Bulkowski's Flat Base Setup

Written and copyright © 2009-2011 by Thomas N. Bulkowski. All rights reserved.

This article discusses a trading setup based on a flat base. A flat base is an area of horizontal price movement that often serves as a spring board for large, upward price moves.

Flat Base Background

As I mentioned in the opening, a flat base is just like it sounds. Price moves horizontally for weeks or months, bottoming near the same price. It need not look like a rectangle bottom with the requirements of having a flat top and bottom.

Instead, price can wobble up and down in a trading range. That trading range is really the key. Price should move within a range, bounded by two prices, for a long time. Once it breaks out upward from that range, then that is the time to buy the stock.

The chart of XL Capital (XL) gives an example. This chart is plotted on the weekly linear or arithmetic scale and not on the log scale. The linear scale helps make price appear flatter so flat bases are easier to spot.

Notice that the trading range bounded by the two red lines shows price forming peaks and valleys as it moves horizontally for several months.

That type of movement, when price wobbles up and down within a narrow range (however you decide to define what narrow means) is what you are looking for. When price closes above the top line (above the top of the trading range), then that is the buy signal.

Flat Base Trading Setup Rules

Here are the rules I use to identify and trade flat bases.

1. Use the linear scale. Switch to the linear/arithmetic scale instead of the logarithmic scale. This helps compress large price swings, making identifying a flat base easier.
 
2. Find a trading range. Price moves in a trading range for weeks or months. The trading range can appear irregular, with many peaks and valleys but price should wobble around a constant price. Imagine sliding price inside a tube. It should fit snugly until the breakout, with the tube not too tall and many would argue that the longer it is, the more powerful will be the breakout move.



3. 3:1 risk/reward ratio. When I shop for flat base trades, I want overhead resistance to be well above the top of the trading range. Since my flat base trades are expected to last years, I ignore minor overhead resistance and look for a thick mass of storm clouds on the horizon.

   The ideal version of the flat base setup appears on the right. Overhead resistance forms a line of price movement on the weekly or monthly scale. It is the price at which the stock traded at for years. It is what I consider "fair value" for the stock.

   Once price pierces overhead resistance (actually support), it tumbles in a swift drop. I do not want price to take years to bottom. I want to see the drop as a steep one. This gives price during the recovery phase the opportunity to climb back up just as fast. It may not, but that is the hope (velocity trending into a pattern is similar to velocity after the breakout).

    

   

   Hawaiian Electric is a good example of a stock suffering a swift decline during February 2009. This is not the result of a dead-cat bounce. Rather, worries about a bank they own plus a weak general market and economy took the stock down in short order. Although the stock did not form a flat base, buying near the low represented a tasty opportunity to profit not only from the dividend buy capital appreciation as well.

   Returning to the discussion of the ideal setup, after the swift decline comes the flat base. The height of the trading range (from highest peak to lowest valley) becomes the measure of risk. The thinking here is that you will place a stop a penny or two below the bottom of the trading range, providing it is not too far below the buy-in price.

   Reward is the distance from the buy-in price to overhead resistance.

   For example, if the height of the flat base is $5, I want overhead resistance to be no closer than $20. That means if I buy at $5 and sell at $20, I will have made $15 per share, or tripled my money.

   Once price breaks out of the flat base, it begins moving up. The recovery could be a swift one, but the odds are against it. For price to triple it could take years, so the flat base setup represents a long-term holding.

 

 
4. Strong stock. I want to see the stock trading during the overhead resistance phase for a long time. In other words, I do not want to see the stock gradually dropping down to the flat base. I want the general market to be responsible for bringing the stock down and not problems with the company. Of course, in some cases, that is too much to hope for.

   

   Compare the stocks of JetBlue (JBLU) with Southwest Air (LUV). Southwest moved horizontally in a large symmetrical triangle from 2000 to 2008, with a base at about 11, but JetBlue peaked in October 2003 and has been trending downward since then (at least until 2009). Southwest Air is a better opportunity than is JetBlue. The target price on Southwest is 11, site of the start of overhead resistance. And notice the swift drop after price pierced 11, whereas JetBlue shows a loose congestion zone forming in mid to late 2008. Both charts appear on the monthly scale.

5. Strong company. Since I intend to hold the security for years while the stock recovers, I want to be sure that fundamental analysis says the company is sound. I will check the ratios and do other research to satisfy myself that the company will not likely go bankrupt.
 
6. Swift Drop. I mentioned it earlier, but I want to add more details here. In the swift decline leading into the flat base, I prefer to find little or no areas where price moves sideways. Hawaiian Electric shows a straight-line run down with no pauses.

   Locating overhead resistance in Hawaiian Electric is easy. It starts at 21 on the chart, and prior valleys bottom at 21 in August 2007 to early 2008.

7. Buy. When price closes above the top of the flat base, then buy. Since overhead resistance is well above the current trading price, you have time to find the flat base and trade it. The move back up to overhead resistance will likely be a bumpy one, but view the chart on the weekly scale. That may help you stay in the trade long enough to make some serious bank, as they say.

-- Thomas Bulkowski

Other Flat Base Examples

• Here is an actual trade using a flat base where I doubled my money.

Written and copyright © 2009-2011 by Thomas N. Bulkowski. All rights reserved. Consultants are mystical people who ask a company for a number and then give it back to them.