In one of our previous articles, we have discussed the Double Top. This article is about the exact opposite of the Double Top, the Double Bottom.
As we have established, every valid trend has a trend line. Sometimes, trends move far away from their main trend line –bullish trends can rise over their trend line, bearish trends can fall under their trend line –valid trends should not cross their trend line to the other side.
Of course, a trend stays intact until it creates a new point 3 before creating a new point 2, since this would start a new trend in the opposite direction. These transitions, however, almost never happen as quickly and perfectly in reality as they do in theory. Usually, trends enter a period of sideways movement before they turn around. Therefore, a trend breaking its trend line can be a first sign of a beginning sideways movement. Once a sideways movement has occurred, one of two things can happen: The trend can either resume its previous direction on a new trend line, or it can turn around and form a new trend in the opposite direction.
I this article, we will analyze one of the most common signs a bearish trend will change direction: The Double Bottom.
This is what a double bottom looks like:
The formation starts with a bearish trend. After a period of falling prices, prices turn around. So far this is normal for a downtrend. A healthy trend would now move back to its trend line, turn around again, and start creating a new bottom. In this case, however, this does not happen. After creating a new top, prices do not start to fall as straight and quickly as a trader would expect for a normal movement to create a new point 2. Instead, they move erratically and lack momentum. After a while, they form a second bottom at roughly the same price level as the first bottom.
As a trader, you immediately realize the trend is in trouble. If nobody is willing to sell the asset below this price, the downtrend cannot continue. Still, this could be a temporary issue that and fix itself after a while. As long as the price does not rise past the previous top, the bearish trend is still intact. It is not time to invest in rising prices yet. For now you should either stay out of the market or switch to a different time frame to find trading opportunities.
As you have immediately recognized, two bottoms at roughly the same price level in a downtrend are the main sign for a double bottom. You know that as soon as the price rises above the previous top, the market has turned around. This is what happens in the picture. Prices break out of the Double Bottom and create a new bullish movement.
The Double Bottom is important in order to recognize fading trends. A trader familiar with the Double Bottom can immediately recognize weakening and movements and adjust his trading accordingly. The ability to interpret the current market phase is an invaluable ingredient to any trend-based trading strategy. It helps you know which options to trade and which to stay away from.
The Double Bottom can help you become a successful trader in a number of ways: Most basically, the formation can help you understand current market phases. From that knowledge, you can predict future price movements.
During the formation of a Double Bottom, prices will move with little momentum and change direction often. Therefore, you should stay away from Boundary options and options with a long expiration date. Instead, you should invest in options that require little movement, High/Low options for example, and keep expiration dates to a minimum.
To trade the Double Bottom directly, you can invest in a High/Low option or a Boundary option once the formation is complete. The price breaking through the level of the previous top will trigger a large number of Stop Loss and Buy Limit orders, which will use in a strong bullish price movement.