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msg #51386
Ignore ham1198
5/1/2007 7:22:29 AM

from SFO magazine. Sorry charts to show. Here's link:

iRoof Pumps Out Profits For Those Who Listen
by: Thomas N. Bulkowski

The inverted roof chart pattern has unique characteristics that can lead attentive traders to profitability.

After the frenzy of holiday shopping ended in December, I still felt the need to buy. Enter: WPS Resources Corp. with an inverted roof pattern (iRoof). It showed a flat top as a support area and the price had broken out upward, so I bought the stock. But did I make a mistake?

Discovering iRoofs
I first encountered the inverted roof pattern in early 2005 when I found its complement, the roof pattern (looks like a gable roof). Since then, I had spotted the iRoof several times but never researched it. Looking at Figure 1, you can probably determine the identification guidelines, but to be clear, here they are:

1. Price forms a flat top, most times it’s horizontal, but allow some slope if necessary.
2. The bottom of the iRoof looks like a V, and together with the flat top, it appears like a diamond with the top half missing.
3. The price trend leading to the chart pattern can be either up or down. This is what distinguishes the iRoof from a head-and-shoulders bottom.
4. Price crosses the pattern from top to bottom several times, filling the pattern with movement.
5. Volume trends downward and most often takes a dome-shape. Do not exclude a chart pattern just because of an unusual volume pattern.

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Figure 1 shows an example of an iRoof in WPS. The top of the chart pattern is flat except for a brief one-day spike that poked through in late October. Fifteen percent of the time, price overshoots the entry of the iRoof, but the overshoot usually consists of a few days of higher price movement. Ignore overshoot when drawing the top line.

Price expands downward in widening turns and then narrows, forming a V-shaped depression in the center. In this example, the breakout is upward when price crosses the top of the pattern. An upward breakout occurred exactly half the time in chart patterns that I reviewed. WPS shows a U-shaped volume trend, and that is unusual because it occurs only 29 percent of the time.

Figure 2 shows two examples of the iRoof pattern, both forming as reversals of the short-term uptrend. I see this often in chart patterns. The price makes a strong move up (green arrows), consolidates and forms the iRoof, and then drops (red arrows), usually approaching the launch price. In these two examples, price does not climb far before reversing. Both have downward breakouts, and Frontier Airlines shows a pullback. I’ll discuss throwbacks and pullbacks later.

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Follow the Numbers
I looked at 500 stocks from July 1991 to July 1996 and another 462 from January 2005 to January 2007. There is nothing magical about these dates; I just searched my database until I found enough samples. I found 200 patterns (see Table 1).

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I measure performance from the breakout price to the ultimate high (upward breakouts) or ultimate low (downward breakouts). The ultimate high or low is the highest high or lowest low before price reverses direction and moves more than 20 percent in the new direction or closes beyond the other side of the chart pattern.

The average increase after the breakout from an iRoof is 19 percent. That may sound either good or bad, but when compared to other chart patterns, upward breakouts rank 20 out of 22 (one is best in all rankings discussed). The best performing chart pattern, by comparison, is a high-and-tight flag, with an average rise of 69 percent in a bull market. Downward breakouts show an average decline of 17 percent. That ranks fifth out of 10 pattern types (with many ties). The best performing chart pattern in a bull market with a downward breakout is a complex head-and-shoulders top, and that pattern has an average decline measuring 23 percent.

The iRoof performance of upward breakouts and downward breakouts compare to a change in the Standard & Poor’s 500 Index of 6 percent and 0 percent respectively. By that, I mean the change in the index from the breakout date to the date price reached the ultimate high or low in the stock.

Failure rates are a different way of looking at performance. The failure rate for upward breakouts is 19 percent. This means that 19 percent of iRoofs I analyzed failed to increase more than 5 percent after the breakout before changing trend and heading lower. Upward breakouts rank 10 out of 17. For downward breakouts, 10 percent fail to drop more than 5 percent. This places the failure-rate rank at seven out of 19.

