Some of the most explosive share price
advances launch from tight, range-bound structures rather than deep
correction-recovery patterns such as the cup-with-handle.
Flat bases often form in the midst of
adverse, choppy markets when deeper bases are few and far between. U-shaped breakouts tend to proliferate as the market emerges from corrections and
bear markets.
Spotting a proper flat base means more
than simply identifying stocks confined in narrow price ranges. The pattern has
five basic traits:
1. The flat base is a continuation
pattern, forming after a prior advance.
2. The pattern should extend at least
six weeks before the breakout.
3. As it forms, the flat base should
tighten as it moves sideways. This volatility contraction should stand out clearly on a price chart.
4. The breakout should
occur on strong, decisive volume.
5. The pivot point is at the high of the
base. So a momentum trader would buy once the stock surpasses the pivot by 1/8
point.
Gemstar (GMST | Quote | Chart | News | PowerRating) broke out of a flat base in early 1999. The following prices are adjusted for
subsequent splits, so I'll be using decimals.
After a hefty price expansion, Gemstar
shares peaked at an intraday high of 17.30 on Dec. 4, 1998 (see Point
A in the above chart), then corrected to a low of 12.66 on Dec. 14 (Point
B), the bottom of the correction. The stock grazed new high ground,
making a session high of 17.42 on Jan 8, 1999 (Point C), but fell back into the base in the same session.
Purists might argue that the failed
breakout invalidates the prior trading history as part of the base. In this
case, the stock's move into new high ground was brief and occurred on average
volume. There was not a material transfer of ownership. However, I would move up
my pivot point to the Jan. 8 high in recognition of resistance at that slightly
higher price level.
Gemstar entered a second decline, but the stock did not revisit its Dec. 14 low. Instead, shares found support at 13.94 (Point D). From
there, that support level more or less held, causing the trading range to
tighten. On March 31, the stock lifted off, surging through the pivot point of
17.42 to close at 18.81 near the high of the day's trading range (Point
E).
Patterns can form in the charts of
indexes as well as individual stocks, allowing you to focus on promising
industry groups.
Fred Wynia, technical analyst and trader for NDB Capital Corp.,
went long insurers in late July 2000 after spotting flat bases in Standard &
Poor's Insurance Sector Index ($IUX.X | Quote | Chart | News | PowerRating) as well as individual issues in
the sector.
To help illustrate the
tightening price action of the flat base, I've plotted the index's Historical
Volatility beneath its price line. HV is the standard deviation of day-to-day price change
expressed as an annual percentage. Suppose a stock is trading at $100 and has an
HV of 20%. The stock has a 66% probability of trading somewhere between $120 or
$80 in a year's time. My measure of HV is based on price closes over the past 50
sessions.
The S&P Insurance Index ($IUX.X | Quote | Chart | News | PowerRating)
peaked at 660.18 on June 2 (Point A),
beginning the flat base. At that time, the index registered a historical
volatility of 39.43. The index fell to a low of 598.64 on June 22 (Point
B). Note that the index closed in the upper half of the day's range,
evidence of support and a possible bottom. Meanwhile, note the downtrend in
Historical Volatility, which on June 22 measured 35.64.
On July 25, the index surged 3.4%,
breaking out of the base and closing in the upper half of the day's range at
661.46 (Point C). At the time of the
breakout, HV was at 29.39.
The breakout coincided with a bullish
fundamental picture in the insurance sector. After the prior day's close, AFLAC
(AFL | Quote | Chart | News | PowerRating), the largest supplemental health insurer in the U.S. and Japan, reported strong
quarterly earnings growth and beat Wall Street estimates.
At the time, a number of insurance
stocks were rallying or forming the right sides of bases, providing further group
confirmation. For instance, AFLAC shares exhibited a bullish correction-recovery pattern
at the time the index broke out. The insurer later advanced to a new 52-week high.
Wynia snapped up shares in insurers American International Group
(AIG | Quote | Chart | News | PowerRating) and American General Corp. (AGC | Quote | Chart | News | PowerRating) as they broke out of flat bases.
AIG's flat base is particularly crisp. Wynia stresses that a stock can exhibit
all the characteristics of a flat base, but if the breakout occurs on weak
volume, he would "question the legitimacy of the breakout."
American International Group peaked on June 15 (Point A) and touched its correction
low on June 22 (Point B). From there, as you
can see, the trading range progressively tightened. The stock broke out on July
25 on strong volume. Wynia snapped up shares at 82.
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