STRATEGIES

The presence of several double-bottom formations across a variety of markets inspires this in-depth study, which teaches how to identify, analyze, and trade these patterns most effectively.

The October stock market low and the ensuing rally completed a double-bottom formation on many of the charts. For professional traders, who watch the market like birds of prey, this formation is one of their favorites.

As a stock or ETF is coming back to test a low that was made weeks or months earlier, the professional trader knows in advance where the sell stops are likely to be placed. By watching how the market trades at or even a bit below the prior lows, one can often get an early reading as to whether or not the lows will hold.

In particular, traders will look for the market (stock, commodity, ETF, etc.) to reverse from the lows. This can be identified by a bullish candle formation and can present a good buying opportunity.

Let’s first look at the basics. After a significant decline, the market makes a low on heavy volume before turning higher. The ensuing rally should be pretty sharp, i.e. 20%-30%. The market then turns lower again. Ideally, the rally peak will occur about midway between the two lows.

Once the first low is reached, there should be signs of stabilization and volume should be lower on the second low than it was on the first. To confirm the formation, the market needs to move above the intervening high.

By looking at the difference between the initial low and the intervening high, one can calculate the upside targets. As I will explain later, it is not always necessary to wait.

Figure 1

chart
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The first example is a current chart of crude oil, which declined 34% from its May high at $114.83 to the August low of $75.71 (point 1). The 19.5% rally from these lows took crude oil to a high of $90.52. Though some of the classic books on technical analysis suggest a rebound of at least 20%, to me, the pattern is more important.

By the first week of October, crude oil was making a marginal new low of $74.95, point 2. The formation only took nine weeks to develop, and as I have mentioned in previous articles, the longer a formation takes to develop, the more significant the price move is likely to be.

The volume pattern shows that the highest volume occurred in August (point 1). Volume then declined into point 2, as indicated by line b. Volume increased as crude oil closed above line a last week. This was the key development that confirmed the completion of a double-bottom formation.

For price targets, you take the difference between the high and the first low ($90.52 -75.71 = $14.81) and add this to the breakout level (90.52 + 14.81 = $105.33). This target is noted by a green line on both the weekly and daily charts.

The double bottom looks more typical on the daily chart, and later I will show you an example of why it is important to be sure you look at multiple time frames. The volume differences between point 1 and point 2 are more easily seen on the daily chart, line d.

The candle chart shows that while crude closed on October 4 near the lows, the strong close the following day was characteristic of a short-term bottom. Stops under this low would have been appropriate.

The volume picked up as crude oil closed above resistance at line a, but is still more than $12 per barrel below the upside target. I normally do not wait until the target is hit, as I try to take half of the position off before that. For crude oil, there is quite a bit of resistance in the $100 to $102 area, which I would use as a first target.

NEXT: Study Double-Bottom Patterns in Individual Stocks