Advanced Bow Tie Trading Methods

Introduction

With picking stocks using discretionary patterns, it's more important to choose those that fit the concept and designer's intent rather than those that fit the exact rules. Below I will discuss the theory behind my Bow Tie pattern, discuss patterns to avoid and setups that don't follow the pattern to the "letter," but are in the "spirit" of the pattern.

Designer's Intent

For those not familiar with Bow Tie pattern, see yesterday's Lesson of the Day or my book: Dave Landry On Swing Trading before continuing.

My style of swing trading is momentum based. That is, in order for me to get excited about a setup, the stock (or commodity) must first show strong momentum in the intended direction of the trade. Requiring such strong momentum has helped to keep me on the right side of the markets. However, I found that it often kept me out of markets that were in the early phases of developing new trends. And, these markets often made strong moves as the new trend emerged. I knew I had to come up with a pattern for these markets in transition or be willing to let them go.

Knowing that top and bottom picking is a losers game, I sought out a pattern that would seek to enter markets only after the trend showed signs of changing and only after the first correction. Waiting for the trend to change helps to avoid the pitfalls associated with fading markets. Waiting for the first correction it helps to keep you out of markets that may have made a false top (bottom). It also helps to keep you from entering markets that are very oversold (overbought). Said another way, the intent of the Bow Tie is similar to trading "first pullbacks".

Referring to the figure below, notice for shorts the market was in a strong uptrend and began to roll over. Markets in transition often correct before resuming the new trend. Notice after the first correction the "new" downtrend resumes. The opposite is true for longs. The market begins to carve out a bottom as the market shifts from downtrend to uptrend. Then, after the first correction of the "new" uptrend, the uptrend resumes. The idea behind the Bow Tie is to first identify this transition in trend through a convergence of moving averages and then look to enter the new trend after the first correction. Keep this figure in mind when looking for Bow Tie setups to trade.

Artrocare Corp. (ARTC | Quote | Chart | News | PowerRating) provides a good real world example. Notice that the stock was in a longer-term uptrend as evidenced by the direction and order (the faster moving averages are above the slower moving averages--10SMA>20EMA>30EMA) of the moving averages (a). Notice that the stock makes a transition to a downtrend as the moving averages all come together and begin to spread out to the downside (b)--giving the appearance of a "bow tie". The stock then has its first correction (c) since the transition in trend. An entry is placed and triggered below the setup (d) to capture the downtrend as it resumes.

Variations

As implied above, I quickly learned from Cooper that patterns that were in the "spirit of" the setup were often just as good or even better than those that fit every detail to a "T". Elantec Semiconductor (ELNT | Quote | Chart | News | PowerRating) provides a good example. Notice that the stock had begun to correct (b) after the moving averages had begun to roll over (a). However, the "official" bow tie in the moving averages did not occur until after this first correction. A significant move out of the first correction would have been missed by waiting for the "official" setup to form at point (c).

I have dubbed these setups a "convergence kiss" because the price comes up as if to "kiss" the moving averages as they converge. The idea here is to anticipate the setup rather than wait for the "official" setup to form. Again, keep the figure under "Designer's Intent" when looking for variations to trade.

Setups To Avoid

Knowing which stocks to avoid is just as important as knowing which stocks to trade

Large Gaps

When a market makes a large gap, usually there is some sort of fundamental shift or some change in the way the stock is valued. These large gaps often "force" all of the moving averages to come together and form the Bow Tie. However, this is a "jump" in price versus a transition. The jump often causes an imbalance and makes the stock extremely difficult to trade. Notice below that after a sharp gap in Emulex, the moving averages converge and spread out again. At point (b), according to the exact rules, a Bow Tie setup forms. However, because you have already missed the thrust out of the transition in trend, the setup is no longer in the "spirit" of the designer's intent and should be avoided.

This is not to imply that all gaps are bad. If the gap suggests the first sign of cracking and not a complete meltdown in and of itself, then subsequent setup that forms may still be worthy. Notice below that after more than doubling in a short period of time, Newport, an institutional favorite gaps down (a). However this didn't immediately cause the crossover in the moving averages and the stock began to stabilize (b). At this point, we know the stock is wounded. The Bow Tie then forms and giving an entry at (c).

Avoiding Extended Markets

After the moving averages roll over and form a bow tie, I like to see the correction in price occur shortly thereafter. Remember, the idea is to enter a market soon after the new trend forms---not once the trend becomes obvious and gets extended. Therefore, I normally like setups that occur within several bars--the fewer the better--of the convergence of the moving averages (the bow tie). Also, similar to the concept discussed above under gaps, the price itself shouldn't be too far extended either. With that said, avoid those markets which take numerous bars to set up and/or get extended away from the bow tie in the averages.

