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Written and copyright © 2010-2011 by Thomas N. Bulkowski. All rights reserved.
This article discusses a trading setup using the cloudbank chart pattern. If you don't know what a cloudbank chart pattern is,
click on the link for a complete tutorial.
Cloudbank Setup Rules
The cloudbank setup has these rules. Reference the ideal cloudbank setup on the right (not drawn to scale) as I discuss the rules.
- Find a cloudbank. Look for a cloudbank chart pattern on the weekly or monthly scale. The cloud should be long, often years in length, with a flat base that touches a
horizontal or nearly horizontal trendline multiple times. The base of the cloudbank represents the fair value of the stock. It's where the stock would be trading if the economy
or other factors didn't pull it down. By the length of the cloudbank, it should be clear to all that the cloud is where price should be trading and the drop after the cloudbank ends is just
an anomaly.
- Steep drop. Look for price to tumble, preferably in a straight-line decline but this is optional. The stock has to make a significant decline such that it represents
not only a good value, but a steal. The decline is often the result of a bear market with problems common to many companies and not just this one. In fact, when selecting a cloudbank,
look for a company that maintains its price until near the end of the bear market.
- 30-week SMA crossover. Wait for price to touch or rise above the 30-week simple moving average. I have found that the simple moving average hugs price better
than the exponential, so use the simple moving average. The 30-week is the same as the 150-day moving average. Other moving average values might work better, but I tested it with the 30-week.
I show the crossover on the picture as Buy.
- Profit potential. Measure from the base of the cloud (A) to the crossover price (the price where the stock rises above the 30-week
moving average, shown as Buy on the chart). If the drop is less than
50% (such as the cloudbank at 10 and the crossover at 7), consider
looking elsewhere for a more promising situation. Often if you wait, the stock will drop to a lower price, so sit back and wait if the profit potential is not high enough. In the 2007
to 2009 bear market, many stocks dropped more than 50%. The next bear market may not show such declines, so be flexible. This rule is to help minimize
the paper loss when price resumes dropping if you buy too close to the cloudbank.
- Sell. When the stock rises to the bottom of the cloudbank (A), sell. Why? Because once price enters the cloud, the rise slows
dramatically. The rise from the lowest low (B) to
the cloud base (A) will take about a year, on average, but so will the move from the bottom of the cloud (A)
to the top (C) while covering about half the distance (129% rise to the cloud in 1.1 years vs 64% in 1.0 years in the cloud). Thus, momentum drops once
price enters the cloud. If you can find another cloudbank forming, you'll have the opportunity to make more money quicker than holding while the stock traverses the cloud.
Cloudbank Bad Setup 1
Let's discuss what not to do, first.
Pictured is a small cloudbank in Continental Air on the weekly chart. During the terrorist attack on September 11, 2001, the stock plummeted but then recovered to A.
Point A is where price rises above the 30-week simple moving average. It's normally the buy point, but not in this case. Why? Because there just isn't enough profit potential
to justify a trade. Wait for price to drop further or go shopping for another cloudbank.
At D, price reaches the lowest low, the turning point in the stock. You know it's the lowest valley because price at E makes a higher bottom and price rises above the
green line at B, confirming the
turn. Higher highs and higher lows mean a rising price trend. The turn DE is also
an ugly double bottom
chart pattern. You will see those 12% of the time when price finishes it's bear market run. In a traditional ugly double bottom, buy when price closes above the highest peak (B)
between the two bottoms (D and E). I show that as a horizontal green line.
In this setup, the buy signal occurs at F when price crosses above the 30-week moving average. Price at this point is about 7, well below the cloudbank low of 38. It
represents a wonderful profit opportunity if you like airline stocks. Wait for price to climb back to the cloudbank before selling. If price never rises that high, then
don't buy the stock.
Cloudbank Bad Setup 2
Shown is Gap (GPS) on the weekly chart and it has the same problems as the prior chart. The cloudbank is several years long with the bottom relatively flat. It represents
overhead resistance to an upward move. In late 2008, during the ending stage of the bear market, the stock plummeted, piercing the base of the cloud at A, at about 16.
Price formed what looks like an Adam & Adam double bottom chart pattern at C and D. Confirmation is at E. That's when the chart pattern becomes valid,
and that occurs when price closes above the peak between the two bottoms (E, shown as a green line).
The cloudbank buy signal occurs at B when price climbs above the 30-week simple moving average. Why isn't this a buy? Because the price difference between B and A is minimal:
16 versus 13 or 3 points. Yes, the stock continued to move up and climbs above the top of the cloud, but what if price reversed at the cloud base? Most investors would wait before selling
and those three points of profit would disappear like water in a desert. Wait for a more profitable opportunity.
