Bottom Picking And Reversal Patterns
18th Jun 2013
All investors find it hard to resist buying a stock after it has suffered a large fall. Take a quick look at the charts of the big four banks, Telstra and Woolworths.
Given how much they have fallen in the past month, it is tempting to buy these companies at their currently depressed prices. This is natural, because we ground our concept of “value” according to price.
If a stock falls from $10 to $5, we at some level, still view it as a $10 stock. Thus, the temptation is to buy a stock that has recently fallen, because we believe it should naturally gravitate back to where we perceive its value to be: $10.
Fear of bottom picking
So, what does this have to do with bottom picking? Fear, both your own and the market’s, is closely tied to the way we treat stocks when they fall. The fear of missing out on an ‘easy’ trade might cause you to take a position in a falling stock too early. So, how do you avoid pulling the trigger too early? Look closely at the market’s behaviour: is technical divergence indicating the selling is easing?
Bottom picking is usually an unpleasant habit. But if you can watch the market, and identify when bearishness is in decline, you can be prepared to take a position when the price starts moving in the right direction.
The technical analysis signs of divergence should tell you to get ready, but the price action should tell you when to go. Once again, patience, and control of your emotions, are the keys to successful trading.
Reversal patterns
Reversals are more technical than simply a stock going up after having fallen and so on. First of all let us confirm that there are only two types of price patterns – a continuation pattern and a reversal.
Continuation patterns are temporary corrections or minor pauses in the market before it continues on in the previous direction. Reversals, as the name implies, are a complete about face of the trend that had been in existence.
These are the common traits of all reversals.
| > | A trend must have been in existence for a reversal to occur. Seems pretty obvious but unless there is a clear and sustained movement in a share price in one direction, then we are only looking at a price fluctuation – not a reversal. |
| > | A major trendline is broken prior to a reversal. The act of breaking the trendline doesn’t confirm a reversal; it merely warns us that there may be a reversal ahead. A break of the established trend may simply be a continuation. |
| > | The longer the trend has been in place and the larger the movement of the share price during the trend, the more significant and larger the reversal. Clearly a trend that has been in place for 6-12 months and has run 20-30% is far more significant than one that has only occurred over a month and moved the stock a few percent. A reversal of the former is far more significant than the latter. |
| > | At the top of an uptrend the reversal tends to occur more quickly than the reversal at the bottom of a downtrend. Shorting at the top (if your timing is right) realises quicker profits than going long at the bottom because prices at the top tend to be more volatile. |
Reversals at the bottom take longer to build and the price movements tend to be smaller. Price movements at the turn of a long-term downtrend will tend to be smaller and gradually build over a longer period as the market gets more convinced of a reversal the volume and price will accelerate.
Volume is an important consideration in determining the power of and stage of the trend. Volume should rise as the trend accelerates and should surge at the completion of the pattern.
In the early stages of a trend the volume is not so important, however, as the momentum builds we need to see the volume rise with it – this shows us that there is true depth in the market, there are more and more buyers on the way up or more sellers as the price drops.
When looking at a potential reversal at the bottom of a trend it is imperative that volume spikes. If the prices begin to rise but there is no discernable change in volume then we’re probably not looking at a reversal.
If you are looking for more information on share market education and how to buy shares click on the corresponding links.
Carl Capolingua
Follow Carl on Twitter @CarlCapolingua
Head of Education
Australian Stock Report

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