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.
Oscillators remain popular because they are easy to use, particularly in hindsight. They are coincidental indicators. If the RSI reaches 25, for example, and the market makes a bottom, then traders will say the low reading on the RSI oscillator triggered the turnaround in the market because it was oversold. While not exactly good for predicting a bottom, the RSI can be used to determine when or where a market has reached an oversold status and could begin to rise.
The best use of the RSI is implied by its calculation. The RSI is a percentage of an index created by a series of closes. As such, it’s not going to identify an absolute low because it is created using closes. For bottoms, convergence is the best technique for analyzing the RSI. In other words, look at a series of RSI readings relative to a chart formation. If the market is making lower lows, but the RSI makes a higher low, then this is a sign of a bottom. It means that despite moving lower intraday, the market has managed to close better relative to the previous closes (see “Seeing convergence,” below).
A similar situation exists with stochastics. This overbought/oversold oscillator is created by comparing the relationship between the high and the close and the low and the close. If the market is making lower lows and closing near the low, then the oscillator will continue to fall. Over a series of days, if the market continues to fall, but the closes are better than 50% of the day’s range or near the high of the day, then a convergence is forming that indicates that a bottom could be in the making.
The ultimate confirmation of oscillators, however, comes from the price action itself. With help from the charts, you can see that a bottom is forming because of the combination of the price action and the oscillator.
Chart patterns are based on raw price data and, as such, often can provide the first clues to a market bottom. Among chart patterns, closing price reversal patterns are some of the most useful.
Studying price patterns, you find that a bottom can form at just about any level on the scale. Although it is suggested to wait for 30 on the RSI and 20 on stochastics before buying, in reality the level of the oscillator has little to do with how weak a market is or how much it will rally. For uniformity in bottoming signals, a much better choice is the closing price reversal bottom and the candlestick hammer.
The closing price reversal pattern -- or as it was referred to by legendary trader W.D. Gann, “the signal bottom” -- is a universal pattern. It exists in all markets. At some point, all markets will at one time post a closing price reversal bottom. This is one of the best indications that buying pressure has outpaced selling and that a bottom is taking place.
A closing price reversal bottom is defined as follows: Following a prolonged move down in terms of both price and time, a market has a lower-low than the previous time period, a higher-close, a close above the time period’s mid-point, and a close above the opening. If this occurs, consider this a sign that the market has bottomed and that the trend is getting ready to turn up.
The signal bottom is one of the most powerful indicators of a major bottom formation. To understand its importance, we need to break the signal bottom down into its components.
A prolonged move in price is an important part of determining the significance of a signal bottom. This type of signal must occur following a strong break in terms of price. Studying previous down swing moves will aid in determining what is meant by a “prolonged move in price.”
A prolonged move in time also is an important indication of an impending bottom. Time is most important in determining a change in trend. Once again, knowing something about the history of the duration of down swings in the market will aid immensely when using this signal. On a daily chart, for example, a typical prolonged move down in the stock market will be seven to 10 days.
A lower-low and a higher-close occur quite often even amid a sharp break. This is why the trader should use prolonged move in price and time as a filter. Without this condition and a follow-through to the upside to confirm the formation, this pattern can trigger a false bottoming signal (see “The signal bottom,” below).
Also, note where the formation is taking place. Often, closing price reversals take place near previous bottoms or inside retracement zones. When studying this signal, a trader is likely to determine that the best trading signal comes following a 50% retracement above a previous main bottom.
Traders should note that this type of formation does not mean anything until the pattern is confirmed. The confirmation takes place when the high of the reversal day is penetrated. Without the confirmation, the signal may fail. Sometimes, the reversal is confirmed the day after the formation; other times, it may not be confirmed until after a base has been built.
Gann’s signal bottom formation, or closing price reversal, is similar to the hammer candlestick pattern (candle with a small real body that forms at the upper end of the bar with a lower wick at least twice the size of the body). Like the closing price reversal, the success of the pattern is determined by the amount of price and time of the previous break, the location of the reversal bottom and the follow-through to the upside (see “Two together,” below).
Often, traders just take the candlestick patterns as they appear without adding the reversals. Success may be improved if you take the signal inside of a retracement zone and especially after a prolonged move down in terms of price and time.
Criticism of RSI and stochastics does not mean these tools should be discarded. When used in conjunction with the signal bottom and hammer patterns, they may prove to be valuable, depending on your market, style and time frame. Traders should look for convergence patterns in the oscillators in combination with closing price reversals and hammer patterns. This is especially true when using stochastics because it’s based on the same components of the charting and candlestick bars.
Bottom picking should not be feared if you understand how bottoms are formed and how to use oscillator and chart patterns to determine the validity of a bottom. There are other techniques, such as swing breakouts and moving averages, but these methods tend to lag behind actual market movement and often are confirmed several days and much price movement away from the low price.
The closing price reversal bottom pattern tends to get the trader in a position within one day of the actual low. Some may consider this too aggressive, but when coupled with risk management rules and proper exit strategies, it can be a successful method of trading.
James A. Hyerczyk is a Gann technician and trading educator who has been analyzing markets since 1982. He wrote “Pattern, Price & Time: Using Gann Theory in Technical Analysis,” and writes a futures and equities advisory newsletter at PatternPriceTime.com. He can be reached at email@example.com.