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TradingDay.com > Technical Analysis Tutorial

T e c h n i c a l   A n a l y s i s   T u t o r i a l
by Alan Farley

Pattern Cycles: Bottoms

Price marks territory as it spikes relative highs and lows within all time frames. Skilled traders observe this signature behavior throughout all markets and all historical charting. Relative direction also characterizes price movement. A series of lower lows and lower highs identify downtrends while uptrends print a sequence of higher highs and higher lows.

As bulls and bears fight for control, Pattern Cycles are born. Since markets won't travel upward to infinity or downward below zero, identifiable swing trades appear within each time frame. Driven by emotional behavior, trend inhales and exhales. Falling price ignites fear as paper profits evaporate. Fresh rallies awaken greed, inviting momentum players to become greater fools. On and on it goes.

BOTTOMS

Bottoms exist as a direct result of this trend physics. The natural movement of impulse and reaction dictates that two unique formations must develop at some point within each Pattern Cycle. In an uptrend, a lower high must eventually follow a higher high and mark a new top. In a downtrend, the sequence of lower lows ends when price prints a higher low. This second event marks the birth of the Double Bottom.

Double bottoms draw their predictive power from the trends that precede them. As a series of lower lows print on a bar chart, downtrends often accelerate. The trading crowd notices and develops a gravity bias that expects the fall to continue unabated. Then suddenly the last low appears to hold. The crowd takes notice and bottom fishers slowly enter new positions. Price stability then triggers more and more players to recognize the potential pattern and jump in.

Stock percentage growth potential peaks at the very beginning of a new uptrend. For this reason, being "right" at a bottom can produce the highest profit of any trade. But picking bottoms can be a very dangerous game. Smart traders weigh all evidence at their disposal before taking the leap. And strict risk discipline must still be exercised to ensure a safe exit if proven wrong.

Eve's rounded bottom takes longer to form than the sharp Adam spike. Look for volume to decrease as the stock heals and prepares for a new uptrend. Adam and Eve formations aren't limited to bottoms. Watch for them at the end of parabolic rallies.

The Adam and Eve Reversal illustrates the importance of the center peak in the creation of Double Bottoms. A very sharp and deep first bottom (Adam) initiates this DB pattern. The stock then bounces high into a center retracement before falling into a gentle, rolling second bottom (Eve). Price action finally constricts into a tight range before the stock breaks strongly to the upside.

Many times the top of Eve prints a flat shelf that marks an excellent entry point. Shelf resistance typically develops right along the top of the center retracement pivot. The relationship between this center pivot and current price marks an important focal point as the skilled trader closely watches the development of a suspected double bottom pattern.

Since bottoms occur in downtrends, risk must be managed defensively. The greedy eye wants to believe the immature formation and is easily fooled. Even spectacular reversals offer little profit if price can't ascend back out of the hole it found itself in. When choosing stop and exit points, violation of a prior low is the natural first choice. Make certain your entry permits you to exit for an acceptable loss at this location. And don't stick around long. Price will gather downside momentum quickly at broken lows as it searches for new support.

Successful bottom entry takes a strong stomach. Even when all the technicals line up, sentiment will be highly negative at these turning points. The potential for short-term profit though is outstanding. In addition to other longs ready to speculate on a good upside move, high short interest will fuel explosive impulses off these levels. Perhaps for this reason alone, serious traders can't ignore double bottom patterns.

The Big W pattern can be identified in all time frames and all markets. It is a powerful tool for locating bottom trade entry.

The Big W reference pattern maps the entire bottom reversal process. This signpost identifies key pivots and flashes early warning signals. The pattern begins at a stock's last high, just prior to the first bottom. The first bounce after this low marks the center of the W as it retraces between 38% and 62% of that last downward move. This rally fades and price descends back toward a test of the last low. The smart trader then listens closely for the first bell to ring. A wide range reversal bar (doji or hammer) may appear close to the low price of the last bottom. Or volume spikes sharply but price does not fail. Better yet, a Turtle Reversal prints where price violates the last low by a few ticks and then bounces sharply back above support. When any or all of these events occur, focus your attention on the second leg of this Big W.

Aggressive traders can initiate entry near the bottom of this second leg when the bell rings loudly. The middle of the W now becomes your pivot for further execution. For price to jump to this level, it must retrace 100% of the last decline. This small move finally breaks the falling bear cycle.

Enter less aggressive positions when this emerging second bottom retraces through 62% of the fall into the second low. But sufficient profit must exist between that entry and the W center top for this trade to work. Longer-term traders can hold positions as price pierces this pivot. Be patient since price will likely pause to test support here.

Then expect another upward leg. Price at this level has a high probability of moving even higher. It can easily retrace 100% of the original downward impulse, completing both the Double Bottom and Big W patterns. This tendency allows for further entry at the first pullback to the center pivot after the next break.

 


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