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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

The Lowdown on Bottoms

Is this what we've been waiting for since the swan dive began in early 2000? Are we finally at the bottom of this long bear market?

If the news is good, it could take months or years to answer that question. But we'll find out quickly if this isn't the bottom, because the major averages will break the lows and resume their selloffs.

In either case, let's take a quick primer on what to expect "at the bottom." Perhaps it will give us a clue about the end of our market misery.

Bottoms print as a result of market physics. Uptrends and downtrends exhibit natural wave motion as they thrust forward, and they pull back to test gains or losses. This action-reaction becomes very important at market turning points. It implies that a reversal pattern will appear at some point in each trend. In an uptrend, a lower high will eventually follow a higher high and mark a new top. In a downtrend, lower lows will finally stop when price action prints a higher low. This marks the birth of a bottom.

There are many variations on the theme, including rounded bottoms, triple bottoms and V-bottoms. The problem is, you never know what type you're in until after the fact. The most common variation is the double bottom, in which a market prints one higher low before rallying out of a base.

Percentage profit potential peaks at the beginning of a new uptrend. So being right at a bottom can produce a significant reward. But bottom-picking can be dangerous business. Make sure to weigh all evidence at your disposal before jumping into a falling market, and apply defensive risk management to ensure a safe exit if you are proven wrong. For example, take losses immediately if the prior low gets taken out.

Bottoms occur in downtrends. There's added danger because traders will often believe a bottom before it's confirmed by the price action. Fast execution can cost you a lot of money in this volatile situation. Less experienced traders should sit on their hands and let others take the bottom bait. There will still be plenty of good trades if and when the market moves higher.

Spectacular reversals offer little profit if price can't climb out of the hole it fell into in the first place. Keep a stop loss under the prior low, and consider an earlier exit when the first bounce runs out of steam. Price can gather downside momentum at broken lows as it searches for new support.

Successful bottom-fishing requires a strong stomach. Negative sentiment infects these turning points even when the technicals line up perfectly. Why are we so attracted to these trades? Being right at a bottom offers a very high reward-to-risk ratio.

Bottoms produce very strong market fuel. There are fresh longs ready to speculate, and short-sellers who don't realize they're trapped. These two forces combine to generate tremendous buying power that can trigger explosive moves. For this reason alone, traders should consider the virtues of bottom-picking.

Market declines evolve into market bases characterized by failed rallies and retracements to old lows. Bear markets end when strong hands finally shake out the last losers.

So the time will come when price can rally to the top of resistance and keep on going. Relative strength will improve at this major turning point, and charts will print bullish bars with closing ticks near their highs. The averages will then start a steady march through the wall, bloodied by previous failures.

Markets must overcome gravity to enter new uptrends. Value players build bases, but they can't supply the critical force needed to fuel strong rallies. Fortunately, the momentum crowd arrives just in time to fill this important chore. As markets rise above resistance, greed rings a very loud bell, and growth players jump on board all at the same time.

 


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