Perhaps one of the most difficult things for a technical analyst (“chartist”) to learn is how to spot bottom patterns in a chart. The message boards and twitter-sphere is full of hundreds of examples every day where traders are calling a bottom in something, only to see their favorite stock or ETF hit new lows the very next day after such bold calls. Why is it so hard to spot a bottom on a chart? And why bother at all?
First, there is the allure of calling a bottom: not only does it seem to be a special achievement and something about which to claim bragging rights, but also, rallies off oversold bottoms can lead to very big gains if one is quick enough to get in at or near the bottom. Not only can the gains be large (over 100% in a matter of weeks or several months), but those gains often come very quickly, meaning that big money can be made fast.
Though the rewards are high if one makes the correct timing call of a botttom, we must remember that most of contemporary technical analysis (TA) theory revolves around momentum and cycles, which works great so long as a stock or index is continuing to move in the direction that standard TA theory predicts.
However, by its very nature, a true bottom marks a reversal in momentum which is something that usually takes time to confirm on a chart. So, when anxious traders boldly announce a bottom, they are often jumping the gun because of one or two signals that they follow, such as an oversold oscillator like RSI or Stochastics. Such oscillators, though useful in certain situations, will do little good in timing a true bottom. Sure, at some point, an oversold oscillator will be right about a coming turn, but it’s the number of times that such oscillators are “wrong” that costs traders losses. That’s because an oscillator spots tops and bottoms of cycles, but a stock that is in continual decline is only able to mount small gains on the reverse cycle as it continues to drop (often in a series of bear flags). In other words, most stocks that are selling off are not in trading cycles, but rather, they are caught up in a trend.
The expert chartist knows that he/ she needs to study carefully those spots on a chart that may be turning points; and even when a reversal appears evident from those points, they realize that often, confirmations are required before they can take a full position in the stock or index ETF. However, once in awhile, there are bottom capitulations that require a different set of criteria to spot a bottom–confirmations may not be required in these special situations.
Let’s review recent examples of both… in the first half of 2013, two former “dog” stocks rallied hard to become the biggest winners on the S&P 500. These stocks were Best Buy (NYSE: BBY) and Hewlett-Packard (NYSE: HPQ). Each is an example of some common metrics to watch for, such as the distance from the long-term bull/bear line known as the 200 day moving average….or the measure of a trend’s strength, such as is shown by by the ADX line (which measures the strength of a trend).
However, each of these two stocks presented a different bottom situation, which at the time was difficult to spot except to the most seasoned of TA observers.
A good case study of the typical bottom pattern is the double bottom. In today’s blog, let’s look at the double-bottom pattern. (In my next blog, I will cover the capitulation bottom, a very different type of bottom pattern.)
A double bottom is simply where the stock reverses, then rises for a short while, then drops again to re-test the approximate level where it previously bottomed. If the stock falls through the level of the previous bottom, then there is no confirmation, and the stock should be avoided. However, if the stock finds support at the previous lateral point (give or take about 2%), and then begins to rise, then you may have a double bottom confirmation.
The wise trader waits for a higher high to begin to take place after the apparent double bottom is in place–this point occurs once the stock moves above the previous lateral high of the bottoming pattern. Some bottoming patterns have a W shape to them, and it’s the high point of the middle of the W that is the lateral point that must be passed. Otherwise, watch to be sure the lateral high of the bottoming pattern is passed, and you likely have a confirmed bottom and this is the point to enter the stock or index going long.
On the chart below is BBY and you will see the dashed blue lines I drew in at two places above the double bottom. Those are the lateral high points of the double bottom zone (most stocks have only one lateral line to overcome, but in the case of BBY, there were technically two.)
Once the lateral high was cleared, the stock was now showing a higher high. For many traders, this is an ideal point to enter and it certainly was for BBY. Other more cautious traders might wait until the next pullback to be sure that a higher low is put in place to further confirm an up-trend has begun. However, if one waited for that pullback to the higher low, they missed a lot of the early gains. Perhaps a compromise tactic would be to take a partial position on the break-through of the previous lateral high at roughly $13 to $14, then take a full position once the higher low is in place (which occurred at the end of the first bull flag near $15).
In my next blog, I will look at the capitulation bottom that HPQ had right before it began its huge 2013 rally. For now, here is the chart on BBY and the classic double-bottom pattern:
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