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Friday, July 10, 2009

DOUBLE BOTTOM PATTERN – Part 2: Important Characteristics

Go back to Part 1: Double Bottom Formation

Important Characteristics of Double Bottom Pattern

Existing Trend:
There should be an established existing DOWNWARD trend. The downtrend should be fairly long and healthy (at least about 3 to 6 months).

Shape of Double Bottom Pattern:
1) The Two Bottoms:
* The bottoms can be either sharp & narrow (like V) or a bit rounded looking & wider. Ideally, the price bottoms should be the same. However, some difference in the price bottoms is still acceptable.
Although the price bottoms do not necessarily need to be exactly the same, but it should appear near the same price level. The price difference between the two bottoms should be less than 3%.
If the price difference between the two bottoms is more that 3%, the pattern may not be Double Bottom.
* If the low of the 2nd bottom does not hit the low of the 1st bottom, it is less worrying.
However, if low of the 2nd bottom is even lower than the low of the 1st bottom, we should be more cautious, as the probability that the downtrend would resume is still higher.

2) The Peak:
The height of the peak between the two bottoms should be around 10% - 20% from the bottom (It could be even more than 20%, but it should not be less than 10%).
In general, the higher the peak between the two bottoms, the better the performance of the pattern.
If the two bottoms are not exactly the same, the higher bottom should be used as the benchmark for the height measurement.

Duration:
Since Double Bottom is an intermediate to long term reversal pattern, the pattern should not be formed in just a few days.
The duration of time period between the two bottoms may vary from a few weeks to many months (generally about 1 to 3 months). Normally, the formation of Double Bottoms should take longer time and less volatile in price swing than Double Tops. Hence, bottoms tend to be wider (due to longer duration to develop) and flatter (as a result of less volatile price swing) than tops.
Basically, the longer the time duration between the two bottoms, the more likely the pattern could work out as a reversal pattern.
Hence, we should be extra cautious if a pattern only has a few days apart between the two bottoms.

Breakout:
Even when the price has increased from the 2nd bottom, the pattern is not completed yet. The chances that the existing downtrend will continue are still higher that the chances of reversal to take place, as it is normal during an downtrend for the price to test a support level a few times before resuming the downtrend again.

Double Bottom pattern is only completed and confirmed when the price increases and closes above the highest point of the peak in between the 2 bottoms, which serves as the key resistance level in this pattern. This highest point is called the “Confirmation Point”.

Remember that we should always assume the existing trend (i.e. in this case is downtrend) is in force unless proven otherwise.
Therefore, it is important to wait for the price to make a decisive breakout by breaking through and closing above the Confirmation Point, with an increase in volume, in order to avoid jumping the gun and/or prevent deceptive Double Bottoms pattern.

Nevertheless, sometimes the price may also make a deceptive/invalid breakout whereby it touches above the Confirmation Point, but then it goes back down again & resumes downtrend.
One possible way to prevent this is by having certain criteria to confirm if the breakout is a valid one.
A minimum penetration criteria for a breakout should be the price closes above the Confirmation Point, not just an intraday penetration.
Some traders may apply certain price criteria (e.g. 3% - 5% break from the Confirmation Point depending on the stock’s volatility) or time criteria (e.g. the breakout is sustained for 3 days) to confirm the validity of the breakout.

Volume:
Usually, volume is lower during the formation of the right bottom than the left bottom, showing an indication that the selling pressures are getting weaker.
In general, volume tends to be diminishing as the pattern is forming. The volume may pick up when the price hits the 2nd bottom, but it is often only a slightly higher than the average volume during the peak.
When the price is breaking out the Confirmation Point, it should happen with an increase in volume.
Monitoring volume for Double Bottoms is more crucial than for Double Tops, as a breakout from the key resistance (i.e. Confirmation Point) accompanied by an expansion in volume may indicate increased buying pressures and a potential change in sentiment from selling to buying. Hence, it may provide higher chances that the pattern is a reversal pattern.
It is even better when the price is rising from the 2nd bottom, the price experiences an accelerated increase, perhaps with a gap up or two.

Potential Price Target:
1) Compute the height of the peak: The distance between the bottom (support) and the Confirmation Point (resistance).
If the two bottoms are not the same, the higher bottom should be used for this calculation.
2) To compute the potential price target: Add the result to the Confirmation Point.

Hence, the above formula implies that the higher the peak between the two bottoms, the larger the potential of the increase.

In general, any price target should only be used as a rough guide. To determine the price target, other factors, such as previous support / resistance levels, Fibonacci retracements, or long-term moving averages, should be considered as well.

Return to Breakout Level:
After the breakout occurs, it is common that prices may return to the breakout level for an immediate test of this new support level before continuing their moves in the direction of the breakout. (Remember that the resistance now has become a new support level). This could actually offer an opportunity to participate in the breakout with a better reward to risk ratio.

To find out more about other Chart Patterns, please refer to:
Learning Charts Patterns

Analysis Tool:
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Related Topics:
* Learning Candlestick Charts
* Options Trading Basic – Part 1
* Options Trading Basic – Part 2
* Understanding Implied Volatility (IV)
* Option Greeks
* Understanding Option’s Time Value

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