What Are Common Trading Strategies Used When Identifying a Double Bottom?

12/29/2014 6:00 am EST

Focus: STRATEGIES

The staff at Investopedia.com offers two common trading strategies, one aggressive and one conservative for how to spot and trade a double bottom formation.

A double bottom is formed when price falls to a new low, retraces upward some distance, turns back to the downside, and stops at approximately the same price level as the earlier low. If the price then rises higher than the first retracement reached, this confirms the establishment of a double bottom pattern, which appears on a chart in the shape of a letter "W," or down, up, down, up. A common characteristic of the classic double bottom formation is an increase in volume on the advance upward from the second bottom point, as many traders who recognize the possible double bottom buy into the market.

There are a couple of common trading strategies for trading a double bottom formation. The more aggressive strategy is to simply buy the market as it approaches the previous low price level, placing a stop a bit further below that level far enough to allow the second bottom to extend just slightly lower without stopping out the trader's position. More conservative traders wait for confirmation of the double bottom pattern. This occurs when—coming off the second low—price goes higher than the level it reached on the retracement from the first bottom. Once that happens, the pattern is complete, and traders buy the market at that level. While these traders have the additional confirmation of the pattern being completed, they still need to place their initial stop below the lowest price reached during the formation of the pattern, and therefore face a larger potential loss than the traders who bought closer to the bottom without waiting for additional confirmation of the chart pattern.

The initial profit target for buyers is the price level that equals the same distance up from the retracement high, as that retracement high was up from the first bottom point. For example, if the bottom was at 100 and the retracement between the two bottom points reached 120, then the initial profit target for buyers is 140, or 120-100=20 and 120+20=140.

By the Staff of Investopedia.com

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