Double bottom is a charting technique used in technical analysis. It is used to describe a drop in the value of a stock (index), bounces back and then another drop to the similar level as the previous low and finally rebounds again. A double bottom is a reversal pattern which occurs following an extended downtrend. The buy signal is when price breaks above the reaction high which is formed between the two lows.
Context: The double bottom must be followed by an extended decline in prices. The two lows formed have to be equal in areas with a minor reaction high between them, though they need not to be equal in price. This is a reliable indicator of a potential reversal to the upside.
Appearance: Price reduces further to form a new low. This is followed by upside retracement or minor bounce, which forms a reaction high before one final low-volume downward push is made to the area of the recent low. In some cases the previous low is never reached, while in others it is briefly penetrated to the downside, but price does not remain below it. This pattern is considered complete once price makes the second low and then penetrates the highest point between the lows, called the reaction high. The buy indication from this bottom pattern occurs when price breaks the reaction high to the upside.
Breakout expectation: A double bottom pattern becomes official when the reaction high is penetrated to the upside, ideally accompanied by expanding volume. Upside price target is calculated adding the distance from the reaction high to the low to that of reaction high. Often times a double bottom will mark a lasting low and lead to a significant price advance which exceeds the price target to the upside.
There can be many variations that can occur in the double bottom, but the classic double bottom usually marks an intermediate or a long-term change in trend. Many potential double bottoms can be formed along the way down, but a reversal cannot be confirmed until key resistance is broken.
The key points in the formation are as follows:
1. Prior trend: With any reversal pattern, there must be an existing trend to reverse. In the case of the double bottom, a significant downtrend of several months should be in place.
2. First trough: It marks the lowest point of the current trend. Though it is fairly normal in appearance and the downtrend remains firmly in place.
3. Peak: After the first trough is reached, an advance ranging from 10-20% usually takes place. An increase in the volume from the fi rst trough signals an early accumulation. The peaks high is sometimes rounded or drawn out a bit because of the hesitation in going back. This hesitation is an indication of an increase in demand, but this increase is not strong enough for a breakout.
4. Second trough: The decline off the reaction high usually occurs with low volume and meets support from the previous low. Support from the previous low should be expected. Even after establishing support, only the possibility of a double bottom exists, it still needs to be confirmed. The time period between troughs can vary from a few weeks to many months, with the norm being 1-3 months. While exact troughs are preferable, there is some room to maneuver and usually a trough within 3% of the previous is considered valid.
5. Advance from trough: Volume gains more importance in the double bottom than in the double top. The advance of the second trough should be clearly evidenced by the increasing volume and buying pressure. An accelerated ascent, perhaps marked with a gap or two, also indicates a potential change in sentiment.
6. Resistance break: The double top and trend reversal are considered incomplete, even after they trade up to resistance. Breaking resistance from the highest point between the troughs completes the double bottom. This too should occur with an increase in volume and/ or an accelerated ascent.
7. Resistance turned support: Broken resistance becomes potential support and there is sometimes a test of this newfound support level with the fi rst correction. Such a test can offer a second chance to close a short position or initiate a long.
8. Price target: Target is estimated by adding the distance from the resistance breakout to trough lows on top of the resistance break. This would imply that the bigger the formation is, the larger the potential advance.
Points to be kept In Mind
• The double bottom is an intermediate to long-term reversal pattern that will not form in a few days. Though it can be formed in a time span of few weeks, but it is preferable to have at least a time of 4 weeks between the two lows. Bottoms usually take more time than the top. This pattern should be given proper time to develop.
• The advance off of the first trough should be 10-20%. The second trough should form a low within 3% of the previous low and volume on the ensuing advance should increase. Signs of buying pressure can be checked by the volume indicators such as Chaikin Money Flow, OBV and Accumulation/Distribution. The formation is not complete until the previous reaction high is taken out.