One of the keys to day trading success centers around stock selection — and there’s A LOT that goes into this. One of these important factors surrounds when a stock bottoms out…
As you read
and understand more about trading…
…you come across significant concepts and terminology that allow you to dig deeper into trading (and improve your knowledge of it).
If you have followed my Investing for Beginners series, you understand many of these. Well, today we dive into another one…
When a stock bottoms out — and why it’s oh-so-important to know about. Beginning with the all-important question...
What is “Bottoming Out”
(And WHY Is It Important)?
The bottom of a stock means the stock has reached the lowest point and is not likely to go any further down from that. The only way for it to go is up. In general, barring the exception of shorting, a trade happens when a trader buys a stock at a low price, hoping the price will go up eventually, and then sells it at this higher price (earning a profit). This kind of buying-selling behavior happens in a bullish market (ie: when the prices are likely to go up). So basically, the idea is to buy low and sell high.
Buying stocks when they are at a low price works well most of the time as the price is likely to go up. It’s a good idea to know the bottom of a stock and figure out when it’s about to bottom out (as it can help determine the future of the stock). Price movements follow trends and are not random. They follow some patterns. And so analyzing the highs and lows helps make buy and sell decisions. There are clues you can use to determine if a stock is nearing a bottom.
What Are The Early Signs
Of A Bottom Out?
One of the early signs of a bottom out is a trend change. Let us take a look at how a stock goes lower and how you can catch that. If a stock is moving lower it’s moving from its highs and it starts trending lower and lower, creating a stair-step pattern (see image). It makes lower lows and lower highs. Stocks never go straight down and they do not go straight up either. They will follow a pattern like the one seen here.
…can be a lot more variable than pictured. At one point this trend will reverse and the stock will begin making higher highs and higher lows. The trend will start pushing upwards. At the point of reversal, where the stock started making higher highs and higher lows, is where the bottom exists. Catch where the pattern is earliest to change in direction. A key point where a stock tends to bottom out is when it declines 60-75% consistently. A bottoming out pattern exists after a consistent and significant decline.
If a stock has bottomed out, it means the stock has reached its lowest point and could potentially be in the early stages of an upward trend.
The Important Signs
Of A Stock Bottoming Out
Many times, a stock bottoming out can be a sign of a reversal. That means that the stock could move upwards shortly afterward. A bottom is an opportunity to buy a stock when the stock is trading at its lowest price. And so it’s important to be able to recognize the signs of a stock bottoming out. It is not easy to find the bottom but there are some signs.
Volume is a key tool for identifying market bottoms and peaks. Volume can be used to track the number of stocks being bought and sold over time.
This helps us judge how the other traders are perceiving the market. Price and volume form two of the most significant parts of market structure, which give rise to uptrends, downtrends, tops, and bottoms. This allows traders to predict important things about the market. Volume is extremely useful to identify bottoms. When entering a long position at or near the lowest low in a downtrend, profit is the highest. When the price declines on increasing volume, the trend is going down.
When the stock is going down and there’s an uptick in volume along with the ongoing downtrend then the stocks will carry on going down, hitting a bottom. Essentially this tells us that the higher the volume of the stock bottom, the stock has already hit the lowest point and is now increasing. Stocks go to the bottom when there are few sellers available. In this situation, buyers outweigh sellers, and, if they’re ready to pay a higher price, it means the price bottom has already formed.
Prices To Reclaim Moving Averages
Moving Average (MA) is an indicator used to identify the direction of a current price trend, without the interference of shorter-term price spikes.
With the use of the MA indicator, you can study levels of support and resistance and see previous price action (i.e. the history of the market). Moving averages don’t make predictions about the future price of stocks. They tell us what the price is doing, on average, over a period of time. Essentially this means you can determine possible future patterns by analyzing this data. The two popular types of moving averages are:
Simple moving average (SMA)
Exponential moving average (EMA)
When the computing average price of a stock is taken over a number of periods, it’s called a simple moving average. As an example, a weekly simple moving average is found by taking the sum of seven days divided by seven. An exponential moving average gives more weight to recent prices. It is found out by first calculating the simple moving average of the previous period. A weighting multiplier is then applied to find the EMA calculation. To have a higher chance of success in a stock bottoming, consider prices to sell high. To do that, use short-term moving averages of 9 to 20 EMAs.
Confirm With Major Indicators
Moving average convergence divergence (MACD) is an indicator that depicts the relationship between two moving averages of a stock’s price.
It’s employed to reveal changes in the strength, direction, momentum, and duration of a trend in a stock’s price. MACD is a good indicator to spot stocks that are bottoming out. MACD fluctuates above and below the zero line. Using this indicator, you can come back from oversold conditions and start heading up. The above figure shows the stock’s trend strength by creating a channel. To create the channel, they drew support by connecting the bottoms and determined the return line by connecting the tops of the MACD.
Image Courtesy investopedia.com
The above figure shows the stock’s trend strength by creating a channel. To create the channel, they drew support by connecting the bottoms and determined the return line by connecting the tops of the MACD. It has to be said that none of these indicators is a sure-shot way to identify a market bottom. But monitoring them together is a good way to find a stock’s bottom. It has to be said that none of these indicators is a sure-shot way to identify a market bottom. But monitoring them together is a good way to find a stock’s bottom.
Your Stock Bottoms Out
A bottom-out pattern is a good indication that stocks are about to trend higher.
Once a new bottom-out pattern starts to form, you should get in but not too quickly. If you get in too early there’s a possibility the stock can continue downward. Get in right after the stock has made its bottom pattern. Every trader wishes to buy during bear market bottoms, but it happens rarely. They waste most of their time in fear, copying what others are doing, and hesitate to make moves that are led with their own strategies, carving out their own paths.
Do not be afraid to move at the market bottom but also don’t be impulsive. If stocks are falling, let them finish their decline before you get involved. Being overconfident and underconfident can both be detrimental. All of these mistakes that we’ve talked about have one thing in common: they are deeply rooted in human psychology. Being overconfident too early, becoming greedy, and falling for hype are extremely natural human behaviors.