How to figure out when a down trend is reversing

Interpretation

A double bottom formation usually occurs at the end of a long down trend. The security's failure to break below the previous low price level, and its subsequent move upward, suggest that a new low has not been made and, therefore, the basic premise of a down trend, namely lower highs and lower lows, is not satisfied. This fact should alert investors and traders that a reversal in the prevailing down trend may now be due.

How to Trade a Double Bottom

Once the price re-tests a previous low and then starts retracing higher without making a lower low, a trader / investor can buy with a stop loss kept just below the equal low price recently reached. A trader may expect the price to rise at least to the immediate previous high price level and, optimistically, even higher as follows :

Target price = Previous high + (Previous high - Previous low)

Let us suppose the previous low of a scrip was say, Rs. 75 and its most recent high Rs. 100. If the price re-tests Rs. 75 but starts rising again without going any lower, the minimum target would be Rs. 100 (previous high), and the optimistic up target Rs. 125 [i.e., 100 + (100-75)]. Chart 1 of Wipro Ltd shows an example of a double bottom formation.

Chart 1: Wipro Ltd monthly chart indicating a double bottom formation

You will observe that after reaching the upper resistance line (the first target after the double bottom was formed) the scrip gave a break out of the resistance suggesting a reversal of the ongoing down trend. Please see marking's on the chart.

Triple Bottom Formation

While the basic reasons for this price pattern and the strategy for trading it remain similar to the double bottom formations, the triple bottom formation indicates prices have thrice found support at a particular price level. Conversely, a triple top formation indicates that prices have thrice found resistance at a particular price level.

Thus, when a security finally confirms a reversal from a triple top or bottom formation, one can expect a stronger reversal.

Triple bottom price formations are relatively rare.

Inverse Head and Shoulders Price Formation

How It is Formed

This price formation occurs after a consistent fall in prices, climaxing with a fast and furious non-stop price crash and, finally, ending in a higher low formation. This is a typical price pattern as the panic crash represents ‘extreme’ human pessimism (‘end of the world’) before investors realize that things may not really be quite as bad.

Interpretation

In an inverse head and shoulders formation, the first shoulder (left shoulder) is formed in continuation with the ongoing down trend. Then a steep and fast crash takes the price to a new low. Thereafter, there is some cooling off and prices retrace to the neckline and subsequently make a higher low. This is an initial indication that a reversal may be due. The breaking of the neckline on the upside is the confirmation of the reversal signal.

How to Trade an Inverse Head and Shoulders Pattern

Once the price breaks out above the neckline, long positions can be initiated with a stop loss just below the right shoulder (the most recent higher low formed). A trader can expect the price to rise by at least the magnitude of the distance between the right shoulder and neckline and, optimistically, even higher equal to the magnitude of the distance between the head and the neckline. Usually the distance between the head and neckline is quite large and hence a reversal after this pattern leads to a huge rally. Chart 2 illustrates an inverse head and shoulders formation.

Chart 2: Japanese Nikkei index showing an inverse head and shoulders reversal pattern

You will observe that the monthly chart of the Japanese Nikkei Index indicated in mid-2005 that the multi-year down trend was reversing.

You will also observe that the optimistic target (index level of 17,000) too was reached in mid-2006.

Rounding Bottom Reversal

How It is Formed

This is a price formation which occurs after a consistent fall in prices. At the later stages of the fall, the price fails to make significant lows though the trading interest measured by volumes remains high. Thus the situation becomes one of high volume trading but no ‘marked’ fall in price. With passing days the price makes highs, but not very significant ones. On the price chart, such a situation unveils itself as a rounding bottom pattern.

Interpretation

A rounding bottom pattern, signaled by high volumes coupled with insignificant price movement, is suggestive of a slow accumulation taking place. Effectively, the ‘big’ players are slowly acquiring the stock without attempting big purchases in order to mask their action. By keeping the price rise gradual, they can more easily acquire significant positions without attracting undue attention of the larger body of market players. Another important observation is that the price tends towards levels where the rounding pattern actually started.

How to Trade a Rounding Bottom

Usually, a rounding bottom formation takes some days to develop. During this period the price tends to move in a roughly defined range. In a rounding bottom formation, a trader can wait for the high of the range to be broken before initiating a long (buy) position. You can keep a stop loss just below the low of the range and hold the long position for an upper target near the starting point of the pattern as indicated in Chart 3.

Chart 3: Weekly chart of Silverline Technologies

After consolidation, the price started making equal highs and slightly higher highs, suggesting a demand for the stock. The break above this 'resistance' level leads to further aggressive buying.

[Excerpt from How to Profit from Technical Analysis by Rajiv D. Khatlawala. Published by Vision Books.]

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