Know When a Market Bottom Is in

11/02/2011 4:00 pm EST

Focus: STRATEGIES

John Bollinger

President and Founder, Bollinger Capital Management

After accurately predicting the market’s recent top, John Bollinger explains the important technical factors that will help traders spot a real, sustainable bottom…when it forms.

We’re talking today with John Bollinger. Now John, you had written just a few months ago that the S&P looked like it was topping out right around the 1300 level, which was indeed the case. What are you looking for now in terms of some bottoming signals?

Well, as you pointed out, we made a top in the market and have come down pretty substantially. It now looks like we’re in a bottoming area.

It’s actually quite an interesting pattern. We made a “W” bottom in relation to the Bollinger bands, which is to say that we came down and we were able to get outside the lower Bollinger band, rally back inside, and then came back down again to retest the area that we now call a support area.

See related: Bollinger on Trading with Bollinger Bands

That retest occurred inside the Bollinger bands. That’s a basic definition of a “W” bottom in relation to Bollinger bands.

We got a rather nice rally out of that. We entered a little bit of trading range, and now we’re back down at the bottom of the trading range. So this is kind of a critical, “must-do” area.

As we speak, we’ve had one day of price stability after a very sharp decline, and we are looking for evidence that this is in fact a sustainable bottom and that we’ll see some positive price action.

One of the things that we would look for we call a sign of strength. It’s actually an ancient technical analysis concept. It’s a day for which you have greater range than normal, so if you’ve been averaging ten points and now you have a 20-point day, that’s one component of the same thing.

You have greater gain than normal. If, on average, you go back and look at the past 20 days or so and measure all the gains, say those, on average, were five points, and you now have a ten-point gain, that’s another piece.

We also look for volume to expand. Again, we look at volume on the up days and if we now have greater volume on this expansion, that’s another component of a sign of strength.

Another bit is volatility expanding in the direction of the trade.

The problem is that this market has been unique. We have had such huge days, back to back, positive and negative days paired. We’ve never really seen this sort of thing in the markets before, so I think we’re going to need much more evidence this time than we normally would before we can turn bullish on the market.

This is certainly a situation in which we want to turn bullish on the market. The evidence is starting to build up that there’s a sustainable bottom in place, but I think that for safety’s sake, we really have to wait and see. Instead of just looking for a simple sign of strength, we have to see more than that to confirm that the worst is in fact behind us.

So individual traders and investors should be looking out for these signals. What’s the best way to go about making a trade decision?

Well, the best way is to find a positive set-up. There’s no question about that.

In past conversations, we’ve talked about this idea that there are only two ways to improve your trading performance: either improve the number of winners versus the number of losers or improve the relative size of your winners versus your losers.

If you concentrate on set-ups where the risk and reward is in your favor, that helps those ratios.

See related: Make Sure Risk/Reward Is on Your Side

So a classic example would be what we just saw in the gold market. We saw three pushes to a high, and in each of these pushes, there was less momentum and the market deteriorated. So in each of these pushes, the probability of the sellers being successful increased. So that’s the sort of thing we’re now looking for in the equity market.

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