Today's Trading Lesson From TradingMarkets

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) 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) 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) 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), 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) and American General Corp. (AGC) 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.