Novice Traders’ Notebook

Cardinal Reversal Patterns — At Bottoms

1. The Double Bottom

Downtrends often end with a process of building a base on the chart. This pictorial display represents a shift from negative fundamentals and pessimistic investor sentiment, driving prices down, to the news turning positive, encouraging traders and investors to become net buyers. Typically, this process takes time, and market participants are dealing with conflicting news that leads to a market trading in a sideways fashion. But as the news turns more positive, the change in the fundamentals creates a new uptrend. One technical base or bottom chart pattern that distinguishes this process is the double bottom. Here, the market is declining, often precipitously, with volume increasing during the steep descents, and each time the market stages a rally, the activity withers, indicating a lack of committed buyers. As the market reaches a low point, a very low point to investors, their reaction becomes one of extreme despair and they sell out, capitulating to the latest bad news. This extreme (point A) will be accompanied by a climatic level of volume.

At this point, the investors have thrown in the towel and want nothing to do with this market. Because of the one-sided appraisal, a market will tend to rally from this point. This rally is due to the lack of sellers, and the short-sellers must bid prices higher (B) just to lock in profits. The rally, usually on light volume, will be apt to have narrow trading days and simply run out of steam. At this point, the news will often be negative again, and the market will fall back toward the previous low level (C). During this decline, however, the volume is noticeably lighter, evidence that the sellers are becoming scarce.

More knowledgeable investors are not selling because their homework indicates that the market is nearing the end of the bad news. The retest of the major low is without the heavy volume, the trading ranges are narrow and the selling is insignificant. At this point, the double bottom is nearing completion. The large-scale selling done at A was actually met with buying by long-term investors seeing an opportunity, sensing that the last of the bad news was unfolding. The latest retest (C) is a final chance to buy at cheap levels. Now the news turns positive, the market rallies and, at D, with increasing volume, the market clears the resistance established at B and a double bottom is complete, signaling an uptrend is under way.

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