From the August 01, 2010 issue of Futures Magazine • Subscribe!

Trading lesson: How to pick a bottom

It’s one of trading’s most fundamental questions: When has the market struck a bottom? Few potential trades generate so much fear while eliciting such gripping desire. The idea of trying to buy when the market has retraced heavily paralyzes some, while the greed of the potential profits causes others to buy irrationally. Combining simple rules with basic risk management can prevent both of these scenarios.

Traders’ styles can affect how they view bottoms in the markets. Trend traders, by definition, avoid identifying tops or bottoms. Their focus is to take the “meat out of the middle,” not get in or out at a price extreme. However, while these traders may not technically pick a bottom, when they liquidate, they are responding to an indication that the market has turned. In terms of oscillator and indicator traders, they often refer to the market action as “oversold,” but this condition does not necessarily constitute a bottom. With regard to chartists, their analysis is often driven by the patterns they choose, whether traditional triangles and head-and-shoulders formations or more sophisticated ones, such as Gann.

There are many ways to be a bad trader, and one is to dive into the market with abandon following a stiff decline, expecting to catch the absolute low before price surges upward. This misstep begs the question: What exactly is a bottom?

Tale of the tape

The difficulty of picking a bottom stems from not knowing what actually is taking place in the market. Let’s be clear: Picking a low is not the same as picking a bottom. A low is simply the lowest price achieved by a market during a certain time period, while a bottom is a low or a series of lows that indicate investor mentality has shifted from selling to buying.

Your trading method determines how you look at bottoming formations. To a day-trader using Level II and tape analysis, a bottom may mean that offers have dried up and a sizable bid is supporting the market. In this case, buying power will overcome selling power, and a bottom will be formed. If we accept that the tape prints before the chart, then we have to believe all bottoms follow this condition. In other words, a bottom begins when demand overtakes supply.

Day-traders use this type of set-up to initiate trades because they know they have an exit. A day-trader will attempt to enter the market on the long side at a low price when he knows that he has someone to lean on. In this example, when a day-trader sees a large bid or a series of bids greater than the selling pressure, he will attempt to go long under the assumption that a bottom may be forming. With his eye on the bidders at all times, the day-trader will stay long as long as the reason for his being long, the large bid, remains in place.

Assume that a low price has been reached and that a significant amount of bids have come into the market to stop its decline. Because the majority of traders use patterns and indicators to trade, we can review some techniques that help identify a bottom. By looking at two different styles of trade, we can see how each user determines when a bottom has taken place and how to trade it. These types of styles are the oscillator and pattern recognition.

Ups and downs

Oscillators are used to identify overbought and oversold markets. An overbought market is one that has risen significantly and has exhausted the buying interest of investors. An oversold market is one that has fallen significantly and has scared off sellers. Moving averages can confirm a change in trend, but an oscillator is used to identify a bottom or top as it is forming.

The two most popular oscillators are the relative strength index (RSI) and stochastics. Both of these oscillators move on a scale set from 0 to 100. Conventional wisdom says that an RSI reading over 70 is overbought and a reading under 30 is oversold. Stochastics traders use readings of 80 to indicate overbought conditions and 20 to indicate oversold conditions. Time is an important input into both RSI and stochastics. A popular time period for both is 14 days, which serves as the default period for both indicators in standard charting packages.

Don’t confuse oversold with a bottom, however. It cannot be determined if a market with an RSI reading of 30 is making a bottom using that information alone. Indeed, you cannot even rationally state that the market is even close to making a bottom. For each market and time frame, not only is research necessary, but so is confirmation.

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