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

Trading lesson: How to pick a bottom

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).

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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.

Price patterns

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.

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