Cloudbank: The Winning Setup
Here's what I consider a perfect setup, or nearly so. Pictured is Celanese Corp (CE) on the weekly scale. The cloudbank is irregular in appearance on both the bottom and the top.
The stock pokes through the horizontal trendline at the base of the cloud, but that's ok. What you're looking for is a solid wall of overhead resistance and that's what this chart shows.
Price drops to C in a straight-line run then makes a higher low at D. This is the start of an ugly double bottom. Confirmation of the ugly double bottom occurs at A when price climbs
above the peak between the two bottoms. If you were trading the ugly double bottom, confirmation (A) is when you'd buy. However, the ugly double bottom is irrelevant to this trade because we
use the 30-week moving average crossover as the entry signal. Nevertheless, the ugly double bottom serves as an indication that the trend has changed.
A is also the point where price rises above the 30-week simple moving average. It's the buy signal providing there is enough profit potential. A is at 15 and the cloudbank
low is at 33. If you ride this up to the cloudbank base before selling, you will double your money.
In this case, the stock cooperates by making a curve recovery from D to B. B is the base of the cloud extended into the future. It represents the time to sell since momentum is clearly
declining (meaning the D to B arc is not a straight line but a curved one, resembling a rounding top chart pattern).
Cloudbank Drawdown
That's all there is to investing in cloudbanks. Of course the ride upward can be bumpy, so let's discuss drawdowns.
| Drop | 5% | 10% | 15% | 20% | 25% | 30% | 35% | 50% | 50% |
| Frequency | 20% | 22% | 16% | 9% | 8% | 7% | 4% | 5% | 8% |
| Cumulative | 20% | 42% | 58% | 68% | 76% | 82% | 86% | 92% | 100% |
The above table shows how far price drops below the buy price on the way to the cloudbank. The buy price is the value of the stock where price crosses the 30-week simple moving average.
For example, I found that 20% of the stocks decline below the purchase price less than 5%. Another 22% decline between 5% and 10%. The cumulative row says that over half (58%)
will decline less than 15%, and 82% will drop less than 30%. At the far right edge of the table, it shows that 8% will lose more than half their value. Ouch!
No one wants to lose money, so you might consider using some type of stop loss order or other method to protect the investment. However, my guess is that should you use a stop,
it will likely take you out before the stock returns to the cloudbank. For buy-and-hold investments, not using a stop is often an acceptable alternative. Monitor the stock and if it looks as if
the fundamentals are going bad, then sell. Otherwise, stick to the weekly or monthly scales and don't worry about the daily gyrations.
Cloudbank Recovery Shape
Let's talk about the shape of the recovery. I used the monthly scale to look at the shape of the recovery -- that is, the shape as price hits the lowest low and bounces. The
figure on the right shows four types of bounce patterns. I did not search for head-and-shoulders bottoms or any other complex variety.
Double Bottom
The first shape is a double bottom. You'll see two spikes separated by a month but usually more (like 5 months). Both spikes bottom near the same price but this need not be exact.
Double bottoms appear 17% of the time.
Ugly Double Bottom
To the right of the double bottom is its cousin, the ugly double bottom. This occurs when the second spike is well above the first, so it's an ugly version of a normal double bottom.
The second bottom should not be too far away in price. It should look as if the second bottom tried to reach the price of the first bottom but didn't make it. The difference between the two
is at least 5% when viewed on the daily chart, but I did not apply the percentage in this case. I just eyeballed it. The two bottoms looked near the same price (as in a double bottom) or they
didn't (ugly double bottom). Ugly double bottoms happen 12% of the time.
V-Shape
The V-shaped recovery happens the most: 63% of the time. It occurs when price makes a strong move down, reverses and powers upward. I'm looking at the
turn around the lowest low, here, not what happens a year later. However, in many cases, the stock continues its straight-line run back up to the cloudbank. That happens most often
when the distance between the cloudbank and the lowest low is small. With longer distances, you'll often see price consolidate (move sideways) for several months. Sometimes the V-shaped
bottom has an extension, but I did not look for that either.
Horizontal
The last variety describing the shape of the stock as it hits the lowest low is the horizontal turn. Often you'll see a short spike downward that is below the others, but then
price recovers and moves horizontally for 5 months or longer before starting the journey upward. This type of turn is the rarest of them all, occurring just 8% of the time.
That's a Wrap
Be sure to read the discussion on the cloudbank chart pattern. The article fills in the details and provides additional performance numbers that you'll want
to consider.
-- Thomas Bulkowski
Written and copyright © 2010-2011 by Thomas N. Bulkowski. All rights reserved. Kiss me twice: I'm schizophrenic.
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