Chart Patterns is a new series of Market School posts that we will be releasing in the coming weeks.
A Double Bottom is considered a bullish signal, indicating a possible reversal of the current downtrend to a new uptrend.
Double Bottoms are considered to be among the most common of the patterns. Since, they seem to be so easy to identify, the Double Bottom should be approached with caution by the investor.
The Double Bottom is a reversal pattern of a downward trend in a stock’s price. The Double Bottom marks a downtrend in the process of becoming an uptrend.
A Double Bottom occurs when prices form two distinct lows on a chart. A Double Bottom is only complete, however, when prices rise above the high end of the point that formed the second low.
The two lows will be distinct. The pattern is complete when prices rise above the highest high in the formation. The highest high is called the “confirmation point”.
Analysts vary in their specific definitions of a Double Bottom. According to some, after the first bottom is formed, a rally of at least 10% should follow. That increase is measured from high to low. This should be followed by a second bottom. The second bottom returning back to the previous low (plus or minus 3%) should be on lower volume than the first. Other analysts maintain that the rise registered between the two bottoms should be at least 20% and the lows should be spaced at least a month apart.
Sometimes the two lows comprising a Double Bottom are not at exactly the same price level. This does not necessarily render the pattern invalid. Analysts advise that if the second low varies in price from the first low by more than 3% or 4%, the pattern may be less reliable.
The bottoms will have a significant amount of time between them – ranging from a few weeks to a year depending on whether an investor is viewing a weekly chart or a daily chart.
Generally, volume in a Double Bottom is usually higher on the left bottom than the right. Volume tends to be downward as the pattern forms. Volume does, however, pick up as the pattern hits its lows. Volume increases again when the pattern completes, breaking through the confirmation point.
Following are important characteristic to look for in a Double Bottom.
Downtrend Preceding Double Bottom
The Double Bottom is a reversal formation. It begins with prices in a downtrend.
Time between Bottoms
Analysts pay close attention to the “size” of the pattern – the duration of the interval between the two lows. Generally, the longer the time between the two lows, the more important the pattern is as a good reversal. Some analysts suggest that investors should look for patterns where at least one month elapses between the bottoms. It is not unusual for a few months to pass between the dates of the two bottoms.
Increase from First Low
Some analysts argue the increase in price that occurs between the two bottoms should be consequential, amounting to approximately 20% of the price. Other analysts are not so definite or demanding concerning the price increase. For some, an increase of at least 10% is adequate. The rise between the lows tends to look rounded but it can also be irregular in shape.
Volume tends to be heaviest during the first low and lighter on the second. It is common to see volume pick up again at the time of breakout.
Pullback after Breakout
A pullback after the breakout is usual for a Double Bottom.
Duration of the Pattern
Consider the duration of the pattern and its relationship to your trading time horizons. The duration of the pattern is considered to be an indicator of the duration of the influence of this pattern. The longer the pattern the longer it will take for the price to move to its target price. The shorter the pattern the sooner the price move. If you are considering a short-term trading opportunity, look for a pattern with a short duration. If you are considering a longer-term trading opportunity, look for a pattern with a longer duration.
The target price provides an important indication about the potential price move that this pattern indicates. Consider whether the target price for this pattern is sufficient to provide adequate returns after your costs (such as commissions) have been taken into account. A good rule of thumb is that the target price must indicate a potential return of greater than 5% before a pattern should be considered useful. However you must consider the current price and the volume of shares you intend to trade. Also, check that the target price has not already been achieved.
The inbound trend is an important characteristic of the pattern. A shallow inbound trend may indicate a period of consolidation before the price move indicated by the pattern begins. Look for an inbound trend that is longer than the duration of the pattern. A good rule of thumb is that the inbound trend should be at least two times the duration of the pattern.
Criteria that Support
Support and Resistance
Look for a region of support or resistance around the target price. A region of price consolidation or a strong Support and Resistance Line at or around the target price is a strong indicator that the price will move to that point.
Location of Moving Average
The Double Bottom should be below a Moving Average of appropriate length. For short duration patterns use a 50 day Moving Average, for longer patterns use a 200 day Moving Average.
Direction of Moving Average Trend
The Moving Average should change direction within the duration of the pattern and should head in the direction indicated by the pattern. For short duration patterns use a 50 day Moving Average, for longer patterns use a 200 day Moving Average.
A strong volume spike on the day of the pattern confirmation is a strong indicator in support of the potential for this pattern. The volume spike should be significantly above the average of the volume for the duration of the pattern. In addition, the volume during the duration of the pattern should be declining on average.
Other reversal patterns (such as Bullish and Bearish Engulfing Lines and Islands) that occur at the peaks and valleys indicate strong resistance at those points. The presence of these patterns inside a Double Bottom is a strong indication in support of this pattern.
Criteria that Refute
No Volume Spike on Confirmation
The lack of a volume spike on the day of the pattern confirmation is an indication that this pattern may not be reliable. In addition, if the volume has remained constant, or was increasing, over the duration of the pattern, then this pattern should be considered less reliable.
Location of Moving Average
If the Double Bottom is above the Moving Average then this pattern should be considered less reliable. Compare the location of the pattern to a Moving Average of appropriate length. For short duration patterns use a 50 day Moving Average, for longer patterns use a 200 day Moving Average.
Moving Average Trend
Look at the direction of the Moving Average Trend. For short duration patterns use a 50 day Moving Average, for longer patterns use a 200 day Moving Average. A Moving Average that is trending in the opposite direction to that indicated by the pattern is an indication that this pattern is less reliable.
Short Inbound Trend
An inbound trend that is significantly shorter than the pattern duration is an indication that this pattern should be considered less reliable.
A Double Bottom consists of two well-defined lows at approximately the same price level. This shape is formed because prices fall to a support level, rally and pull back up, then fall to the support level again before increasing and eventually breaking through the resistance line.