Livermore's 'Shakeout +3' Pattern Marks Early Entry

November 19, 2012

Famed trader Jesse Livermore is worth reading about. His story features smart moves and dramatic highs and lows.

It's much more than what can fit in a short newspaper column. But one aspect of Livermore's legacy that can be reviewed quickly is a stock chart pattern called the " + 3.

This rare pattern consists of two sharp sell-offs, with the second slump undercutting the first sell-off's low. It's a bit like a double-bottom structure, but it generally unfolds more quickly — within a few weeks vs. the 's seven weeks or more.

So where does the "+3" come in? That refers to when you see the stock turn itself around after its two big sell-offs. You'll see it bounce back and soon jump to new high ground.

You want to see the stock rise at least three points above the first sell-off low in heavy , triggering an early entry. That's where you get the "+3." So if a stock has a first sell-off low of 30, a three-point gain past that price represents a 10% rally — signaling real demand.

For a higher-priced stock, you could look for a bigger gain. If it trades, say, around 50 or 60 a share, you might want to see a five- or six-point gain and think of that pattern as a "shakeout +6" if you want. The point: It must be an unusually strong move higher.

Lululemon Athletica (LULU) provided a good example of a shakeout + 3 with its action in late 2011 through early 2012.

The athletic clothing retailer made its first low at 42.18 on Oct. 4, 2011. 1 It dropped to its second low at 41.70 on Dec. 1. 2 Then came the market's follow-through on Dec. 20, confirming a new uptrend. That put IBD-style investors on the lookout for good stocks staging breakouts.

Given that Lululemon was trading around 40, you would watch for the stock to rise past 42.18 by at least 3 points or more. The stock delivered on Jan. 4 with a nearly 9% gain in big volume to 51.15, 3 more than 8 points higher than the 42.18 low.

As with any , you want to see big daily volume, meaning 40% above average or more. Lululemon's turnover surged 104% above average that day.

After shaping and then clearing a pattern first defined by the legendary Livermore, Lululemon ended up climbing as high as 81.09 in early May, a 79.5% gain.