As an example, notice below that VoiceStream Wireless loses over 30 percent of its value and is in a strong downtrend before the official Bow Tie sets up (b) (Note: it actually made a higher high before the bow tie (a) formed, similar to the "kiss" pattern discussed above). This is over two weeks after the convergence of the moving averages (a). Remember, the idea is to capture a transition in trend. This does not mean that the stock it not worthy of trading with some other pattern. It's just not in the spirit of the Bow Tie.

In Closing

When looking at any discretionary setup, don't get too caught up in the specifics. True, you shouldn't stray too far from the pattern. Just remember your goal is identify patterns that have designers intent in mind. If the concepts are there, then it might just be worth considering. On the other hand, just because a setup fits the rules to a "T" doesn't necessarily make it a good setup.

Q. What would you recommend to those learning to trade a new pattern?

A. First, learn what the designer's intent and seek patterns which capture these concepts regardless of how perfect the setup fits the rules.

Q. Doesn't give those trying to learn patterns "free range" to chose?

A. As long as they understand the intent, then it's ok to look for variations But, yes, you are correct. Many times people are just looking for action and will pick sub standard setups. I'm amazed at the number of emails I receive asking me if ABC and CDE are Bow Ties (and other patterns) when they don't look remotely anything like the pattern. My point is to understand the concepts FIRST before trading them.

Q. Why are all your examples on the short side?

A. I always like using current market examples in my articles. At that time (early April 2001) we were in a bear market and I didn't have any on the long side.

Q. Would anything be different on the long side?

A. Not really. About the only thing that might be different is that stocks probably gap down more on surprise news than they gap up. Things are torn down much easier than they are created.

Q. You didn't mention the half Bow Tie--one that forms soon after a stock breaks out of a base.

A. This was discussed in the original article. This is more of a breakout of a base followed by the first pullback. This is a common concept (i.e. buying the first pullback out of a base breakout). I wanted this article to be a more advanced article. There's really nothing advanced to discuss here.

Q. Do you prefer a Bow Tie to a half Bow Tie?

A. Yes. My intent was to capture a transition in trend from uptrend to downtrend. Not a base breakout. If you're lucky enough to capture this transition, you have the added bonus of traders still trapped on the wrong side of the market.

Q. Any other tricks of the Bow Ties you care to share with us?

A. Volatility is important. But that's not just for Bow Ties. I use it in all the patterns I scan for. I learned this from Connors. It helps to weed out stocks with less potential. I'm a huge fan of volatility. I think in volatility lies the "ancient Chinese secret".

Q. For example?

A. A friend of mine once showed me a very simple pattern. This trader, who I have utmost respect for, believed that this pattern, although extremely simple, worked. I did the programming for him and started running scans. They were cranking out 300-400 stocks each day that fit this pattern. So, on the surface, this pattern did not work. Because I respected this trader, I began experimenting with volatility to see if in fact something was actually there. Adding the volatility layer reduced the scans down to 20 stocks or so. From that, we were able to quite effectively pick and choose. And, it did work!

Q. What was the pattern?

A. I could tell you, but I'd then have to kill you. Seriously, the point here is that volatility can be a wonderful filter.

Q. How do you measure volatility?

A. I use historical volatility and as a general rule, I like to see the historical volatility readings of 40 or higher for most of my patterns (including Bow Ties). This tells me that I'm looking at stocks that have the potential to make a large move in a short amount of time---a perquisite for the swing trader. Occasionally, there are times when I may adjust my volatility cut offs.

Q. For instance?

A. The example I used above about scanning for a common pattern was during the bull market blow off. At this time I bumped it up to 80 or so to keep the list manageable. So it all depends on the market conditions and how common the pattern is. The more common the pattern and the more volatile the market, the higher your minimum number will have to be in order to keep the list within reason.

Q. By filtering with volatility, doesn't that sometimes weed out good setups?

A. Yes. On occasion a setup in a historically non-volatile stock such as a consumer non-durable or a utility will get culled out.. Stocks such as these, which are known for lower volatility (vs. a technology stock), will be missed when the volatility begins to wake up.

Q. Can you give us an example?

A. Sure, Clorox comes to mind. Because I had a volatility cutoff, this one didn't show up in my scans even though it was a text book example. I remember the stock being all over the media after it cracked from the Bow Tie. At first I thought something was wrong with my software because it didn't catch it.

Notice above that the 50-day HV (a) was below the 40% cutoff (the red line) so the Bow Tie (b) did not show up in the scans.

Q. Does this bother you, missing these opportunities?

A. Naaa, you can't kiss all the women. I used to get mad when I missed wonderful setups, now it just motivates me to do more research. Maybe at some point and time I'll do some research here. I can already see the article already: "When Volatility Wakes Up In Boring Stocks". (Dave begins to laugh).

Q. As always, thank you for your time and wonderful insight.

A. You're welcome!