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

Trading lesson: How to pick a bottom

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).

chart

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).

chart

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.

Better together

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 jhyerczyk@yahoo.com.

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