins widen, and plows the profits back into building more stores and updating existing ones.

Jim calls his friend, Tom, and tells him of his plans to expand the operation statewide. They chat for a while and exchange business tactics on how best to manage the expansion. When Tom gets off the phone, he decides to conduct his own research on JCB. He visits several stores and sees the same thing: packed parking lots, people pushing full shopping carts, and lines at the checkout counters.

He questions a few customers to get a sense of the demographics. At a few stores, he even chats with suppliers as they unload their wares. Back at the office, he does a thorough analysis of the financials and looks at the competition. Everything checks out, so he orders his trading partners to buy the stock at no higher than $10 a share.

When news of the expansion plan hits the wires, the Street panics. It is, after all, a soft economy, and expanding willy-nilly when a recession looms is daft, maybe even criminal, according to some news outlets. The stock drops below 10 and Tom's crew makes its move. They buy as much as they can without raising suspicion. The stock rises anyway. It goes back up to 11, then 12, and rounds over at 13 before heading back down.

Several months go by, and the economic outlook is as bleak as ever. The stock eases down below 10. After Tom checks in with Jim for the latest public news, Tom's team buys more. It is an easy score because investors are willing to dump the stock, especially as year-end tax selling approaches.

Six weeks later the company releases the sales numbers for JCB; they are better than expected. The stock rises 15% in minutes and closes at 10.75. And that is just for starters. Six months later, it's clear the economy was never in danger of entering a recession and everyone sees boom times ahead.

The stock hits 20.

Years go by, the stock splits a few times, and the holiday season looms. Tom interviews a handful of customers leaving JCB Superstores and discovers that they are all complaining about the same thing: The advertised goods are not on the shelves.

Tom investigates further and discovers a massive distribution problem, right at the height of the selling season. JCB has overextended itself; the infrastructure is simply not there to support the addition of one new store each week.

Tom realizes it is time to sell. He tells his trading department to dump the stock immediately but for no less than 28.25. They liquidate about a third of their holdings before driving the stock down below the minimum.

Since it is the holidays, everyone seems to be in a buying mood. Novice investors jump in at what they consider a bargain price. The major brokerage houses climb aboard and tout the stock, but Tom knows better. When the stock recovers to its old high, his trading partners sell the remainder of their holdings. The stock tops out and rounds over. During the next month and a half, the stock drifts down, slowly, casually. There is no rush for the exits-just a slow trickle as the smart money quietly folds up shop and moves on.

Then news of poor holiday sales leaks out. There is a rumor about distribution problems, merchandising mistakes, and cash flow problems. Brokerage firms that only weeks before were touting the stock now advise their clients to sell. The stock plummets 39% overnight.

One or two analysts say the stock is oversold; it is a bargain and investors should add to their positions. Many bottom fishers follow their brokers' advice and buy the stock. Big mistake. The buying enthusiasm pushes the price up briefly before a new round of selling takes hold. Each day the stock drops a bit lower, nibbling away like waves washing against a castle of sand. In 2 months' time, the stock is down another 30%.

The following quarter JCB Superstores announces that earnings will likely come in well below consensus estimates. The stock drops another 15%. The company is trying to correct the distribution problem, but it is not something easily fixed. It decides to stop expanding and to concentrate on the profitability of its existing store base.

Two years later, Tom pulls up the stock chart. The dog has been flat for so long it looks as if its heartbeat has stopped. He calls Jim and chats about the outlook for JCB Superstores. Jim gushes enthusiastically about a new retailing concept called the Internet. He is excited about the opportunity to sell office supplies online without the need for bricks and mortar. There is some risk because the online community is in its infancy, but Jim predicts demand will expand quickly. Tom is impressed, so he starts doing his homework and is soon buying the stock again.

Investment Footprints

If you picture in your mind the price action of JCB Superstores, you may recognize three chart patterns: a double bottom, a double top, and a dead-cat bounce. To knowledgeable investors, chart patterns are not squiggles on a price chart; they are the footprints left by the smart money. The footprints are all they need to follow as they line their pockets with greater and greater riches.

To others, such as Tom, it takes hard work and pavement pounding before they dare take a position in a stock. They are the ones making the footprints. They are the smart money that is setting the rules of the game-a game anyone can play. It is called investing.

Whether you choose to use technical analysis or fundamental analysis in your trading decisions, it pays to know what the market is thinking. It pays to look for the footprints. Those footprints may well steer you away from a cliff and get you out of a stock just in time. The feet that make those footprints are the same ones that will kick you in the pants, waking you up to a promising investment opportunity.

This book gives you the tools to spot the footprints, where they predict the stock is heading, how far it will travel, and how reliable the trail really is. The tools will not make you rich; tools rarely do. But they are instruments to greater wealth. Use them wisely.

The Database

Let me tell you about the stocks I used to compile the statistics in this book.

• 1,396 stocks were used; most start in July 1991 and extend into 2020.
• Not all stocks covered the entire period.
• Some stocks no longer trade. It's important to include what happens when a company goes bankrupt or merged out of existence.
• All stocks use daily price data, not intraday, but some chapters use weekly or monthly data.
• Most chart patterns were added in real time as new data arrives each day. This avoids look-ahead bias (where I only catalog patterns I can see have done well).
• The real-time addition of data was done for more than 20 years.
• All stocks have been split adjusted unless I no longer actively follow them.
• When a new stock is added to the database, it may have been dividend adjusted by the data provider. However, I don't adjust stocks I use in my database for dividends.
• A stock becomes part of the database provided it trades above $5 a share (usually), isn't thinly traded (I like to see daily volume over 100,000 shares), and the stock has a heartbeat (meaning it has a reasonable high-low yearly trading range).
• Market capitalization varies with all three represented (small, medium, and large).
• Most stocks chosen are from American companies whose stocks trade on the NYSE or NASDAQ exchanges.

The Sample Trade

Most of the sample trades included in the chapters of this book are fictitious. Each sample trade uses techniques I wanted to illustrate, incorporating fictitious people in sometimes unusual circumstances. Call it poetic license, but I hope they give you some ideas on how to increase your profits or minimize your losses. Maybe you'll find them entertaining, too.

Testing Chart Patterns

How do you test chart patterns? It's not an easy question to answer. If you use commonly available software that tests trading strategies, you'll enter rules to model the shape of a double bottom, for example. When price closes above the top of the pattern, it signals an entry, so the software simulates a buy.

What about the exit signal? When do you sell? Should you use a stop-loss order or a signal from MACD or even a moving average crossover? No. Why not? Because you're not testing the chart pattern. You're testing how well a stop-loss order works or you're testing MACD or the moving average crossover system.

So I invented two tools I call the ultimate high and ultimate low to solve the testing problem.

Let's look at a chart so I can explain how these work and you'll understand the statistics in this book. Figure I.1 shows two chart patterns, a double bottom and a head-and-shoulders top. Let's take the double bottom first.

Trading the Double Bottom

It appears at AB, two valleys that bottom near...