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Friday September 03, 2010 |
Double
Bottom
A double bottom formation is in many ways the mirror image of
the double top. After an extended decline to new lows a stock puts-in a
bottom on massive volume and a moderate rally ensues. After several
sessions (sometimes weeks) the stock drifts back to test the first bottom but
this time buying accelerates and another rally occurs.
Why Does It Happen?
Whereas double tops are all about distribution, the double bottom is about
accumulation. After an extended decline characterized by aggressive
short-selling and valuation concerns, value-oriented investors with longer-term
time horizons begin to take positions in the stock. They understand that
the only way to build a large position in a stock that they like is to do so
when selling predominates. It is their willingness to buy the stock when
all of the news is bad that creates a clear support level, the first bottom (bottom#1). This first
part of the pattern will normally be sufficient to force many
professional short sellers (bears) to cover positions. This coupled with
buying from longer-term value investors may be enough to rejuvenate investors
that recently purchased the stock at higher levels -- they may even rationalize that the
"market" is finally beginning to realize that the current weakness is without merit
a few bullish speculators may be enticed to take new long positions.
Unfortunately, after several sessions of positive price action buying
pressures are exhausted and the stock once again begins to falter. The
reaction to the decline that formed bottom#1 is complete. Technical
traders call this the reaction high. Sensing easy profits, short
sellers return and bullish speculators decide to take profits, modest selling
becomes a route. As the stock approaches bottom#1 volume remains light and in many cases the stock will actually fall through
the previous low on very light volume. It is at this point in time that
pessimism is greatest, there seems to be no legitimate reason to continue
holding the stock. Novice short sellers add new short positions and beleaguered
bulls who purchased the stock at much higher levels begin to surrender in
anticipation of a new leg lower. However the expected big decline
never materializes, selling pressures have been exhausted and this is when professional short sellers realize the "jig is
up". It is the new buying by bearish investors to cover short
positions to capture profits and the continued accumulation by longer-term investors that helps the stock stabilize. As a second bottom (bottom#2)
begins to take shape the pace of short covering accelerates and a new group of
bullish speculators take long positions, the rally explodes. On the chart
two equal bottoms are created, the double bottom is in place. In many
cases double bottoms lead to important rallies because a vital support level has
been established.
How are Technical Targets
Derived?
The technical target for a double bottom
formation is derived by adding the difference between bottom # 1 and the reaction
high to the new breakout
level. After the second bottom has been created, the new breakout level is the
reaction high. No double bottom formation is complete until the stock
rallies through this level.
The Double Bottom for Mercury Interactive
When momentum stocks "wreck" it is not pretty. That was
certainly the case for Mercury Interactive (MERQ). After a parabolic rally
that saw the stock reach $160 in October of 2000 the stock fell all the way to
$35 by March 12, 2001. That date is March is important because it was then
the double bottom pattern for Mercury Interactive began to take shape.
Despite a myriad of bad news, Mercury Interactive stopped going down on March
12, 2001 and put-in bottom#1. In fact, the stock rallied to a reaction
high at $51.68 by March 27 only to fall all the way back to test the March 12
lows a week later. When Mercury Interactive fell through the previous support
level at $35 on April 4 there seemed to be few compelling reasons to own the
stock -- then the most peculiar thing occurred. Despite several Wall
Street analyst downgrades the stock began to move higher on increased
volume. Indeed, volume surged to better than 8.9 million shares on that
session and the share price slowly began to climb. On April 17 the stock
surged through the reaction high at $51.68 and that is when the real fun began. Before the start of May Mercury Interactive had achieved its
technical objective.
Vital Signs
-
For double bottoms volume must increase as the
stock moves toward the first and second bottoms. In many cases, volume
will actually be higher at the first bottom because this is where
value-oriented investors first take positions.
-
No double bottom pattern is truly valid until
the stock moves through the reaction high.
-
Upside breakouts through the reaction high
often lead to small 2-3% advances followed by an immediate test of the
breakout level. If the stock closes below this level (now support) for
any reason the pattern becomes invalid.
-
Technical targets are implied but they are by
no means assured. Targets are guideposts only.
We have now completed our analysis of the double top and
bottom patterns. Now let's move-on to the three part patterns, the triple
top and bottom.
double
top 
triple top
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