A Chart Formation the Pros Love

11/03/2011 5:00 pm EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

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

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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

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Figure 2

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I have found that you can also use the guidelines for double-bottom formations when the second low is higher than the first low. The above chart of Monsanto (MON) begins in March 2010, when MON was in a steep slide from the 2009 high at $93.35. By the time it made its low at $44.61 (point 1), the stock had lost over half its value.

Volume was the heaviest seven weeks before the lows, as MON reversed sharply to the upside, reaching a high of $62.29. This was a 39.6% rally from the $44.61 low. On the ensuing decline, the heaviest volume occurred on September 28, 2010, which was five days before the low on October 5. This low at $47.07 was 5% above the prior low.

If you examine the formation on the daily chart, the two lows are three months apart, which is fairly normal for double-bottom formations. The resistance at line b was overcome in November, and measuring from the initial low, the upside target was ($62.29 - $44.61) $17.68. Therefore, the upside target would be ($62.29 + $17.68) $79.97.

The high in February 2011 was $76.69 and even though MON recently reached a high of $78.71, I would not have recommended staying with the entire position for that long. It would be prudent to take profits on part of the position once prices came within 5%-7% of the upside target. Of course, stops should also be raised once the position moves in your favor.

Figure 3

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Statoil (STO) is a Norwegian oil and gas exploration company that recently completed a double-bottom formation. On April 8, STO made its high for the year at $29.66. The selling was heavy in early August, pushing STO to a low of $20.12. The day after the lows, STO had a strong close (see arrow) consistent with a short-term low.

Over the next six days, STO rallied 21.8%, peaking at $24.52. The following day, STO gapped down and spent the next five weeks drifting lower. It finally dropped to $20.37 on September 26. STO rebounded for six days before again testing the lows, hitting $20.40 in early trading on October 4 before closing strong at $21.68 (see arrow).

For those who bought the following day’s open at $21.51, the risk was under the low at $20.37. Even if you were only expecting STO to test its prior high, the target was $24.52, which made for favorable risk/reward. 

As it turned out, STO accelerated to the upside and closed above key resistance (line a) on October 14. Take a minute to calculate the upside target.

The volume patterns were also consistent with a double bottom. The volume associated with the low at point 1 was significantly higher than it was at point 2. Also, the trend of declining volume, line c, was broken when STO closed above key resistance.

I hope you came up with an upside target of $28.92. This target is quite close to the significant resistance at the April high, which is quite common. If it were reached, it would also partially fill a gap from early May.

NEXT: Confirming Double Bottoms Using Multiple Time Frames

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Figure 4

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Tesoro Corp. (TSO) is an oil and gas marketing and refining company. It made a sharp low at $17.82 on heavy volume in early August (point 1). TSO came close to retesting the lows at the end of August before surging to a high of $25.42 in early September. This was a gain of $41% from the lows, definitely fulfilling the criteria of a double bottom.

By the latter part of September, TSO was in a steady decline and made a new low of $17.43 on October 4 (point 2) but closed the day at $19.92. The candle formation at point 3 was positive. The volume surrounding the low at point 1 was greater than that at point 2, and the volume on the upside reversal was strong (see arrow).

TSO gapped higher on the opening October 14 (point 4) and closed well above the resistance at line a, as well as the late-July high of $25.79. As noted on the chart, the upside target was at $32.67.

Figure 5

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If TSO’s July high at $25.79 looks a bit out of place, the above weekly chart will clarify the picture. On the weekly chart, the July high (point c) is just part of a flag formation, lines a and b.

It is a continuation pattern that corrected the rally from the July 2010 low of $10.40 to the April 2011 high of $28.74. This correction held above the 61.8% Fibonacci retracement support level, which was point 2 of the double-bottom formation. The weekly candle formation further identifies the reversal that occurred the week of the lows.

The combination of the weekly and the daily analysis can give greater confidence in the conclusions. On the bottom of the chart, I have also included the on-balance volume (OBV), which does a very good job of indentifying the lower volume that should coincide with the second low in a double-bottom formation. Often times it will be rising from the low at point 1, and on the daily charts, the bullish divergences will often be quite clear.

In this example, the OBV broke its downtrend, line d, on the rally from the low at point 1. The OBV then moved above its weighted moving average (WMA) the week before the low was formed (line e). This put the trader on notice to watch the action the following week, as the bullish divergence (higher OBV at point 2 then at point 1) was a positive sign.

NEXT: Retail Sector ETF Forms Classic Double Bottom

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Figure 6

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One sector I have been favoring since late August is the retail sector, which enters a strong seasonal period in the fall. The daily chart of the SPDR S&P Retail ETF (XRT) shows that it dropped sharply amid heavy volume in early August and then eventually made a low of $43.50 on August 19, 2011.

By the end of August, XRT had rebounded back to $50.50, and this level was tested but not exceeded in the middle of September. On October 4, XRT dropped with the rest of the market and hit a low of $43.61 in early trading before closing the day higher at $46.85.

Just eight days later, XRT closed convincingly above the resistance at line a, which completed the double-bottom formation. The upside target was therefore at $57.50. Recently, XRT has traded as high as $54.92.

The OBV also helped to identify the double-bottom formation, as it started rising after the low at point 1. By the time XRT had dropped back to $43.61 (point 2), the OBV was significantly higher. The bullish divergence, line c, was a sign that the ETF was being accumulated. The OBV subsequently broke through its resistance at line b and confirmed the price action.

Conclusion

At the recent lows, there were quite a few markets and ETFs that appeared to form double bottoms. Last week, many of these formation were confirmed, but many have not yet met their upside targets. This should provide a good opportunity for those students of the market to watch how the patterns unfold.

By studying these formations, you will be better prepared to act once you think a double bottom is being formed. For those markets on your watch list, write down the price and volume of the first low. You can then set up an alert notice at, say, 3%-5% above the level of the first low so you can be prepared to act if the original low is tested.

A stop at 1% or more below the original low should be adequate once you see that the low has held and that the market has reversed.

Tom Aspray, professional trader and analyst, serves as senior editor for MoneyShow.com. The views expressed here are his own. Readers can post questions or feedback in the comments area below or send to TomAspray@MoneyShow.com.

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