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How To Trade A Squat Formation

Author: Sheldon McIntyre (info)
Website: http://profilingleadership.typepad.com/my_weblog/
Posted: March 7th, 2007 at 11:03 am EST
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For most of my career as a trader I have targeted stocks breaking into new high ground from solid base formations such as a base-on-base pattern, cup with handle pattern, high tight flag pattern, cap pattern, etc.  Occasionally a stock breaks out from a new base only to reverse back into the base prior to the market close (squat formation).  In the beginning this type of price action was fustrating and I did not know if it meant the breakout was a failure or not. Instead of just dumping the stocks I begin compiling a list of these squat formations.  I discovered that I should hold the stock for 4 more days and if the stock does not take out the breakout day high by the fourth day there was a high probability (87%) that the stock breakout was a failure.

Let me touch upon the psychology behind the squat formation.  When a stock breaks out there are more sellers than buyers and that drives the stock price back into the base.  However, the sellers do resist selling too hard and the stock holds in the base.  Meanwhile, the buyers are concerned about the possibilityof more overhead selling and resist buying.  Thus, the passing of days begins to erode the patience of both sides of the trade.  The result can be either the sellers finally capitulating or buyers regaining confidence in the trade pushing through whatever overhead stock that remains.  For that reason, it is imperative to let the trade prove itself to you before taking a trading decision. 

The only caveat is if the trade hits your stop-loss level before the fourth day.

I often add to my position if it takes out the breakout day high if it is within 5% of the original pivot.

   

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