Calculate Success
The measure rule is a guideline to gauge the minimum price move after the breakout. Measure the height of the iRoof from flat top to the lowest low in the chart pattern and add (upward breakouts) or subtract (downward breakouts) the result from the breakout price. The breakout is the price at which the stock pierces the chart pattern boundary. For upward breakouts, that’s the flat top. For downward breakouts, it’s where price crosses the trendline.

The measure rule works between 71 percent and 73 percent of the time, depending on breakout direction. I suggest you take the height and multiply it by 71 percent or 73 percent and then add/subtract the result to/from the breakout price. This gives you a more conservative price target—one that typically reaches its goal.

Travel the High Road
In nearly all chart patterns, tall performs better than short. But what do tall and short mean? Measure the height from the highest high (the flat top) to the lowest low in the iRoof and divide the result by the breakout price. If the breakout is upward, a tall pattern is greater than the median 8.84 percent. For downward breakouts, a tall pattern is greater than 9.33 percent.

Upward breakouts from tall patterns result in average gains of 25 percent compared to gains of just 15 percent for short patterns. Downward breakouts show tall/short declines averaging 21 percent and 14 percent respectively.

I mentioned throwbacks and pullbacks earlier. Throwbacks occur after an upward breakout when the stock returns to the breakout price within a month. For the iRoof pattern, a throwback happens 65 percent of the time, taking an average of 10 days to make the return trip. Figure 1 shows an example of a throwback. Pullbacks are similar to throwbacks except the breakout is downward. The stock returns to the breakout in an average of 12 days, and 56 percent of iRoof patterns have pullbacks. Figure 2 shows an example of a pullback.

Finally, many traders believe that chart patterns acting as continuations of the prevailing price trend perform better than reversals. My research suggests otherwise. And the iRoof is just such an example. iRoofs with upward breakouts that act as reversals show price climbing an average of 21 percent after the breakout, but continuations have post-breakout gains of just 18 percent. The downward breakout performance is unreliable because of the low sample count for continuations.

Trading the iRoof
One setup that works well with many chart patterns is trading a quick decline that follows a quick rise. Figure 3 shows an example. Price begins moving up after breaking out of the small congestion region shown near the launch point. The climb to the iRoof reversal is a strong run at a slope that is too steep to last. The stock consolidates in the iRoof pattern, forming a flat top and a widening, then narrowing price pattern. Price breaks out downward and tumbles, making a strong push lower. The stock bottoms near, but not quite at, the launch price.

click image for larger view

The iRoof perched atop the uptrend is a lighthouse on a cliff—a visible beacon on charts that is easy to find. Using the launch point as a price target also makes this a low-risk setup. Just be aware that price may not make it back to the launch price every time. And before you trade this setup, make sure that there is something to reverse. This means that price should have climbed far enough to be profitable to trade (contrast the meager decline in the right half of Figure 2 with the larger decline in Figure 3).

The iRoof pattern acts as a reversal slightly more often than a continuation pattern, 58 versus 42 percent. If you can determine when the downward move has stopped, then buy. After the downtrend ends, the average rise is a tasty 45 percent.

If the breakout is in one direction and then quickly reverses, trade in the new direction. These “busted” chart patterns tend to do quite well. An iRoof with a downward breakout that reverses direction and soars out the top of the chart pattern rises 28 percent, on average (from the low at the turn to the new ultimate high). That dwarfs the 19 percent average rise for iRoofs with upward breakouts. Upward breakouts that reverse drop an average of 22 percent, well above the downward breakout average of 17 percent.

If I knew in December what I know now, I would not have bought WPS (now called Integrys Energy Group after a merger with Peoples Energy). In fact, I sold the stock for a 3 percent loss, because I believed the utility sector was making a bearish trend change. I was fooled. A week later, WPS started rising in a straight-line run up from 53.07 (where I sold) to the merger price at 57 and change.

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