How Do Investors Use Double Bottom Patterns?

When analyzing which securities to add to your portfolio, there are two approaches you can take, fundamental analysis and technical analysis. The former focuses on the financial health of companies while the latter looks more closely at current market trends. If you’re using a technical approach, one of the key methods to use is the double bottom pattern. This W-shaped pattern is used to track downward movements in a security’s price. Here’s more on what double bottom means and how to use it to shape your portfolio. Learning technical analysis is best done with an experienced mentor, such as a financial advisor.

Double Bottom Pattern, Definition

Technical analysis relies on charting to essentially “read” a security’s movements. The double bottom pattern is an indicator that’s used to describe changes in price trends and momentum. A double bottom looks like “W” shape, in that it begins with a stock’s or security’s price at a specific high point, then dips, rebounds slightly, dips again, then rises again.

For a true double bottom to exist, the two low points have to form near a similar price level. Double bottoms usually occur when a security or index is approaching the end of a downward trend and the price is set to begin increasing again. It’s at this point that selling pressure typically begins to ease.

What Double Bottom Tells Investors

A double bottom pattern can be useful for determining when a share or index is set for a price increase. If you rely on technical analysis then knowing how to pinpoint double bottom patterns matters for choosing when to buy or sell a particular security. Generally, the first bottom should reflect a dip of at least 10%, though you may see price drops of 20% or even 30%.

If you’re able to buy in at the bottom you can reap the benefits on the way up as the stock’s price climbs. But again, knowing how to read the double bottom pattern is key. A smaller dip in pricing, say 3% or 5%, for example, may not be as reliable for determining mid- to long-term momentum as it may only measure a temporary blip in volatility.

The key marker of a double bottom is two distinct lows that fall within the same price level or range. Most often, the first low tends to be more distinct as it signifies peak selling activity. The second bottom, though it reaches a similar price range, may be less sharp as most of the panic selling surrounding the security has already happened by this point.

How to Chart a Double Bottom Pattern

If you’re interested in applying technical analysis when choosing equities, then charting double bottoms can help with making more informed trading decisions. When using the double bottom pattern, it’s important to consider the time period you’re measuring. For example, this particular technical indicator generally works better when you’re looking at share price movements over a period of weeks or months as it’s easier to spot sustained periods of increased selling activity.

When reading chart patterns for the double bottom, there are a few key characteristics to look for, including:

• Where the first and second lows occurred

• How much time has passed between the two lows

• Where the price breaks above the first and second lows

• Trading volume from peak to peak and low to low

It’s also important to compare double bottom patterns and what it’s telling you about a stock’s trade activity to what fundamental analysis of the same security tells you. Again, fundamental analysis is all about measuring a company’s financial health in terms of things like revenues, cash flow and debt.

If a company has strong fundamentals overall, you can then look at how that may serve to push prices up against the backdrop of current market conditions. When the market as a whole is indicating a coming uptrend in pricing that can reinforce what the double bottom pattern is saying about where a stock’s price is headed.

Double Bottom vs. Double Top

A double top pattern is the reverse of a double bottom pattern. With a double top, you end up with a U-shaped stock chart pattern in which a security experiences two highs, with a slight decline in pricing in-between.

You’re more likely to see this type of charting pattern when a share price has been rising steadily. The double top indicates that the price has reached its peak and is likely to shift from bullish to bearish in terms of trading activity. That can be useful for determining when to make your entry or exit point.

Managing Risk When Trading Double Bottom

One mistake that’s easy to make when using double bottom patterns is misreading what the stock charts are telling you. For example, it’s easy to mistake a temporary increase in volatility as a signal that a stock’s price is about to bottom out when it’s not an accurate indicator that a double bottom is approaching.

This is where it’s important to consider the strength of pricing trends surrounding a particular security and what trading activity around that security looks like. For example, one giveaway of a double bottom is higher trading volume surrounding the first low, with a decrease in trading volume at the second low. If you notice that the trading volume on a second low is similar to the first low or even higher, that could be a sign that stock prices are set to dip again.

Buy in too soon and you could end up losing money if the stock’s price does indeed drop because a true double bottom hasn’t been reached. Again, looking at longer-term pricing trends over periods of weeks or months can make it easier to determine when a breakout is likely to occur. You can then compare those trends to the trading volume and the share’s overall momentum to decide if it’s the right time to buy.

The Bottom Line

Technical analysis is one of the basic ways to evaluate if and when a security would make a good investment. It’s particularly useful if you’re an active day trader rather than a long-term buy and hold investor. Understanding what the double bottom pattern means and how to interpret it can help you capitalize on pricing movements if you’re able to spot a stock that’s ready for a sustained turnaround. But keep in mind that like any other trading strategy, you risk losing money if the expected price increase doesn’t pan out.

Tips for Investing

• Consider talking to a financial advisor about whether technical trading is a good fit for you, based on your investment goals and risk tolerance. If you don’t have a financial advisor yet, finding one doesn’t have to be complicated. SmartAsset’s financial advisor matching tool can help you connect with professional advisors locally. It takes just a few minutes to get your personalized recommendations. If you’re ready, get started now.

• A free, easy-to-use investment calculator will help you keep your eye on the big picture as you sharpen your technical skills.

Photo credit: ©iStock.com/Skarie20, ©iStock.com/LARISA SHPINEVA, ©iStock.com/monsitj

The post How Do Investors Use Double Bottom Patterns? appeared first on SmartAsset Blog.