Chart Analysis – Bottoming Formations Part 3

10/25/2007 12:00 am EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

Often times, the most dramatic and sustainable rallies come after the completion of a long-term base formation. Sometimes this base will have the characteristics of a double bottom formation. In the first two articles on bottoming formations, I concentrated on the weekly charts, and there’s a very good reason for this. One of the important caveats of chart analysis is that the longer the formation takes to develop, the more important it is. This of course is also true of trend lines, as the break of a three-week up-trend might result in a three-five day correction, while the break of a thirty week uptrend would be much more significant. Therefore, I believe that to objectively analyze a chart, one must look first at a long-term weekly chart; otherwise, what may appear to be a double bottom or top formation on the daily charts might just be part of a continuation pattern, and not indicative of a major trend reversal. Of course, the other primary reason to look at the longer-term charts is that they can be used to confirm whether your levels of support and resistance have long-term significance.

Figure 1

The weekly chart of iShares Australia (EWA) shows a six-year trading range that was resolved during the first half of 2003. The resistance in the $11.90-10.90 area (line A) was a significant barrier, while every drop to support in the $8.12-7.50 zone (line B) did not last long. On the chart you will see two distinct lows. The first occurred in the middle of 1998 as EWA dropped to a low of $8.12 (point 1). It would be a little over three years before this level was broken, as it dropped to $7.50 in 2001 (point 2). The time between the lows in this instance was greater than is normally seen, and often times you will only have 20-40 bars separating the lows. Volume should be heaviest on the initial low and decrease as the second low is made. This was the case for EWA, but it is a bit difficult to tell from the volume scaling on the chart, as volume greatly increased during the breakout through major resistance in 2003 (line C), and the rally that followed. In fact, the breakout was accompanied by the highest volume in six years. This increase in volume confirmed the significance of the breakout, as EWA has continued to act strong, having doubled since the trading range was completed.

Figure 2

Of course, one can look for double bottom formations in commodities as well as stocks. The weekly chart of soybeans (Fig. 2) shows a typical double bottom that formed between 2000 and 2003. On the bottom of the chart you will note that the volume bars are either red or blue. They are colored red when the price was lower than the previous period and blue for when it was higher. The volume shows a series of lower peaks going into the first low at .5488 (point 1). Volume rose significantly as prices turned higher (see circle) but the rally stalled below the .6330 stage, which suggested that this would be a significant level of resistance. On the next decline, which ended in July 2001, volume was consistently lower as soybeans dropped to .5492 (point 2), just above the previous low. Volume again spiked as soybeans rallied from the lows and did exceed the previous peak, reaching .6382 before turning lower. There was no evidence of heavy selling on this pullback as soybean prices were well supported. The strong resistance in the .6380-.6410 level (line A) was overcome in June 2002 (point C). Although volume was stronger on the up weeks, there was not the very high volume that a technician would have ideally liked to see on the breakout. The width of the formation gave an upside target in the .7380 area, which was met in the next year.

Figure 3

In some cases, a double bottom is just part of a more complex bottom formation. This was the case with the daily chart of KEMET Corp (KEM). In April of 2005, the selling in KEM was relentless as the stock dropped from $7.90 on April 1 to $6.10 at the start of May (point 1). The selling midway through the decline was quite heavy but as the lows were made the volume was 1/3 lower. After a six-week rally back to initial resistance at $7.20 (going back to the October 2004 lows) the sellers came back in dropping the stock to marginal new lows at $6.09. Cumulative volume on the formation of this low was clearly less than it was at point 1. After the second low was formed, the initial resistance for the double bottom formation was in the $7.16-7.20 area (line B). The volume was very heavy as this resistance was overcome, point b, as it was six times greater than the ten-day average. Several days later, the stock gapped to the upside and hit a high of $8.72 and made new highs for the year. KEM moved sideways for the next two months before again dropping in October 2005. Though KEM made a low of $6.42 it was still above the previous lows (points 1 and 2) and this suggested that the double bottom was just a part of a more complex bottom formation. The key resistance for KEM was now in the $8.60-8.80 area as indicated by line A. This level was overcome on January 26, 2006 and the volume was again very strong (point a) confirming the price action. If you had bought KEM on the day after line B was overcome at $7.31, there would only have been a few days in late October 2005 when you were at a loss.

Figure 4

In our last example, Micrel Inc. (MCRL), which is part of the same industry group as KEM, we see a combination of a triple bottom and falling wedge formation. MCRL had hit its highs in January 2004, which were followed by a steady decline for the first half of 2004. The selling picked up in July 2004 as the higher volume (red bars) indicates. Finally, on August 11, 2004, MCRL hit a low of $9.41 but volume was less than it had been a month ago. Over the next three months, MCRL managed to rebound back to first strong resistance in the $12.00 area. This was a difficult area to overcome and the stock again moved lower dropping to $8.22 in early 2005 (point 2). Volume at this low was noticeably less than at point 1. The following rebound lasted a few months but failed well below the previous peak and just tested the downtrend, line A. In late April 2005, MCRL dropped just below the previous lows but held above the initial low of $7.90 (point 1). Volume was light on the decline but picked up nicely as MCRL turned higher, breaking the downtrend, line A, at point 4. During the initial rally phase MCRL gained 30% from the breakout point.

So what can be done to spot the various bottom formations discussed in this series of articles? First of all it takes dedication and adherence to a trading plan to be a successful trader or investor. This requires regular monitoring of the markets and of individual stocks. If you are an investor, this can be done weekly, while traders will probably follow a daily routine. Often times, one way to identify stocks that may be bottoming is to watch the biggest losers list. Those stocks on the list that have been in protracted declines for a period of time may be forming an initial low. If a stock or market rallies significantly from this low and you can draw a long-term downtrend, it may bear watching. If this is a test of a previous low then the volume should be checked and compared with the volume at the first low. Significant divergences here could provide the first clues the stock was sold out. A stock’s reaction to news can also be illuminating. It can be very significant if, after a series of negative reports (which may occur over several years), a stock stops its decline and turns higher, even in the midst of bad news.

As I will go into in much more detail in future articles, risk management is a key ingredient to successful trading. Of the bottoming formations I have discussed, typically reverse head-and-shoulder and double- and triple-bottom formations have the most favorable risk/reward characteristic, while falling wedges typically involve greater risk. In the next series of articles I will look at continuation patterns, which, if identified correctly, can provide very favorable risk/reward trades.

As always I welcome your feedback on these articles. I can be contacted at tomaspray@intershow.com. I would also appreciate any suggestions you may have for future articles.

Tom Aspray, professional trader and analyst, serves as video content editor for InterShow''''s moneyshow.com video network. Mr. Aspray joined InterShow full time in June of 2007 where he also does other editorial work for the site, including the bi-weekly trading lessons and the weekly charts to watch. Mr. Aspray has written widely on technical analysis and has given over 60 presentations around the world. Over the years, he has applied his methodologies not only to the stock and commodity markets but also the global markets, mutual funds, and foreign exchange. Many of the technical indicators that Mr. Aspray wrote about in the 1980s, such as the MACD, have since gained worldwide acceptance. He was originally trained as a biochemist but began using his computer expertise to analyze the financial markets in the early 80s. As a consultant, Mr. Aspray wrote daily institutional reports for firms such as Fleming Jardine and Barings Bank and was noted by the Wall Street Journal as one of the "top bond market technicians."

Related Articles on STRATEGIES