Chart-Pattern Review: Tops, bottoms, and flags

by Thomas Bulkowski

©2005, Reprinted with permission of Active Trader magazine (www.activetradermag.com)

A trader and analyst examines how three pattern types (tops, bottoms, and flags) can lead to profitable setups.

This study describes how to recognize and trade three main types of chart patterns: double bottoms and tops, Big Ws (or Ms), and flags. Many traders are familiar with the six formations shown in Figure 1, but nearly all of these patterns also include variations with different performance characteristics. (High, tight flags [HTFs] are one exception to this rule.)

This review discusses how to identify Figure 1’s patterns as well as their 17 variations, which can lead to profitable trade setups, especially if you wait for confirmation.

Click here to view Figure 1: Double Top, Double Bottom, Big W, Big M and Flags

Double bottom

Figure 2 shows four double bottoms with different combinations of “Adam” and “Eve” valleys. An Adam valley is narrow, which means it usually contains one or two price spikes. In contrast, an Eve includes a wider, more rounded price reversal than an Adam.

Both bottoms of the Adam & Adam pattern appear similar and are narrow with long spikes. Adam & Eve has one spike bottom and one rounded price reversal; Eve & Adam includes a wide bottom followed by a narrow one — the opposite scenario. Finally, Eve & Eve has rounded valleys and represents the classic double bottom.

Look for a downward price trend leading to the twin bottoms when trying to identify this pattern. The rise between the two bottoms (i.e., point Ain Figure 2) is the confirmation point, which should be at least 10 percent above the lowest bottom. Taller patterns perform better than short ones, so keep that in mind if you ignore the 10-percent guideline. When price closes above a double-bottom confirmation, go long.

The price difference between bottoms is small — usually two to five percent — and the second bottom typically occurs within three to six weeks of the first one. Performance suffers if the distance between both bottoms is longer than two months.

Volume is typically heavier on the first bottom, but don’t throw out a double-bottom pattern because the second bottom’s volume exceeds the first one.

Each combination performs differently. For example, an Eve & Eve pattern leads to the strongest price increases (measured from point A to the pattern’s ultimate high, or the highest high before a 20-percent decline from its highest peak to its subsequent lowest close). Eve & Adam leads to the weakest rallies, while the performance of Figure 2’s top two patterns is in between the other two double-bottom formations.

Double tops

Figure 3 shows four types of double tops, which are the opposite of double bottoms, in the same Adam & Eve combinations as Figure 1. Here, Adam peaks are narrower and sharper than Eve peaks.

The valley between both peaks (point A, upper right) is the double top’s confirmation point. When price closes below it, the pattern (and a downtrend) is confirmed — an essential feature.

Look for an uptrend leading into the double top. The valley between the tops should drop at least ten percent, and price can vary up to three percent between peaks. The tops should be about two to seven weeks apart but allow variations. Higher volume usually occurs on the left top.

If double-top peaks appear similar, the pattern is either an Adam & Adam or an Eve & Eve. If the tops look different, the formation is either an Adam & Eve or Eve & Adam. An Adam peak often remains narrow even near its base, while Eve tends to widen out at its base. If an Eve top has spikes, they will be shorter and appear more often than in an Adam peak.

Looking for other peaks in the same stock can give you a sense of what it considers to be an Adam or Eve top. When it’s tough to decide whether it’s an Adam or Eve, other price peaks (and the surrounding price action) can help.

Big Ws and Ms 

Figure 4 shows a Big W pattern, which includes a double bottom (points 1 and 2), but it also has tall sides (points A and B). The decline from point A to bottom 1 is usually a straight drop with few or no pauses; the selloff should be at least 1.5 times the distance from bottom 1 to point C.

Swing traders will want to take profits as price rallies from bottom 2 and nears point A — the start of the first downhill run. Price often stalls and drops to form a handle, or consolidation range. However, if the overall market and industry group continue to climb, price may resume its uphill run.

A double bottom isn’t necessarily the only pattern that appears at the base of a Big W. Triple bottoms, head-and-shoulders bottoms, and other chart patterns also tend to form, so consider trading those variations as well. Any Big W, however, must include a straight and steep drop from point A to bottom 1.

Figure 5 shows a Big M pattern, which is the exact opposite of a Big W. Look for a double top with a long, straight uphill run leading to top 1. The pattern confirms when price closes below the valley between both peaks. Expect price to continue lower at this point since it will often approach point A’s low before recovering.

Flags 

Figure 6 shows the three types of flags (down-slope, up-slope, and horizontal) as well as a “loose” flag (below), which includes fluctuating price moves as opposed to the other patterns’ compact channels. The down-sloping flag forms when price retraces against the main thrust direction — the most common flag type. Price can also slope up (center) or move sideways (right) after an uptrend. (Note that each of the three main flag patterns can also form following a downtrend, and the following characteristics and trade ideas also apply to them.)

The best performing flags appear after a dramatic rally. Price then consolidates for up to three weeks before resuming its climb. A flag that lasts longer than three weeks turns into a rectangle or channel, where price bounces between two parallel lines (i.e., support and resistance or trendlines).

Flags have two parts: the flagpole, or steep uptrend, and the flag, which is the pattern’s consolidation area. Volume trends downward in the flag portion.

A flag is a half-staff pattern, meaning it often appears in the middle of a trend (up or down). To find a price target, measure the distance from the low at the bottom of the flagpole to the pattern’s top, which is often the top of the flagpole. Then, add this value to the lowest low of the flag.

Price often fails to hit this target: Flags reach this threshold only 64 percent of the time in bull markets, and their success rate is just 55 percent in bear markets. Adding half of the flagpole’s height to the flag’s lowest low will result in a more accurate price target.

Finally, a loose flag doesn’t perform as well as the tight, well-formed flags shown in the upper section of Figure 6.

Figure 7 shows a high, tight flag. An HTF often isn’t a flag at all but a consolidation region that appears after a strong up move. It forms when price doubles or increases 90 percent or more within two months. Price should then move sideways while volume trends downward.

Tight HTFs offer better trading setups than loose ones. Figure 7 shows a loose HTF. In contrast, tight flags typically follow a trendline and resemble one of the up-, down-, or horizontal-sloping flags in Figure 6.Wait for price to either close above the pattern’s highest peak (point A) or to pierce the trendline formed along the top of the HTF’s flag portion (line AB). Once price breaks above the flag, it rallies at least half the flagpole’s height 90 percent of the time, so use this rule to predict a price target.

For example, if price climbed 120 percent in the two months prior to the HTF, expect a rise of at least 60 percent after the breakout, but use a stop to protect your profits. Narrow patterns with flags shorter than 14 days (the study’s median length) tend to perform slightly better than wide ones.

Closing position 

The six main chart patterns discussed here (double tops and bottoms, Big Ws and Ms, and basic flags and their high, tight counterparts) represent 17 types of buy or sell signals.

For the best post-breakout performance, look for an unusually tall pattern and trade the breakout in the direction of industry and market trend, which helps maximize gains and minimizes any mistakes.