Buying Top Growth Stocks: Why The Shakeout + 3 Pattern Makes Money

In the family tree of bullish chart patterns, the double-bottom base is a key member. If this one had a cousin, it would be the “shakeout + 3 points.”

Why learn this pattern?

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It might not occur as often as the double bottom, but it carries many of the same elements of price-and-volume action. (See the recent Investor’s Corner column for a full explanation of the double-bottom base.) So, by searching for this pattern, you’re also training your eyes for the double bottom.

Another reason? Shakeout + 3, a concept discussed by legendary trader Jesse Livermore in his book “How to Trade in Stocks,” can yield an earlier entry point than a double bottom.

Keep in mind, though, that because the buy point is often found deep within the base, the stock can still swing sharply as it moves up in price and approaches the high in the base. It’s perhaps easier to be shaken out of the stock, even with an 8% stop-loss sell rule in place.

Shakeout + 3 is not discussed in William O’Neil’s investing classic “How to Make Money in Stocks,” but it’s been featured in a few examples at IBD’s advanced workshops and complimentary trading summits.

The Basic Features

Like the double bottom, the shakeout + 3 features two sharp sell-offs, and the second drop undercuts the first low.

This shakeout pushes the supply of readily available shares from the hands of the weak into the hands of the strong. Then the stock immediately turns and rushes higher, often within just a week or two. When the stock returns to the price of the first low, say $30, add three points. That’s your entry point.

A three-point rally in a $30 stock is a 10% gain. In other words, there must be a genuine sign of torrid institutional demand. A stock priced at $100 a share or higher might need around a 9, 12 or even 15-point gain to reflect the same strength of demand.

In January 2010, China’s fast-growing economy hotel chain, Home Inns, reversed from a two-year high of 41.70 (1), then plunged 36% in just four weeks’ time. From that point in early February, the stock worked its way to the top of an unusual-looking base.

In June, Home Inns formed a narrow handle (2), then rallied three weeks in a row while motoring past a 39.73 buy point. But in early July, the stock dipped as low as 36.63, forcing holders to exit with an 8% loss.

The NYSE composite and S&P 500 followed through on July 7 the same year. Meanwhile, Home Inns fashioned a rare five-week square box pattern with a 42.94 buy point. The initial rally got choppy, but the breakout worked (3).

A Lower Buy Point

In the week ended March 19, Home Inns hit a low of 30.22 (4), then rallied through the end of April.

During the week ended May 7, Wall Street got hit by the Flash Crash. Home Inns nose-dived as much as 18%, undercutting the 30.22 low in heavy volume.

But notice how in the very next week, the stock rebounded 16% in even faster trade (5). That week, shares also triggered the shakeout + 3 rule, rising past 33.22.

Pullbacks in the following weeks never came close to forcing holders to cut losses at 7% or 8%, the golden rule of investing.

Home Inns closed the week ended May 14 at 36.19, still 13% below the high in the base of 41.70. At the beginning of the week, it marked a 99 Composite Rating, 99 EPS, 84 RS and A for SMR. By the end of that week, its Accumulation Rating improved from C+ to an A-.

Over the next five months, Home Inns rallied 63% to a high of 54.25 on Oct. 15, 2010, before going into a deep dive. On Nov. 4, Home Inns fell 8% and undercut its 50-day moving average near 48.74 in the heaviest volume on a down day in price since the May breakout, a clear sell signal.

More Examples

Home Inns is not an isolated example.

In October 1990, Cisco Systems (CSCO) flashed a shakeout + 3 breakout at a price of 25 en route to a 140% rally and new highs in just four months. Qualcomm (QCOM) also rolled past a shakeout + 3 buy point in October 1998 before breaking out and making giant strides in 1999.

Leading software sector play Workday (WDAY) has built a double-bottom base. But as the chart in Leaderboard shows, the enterprise software also marked an early entry via the Shakeout + 3 pattern.

Editor’s Note: A version of this column originally ran in the Nov. 8, 2010, edition of IBD. Home Inns merged with BTG Hotels in April 2016. Please follow Saito-Chung on Twitter at @IBD_DChung for more commentary on growth stocks, chart patterns, buy points, sell signals, and financial markets. 

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