Trend trading the flat base pattern

June 26, 2016 09:00 AM

The markets attract millions of people who seek to make a fortune, but to succeed you have to have a kind of pragmatic focus. You must determine what works with a single-minded purpose combined with a ruthless ability to discard what is ineffective.

The reason is clear. The stock market is riddled with quicksand and landmines presenting a million ways to make a fortune as well as a billion ways to lose one at the same time. 

Worse, humans tend to complicate what is simple and make simple what is complicated. Both paths lead away from the goal they sought in the markets to begin with—making money.

With danger lurking from all angles, you can appreciate the need for personal qualities such as focus, will and determination combined with a winning trading method. Like bricks and mortar, successful trading is built upon a firm foundation of skill and will.

Fortunately, one price pattern offers the necessary simplicity to provide that foundation.

Symphonies & trends

Imagine going to a concert where a talented piano player is giving a solo performance. The player steps to the piano and his hands create beautiful music from the piano’s ivory keys.

Consider if the pause between each stroke of the piano keys were taken away. You would be left with just noise. The beauty of the performance would be taken away because without the pause there is no opportunity for harmony or balance between the notes to exist.

This is like trend trading in the market; you just have to know where to look for a pause in the trend and when to time your move. But to know when to time your entry you have to know where to find the pause in the trend. This is where the flat base pattern can help.

Identifying entries

There are dozens of price patterns, but few can match the risk/reward ratio of the flat base pattern. Forming along the directional movement of a price trend, 
the flat base serves as a low-risk trade with explosive high-reward potential.

During the transition from expansion to contraction, price will trade within a tight, sideways pattern after establishing support and resistance (see “Building a base,” below). As price enters a period of contraction, it forms support and resistance levels marked by low trade volume. When these conditions are met it creates a fertile field where the flat base pattern can grow. 

This tight trading range becomes Ground Zero for price to explode into expansion and resume the previous trend. Also, it acts as a reference point for the overall risk you have to assume before ever taking a position.

If a flat base pattern is trading within a five-point range, then your stop loss point is at the opposite end of your entry. Knowing where your stop loss is in advance (five points) helps you calculate the size of your position and prevents you from overexposing yourself to risk (see “Targeting gains,” below). 

First, you have to understand the two types of price action in play.

Expansion and contraction

In trading, there are two kinds of price action: Expansion and contraction.

When an underlying security is experiencing expansion, a price trend is in effect. Price trends take place when one side has control — the bulls or the bears — moving the market in a particular direction.

When the bulls are in control of the trend, price is expanding upward. You quickly can identify a bullish trend on a stock chart by spotting where price is starting and ending. For example, if you’re looking at a yearly stock chart with price beginning on the lower left-hand side of the computer screen and price is trading up to the upper right-hand portion of the screen, then, at a glance, you can identify that a bullish price trend is in effect.

If the bears are in control, price is expanding downward. Using the previous example, if you look at a yearly stock chart with price beginning at the upper left-hand side of the computer screen and moving toward the lower right-hand portion of the screen, then, at a glance, you can identify that a bearish price trend is in effect.

Both types of price movement show that the underlying security is experiencing expansion.

When an underlying security is experiencing contraction, its price is caught between two price points with neither the bulls nor the bears in control. These two price levels serve as support and resistance that acts as a type of gravitational field that keeps price trapped.

Short-term traders use this to their advantage by trading back and forth, playing support and resistance against each other.

But for those with an eye on the bigger picture, the expansion that led up to this contraction period offers more risk/reward. It’s during this pause in price expansion where more potential opportunity exists. 

What’s unique about the “flat base” is that the decrease in trade volume that helps to identify the pattern also acts as the trigger.

The "when"

A spike of trade volume acts as the trigger for an entry signal.

Using a 20-day simple moving average will help you track volume levels leading up to the trigger. When volume spikes by 150% above the 20-day volume average while also trading through support/resistance, then you have an actionable trade.

This volume level provides the necessary fuel so price can break through support/resistance and keep following through (see “Entering on volume,” below). Anything less, you run the risk of experiencing a false breakout.

False breakouts can occur at these levels because other traders also can see the flat base patterns form. The risk is that they will bid up price in an attempt to attract other traders into taking a position. They try to create the illusion that there is a move underway, but then quickly sell their positions into the rush of orders from slower technical traders. This creates an artificial move that quickly loses steam, causing the breakout to stumble.

Often, higher frequency traders will also double-dip by taking the other side of the decline, selling into it. After the initial breakout, the false breakout sputters as the scalpers bail out and then turn around and pile on more orders on top of unsuspecting traders. 

To avoid being trapped, exercising your patience and timing your entry are critical. At the right time, enter when price breaks through support/resistance and only when the appropriate volume levels are met. This combination of factors will help avoid false breakouts and unnecessary risk.

This will lead to a greater success rate because the higher volume will give legs to the breakout to follow through and help sustain its move.

Pattern enhancements

To further put the odds of success on your side, use the 20-period simple moving average and the 50-period simple moving average with the underlying security’s price action. This combination of short-term and intermediate-term moving averages acts as a trend filter to keep you on the right side of the trend. To accomplish this, be sure that the moving averages are in the proper order.

Price should be trading above both averages with the 20-period one trading above the 50-period average. This sequence shows that a strong bullish trend is in place once a flat base pattern forms, revealing which direction to trade.

But if price is trading below both averages with the 20-period average trading below the 50-period one, then a bearish trend is in effect. This sequence will tell you that you should be looking for shorts.

If the flat base pattern forms over an eight-week period or longer, then look for the averages to move sideways and intersect. As long as price stays in a tight trading range, this combination of factors could reveal a strong setup once volume triggers an entry. 

Just be sure to abort the trade if the pattern falls apart.

One final tip

Flat base patterns offer great reward potential, but they do require a degree of patience. The reason is they take time to form, so when the entry signal is confirmed the move can be sudden and explosive. If you don’t maintain good diligence, then you could miss a trade at a critical time.

This can be a bit frustrating when you’ve been tracking a setup for a while, especially if you’re a trader who craves more action. 

But keep in mind that these patterns are fairly abundant and form on every time frame.

If you need more action, then consider scrolling through the different time frames to look for setups. Just remember to stay on the right side of the trend and adjust your risk as needed.

About the Author

Billy Williams is a 20-year veteran trader and publisher of www.StockOptionSystem.com, where you can read his commentary and a report on the fundamental keys for the aspiring trader.