Bulkowski’s Four Stages

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Background

The book, Stan Weinstein's Secrets for Profiting in Bull and Bear Markets, published in 1988, is a remarkable book. Based on his reputation and the numerous examples he gives, his system seems to work, but I wanted to prove it.

The first time I read his book and tested his system (many years ago), I could not get it to work. I reread the book recently and tried to test it again using better tools. I finally succeeded and this page discusses the results.

Methodology

Weinstein’s strategy revolves around two themes: identifying which stage the stock is in and using a 30-week moving average to help with timing and identification. To test his method, I used a portion of my existing trades and mapped the stage in which the buys and sells occurred. To do this, I had to understand his method.

Switch to the weekly scale on the stock of your choice and look for these four stages, outlined in my awful drawing.

Stage 1

Stage 1 is the horizontal trading range that begins the method. After declining out of stage 4, price moves sideways, sometimes rising above the 30-week moving average and sometimes not. The moving average flattens out, following price horizontally. Price is choppy but usually forming a rectangle or sideways price movement. Volume may rise as people cash out of the stock after waiting for it to move up.

Stage 2

Stage 2 is the uphill run. Price breaks out of the trading range of stage 1 on impressive volume, which helps power the stock upward, leaving the moving average trailing behind. In the early portion of stage 2, price may throwback at least once to the top of the trading range marked during stage 1. The moving average turns up. Price makes higher highs and higher lows (think of an ugly double bottom here). If you don’t see higher lows, then it’s not stage 2. Price will remain above the moving average. If it does not, then consider taking profits. Weinstein says that stage 2 is the ideal time to buy.

Stage 3

Stage 3 is the top. Price levels out and begins to move horizontally again. The moving average is climbing but flattens out, eventually catching price, slicing through it. Volume may increase as price churns sideways, forming sharp peaks and troughs while trying to pick a new trend direction. Weinstein says traders should take profits in this stage, but investors can hold on by selling half their position. If price moves up, forming another stage 2 advance, then continue to hold. A downward breakout from the trading range should cause a sale.

Stage 4

Stage 4 is the downhill run. Volume is not the key to this stage because it can be heavy or light as price drops. Price breaks out downward from the stage 3 top and may pullback into the trading range. After that, though, price continues down. The moving average usually remains above the stock as price drops.

Results

Once I understood his stages, then I looked at each buy and sell in the stocks I traded and determined where they occurred in the four stages. For each buy and each sell, I tallied profits or losses according to the stage then computed the average return (dividends, fees, and commissions included). I logged 348 buys and 352 sales from April 1987 until February 2008. That includes the 2000 to 2002 bear market in the S&P 500 index. The few missing buys are because I do not have price data for the purchases of some stocks that no longer trade. These are not all of the trades I have made over the years. In fact, I removed 11 of the more profitable trades (very long term holdings) that unjustly skewed results.

The table shows the results of the tests. For example, I found that buys occurring in stage 1 made 14.3%. If I sold in stage 2, I also made 14.3%. The worst performance came from buying and selling stocks in stage 4. The reason the stage 2 buy is so low (4%) is because I am buying well after the breakout and well into the advance, leaving little profit potential. That is also why I found buying in stage 1 is so effective. I catch price either within or just as it’s leaving the congestion area.

The number of samples is the number of trades used in the study. The percentage profitable trades are just a frequency distribution of the number of profitable trades divided by the total of the trades. For example, 73.4% of the stage 1 buys were profitable while just 21% of those stocks bought in stage 4 made money. Over 80% of the sales in stage 2 made money, but just 13.2% of those sales in stage 4 made money.

This table shows which buy and sell stage combination works best. The winners are to buy in stage 1 and sell in stage 2 (27% gain from 44 trades) followed in second place by buy stage 4 and sell stage 2 (22.7% gain in 10 trades). This (buy stage 4 and sell stage 2) is more dangerous because you are buying as price drops and hoping for a recovery.

Example

The chart shows The Boeing Company on the weekly scale. The red line is the 30-week moving average. In stage 1, the moving average is coming down out of stage 4 and eventually drops below price when it moves into stage 2. Notice the ugly double bottom when price makes a higher low. In order to advance, price has to make a higher low.

The move up to stage 2 is a strong one with price remaining above the moving average. In stage 3, the moving average levels out and price moves sideways in a very chopping action for about six months. In stage 4, a pullback occurs, giving traders and investors another opportunity to exit before the decline resumes.