Recognizing When a Stock Has Hit Bottom

During market corrections, analysts and the media are quick to remind us that we should take advantage of opportunities to add quality stocks to our portfolio at bargain prices. Traditionally, many analysts suggest that investors should prepare to bottomfish during the tax loss selling season as stocks absorb a final surge of selling pressure before an anticipated bounce-back during the first quarter. But how do we know when the stock has dropped as far as it's going to go? After all, you don't want to buy too early, only to watch another 10% or 20% get shaved off the price before the stock stabilizes and reverses its downtrend.

There are a handful of technical analysis tools that can be used to help identify the end of a downtrend in a stock's price. While technical analysis can have powerful predictive value, it is not a 100% science. Stock prices can and frequently do behave in a manner contrary to that predicted by technical indicators. To reduce your risk further, you should concentrate on stocks with solid fundamentals and good value. Here are some key technical indicators that frequently signal the imminent reversal of a downtrend:

Selling Climax

A key principal of technical analysis is that volume moves in the same direction as prices. Volume increases generally accompany price increases and visa versa. A selling climax is typically indicated by a considerable increase in trading volume above recent averages and a substantial decline in price. The fact that the price and volume are not moving in the same direction suggests that the pattern is false and likely to reverse. Frequently, trading volumes accompanying a selling climax are the highest in the stock's history (excluding previous block trades). A selling climax frequently indicates a final blow-off by panicked investors or the final liquidation of a large position by a major institutional shareholder.

Double Bottom

A double bottom often occurs immediately following a selling climax. Very conservative investors may wish to wait for the completion of a double bottom to confirm a breakout from a selling climax. It is important to note, however, that a selling climax is not always followed by a double bottom. A double bottom is indicated when a breakout following a selling climax fails briefly, allowing the stock to drift back to or close to its low price during the climax. The second "bottom" should be accompanied by low volume, often near non-existent. If volume expands after a double bottom, a breakout is likely.

Hammer and Dragonfly Doji

In candlestick charting, a form of technical analysis, a hammer is indicated by a day in which prices decline dramatically only to rebound and close near the high for the day. The hammer typically follows a long or mid-term downtrend and can often be indicative of a selling climax when accompanied by above average volumes. A dragonfly doji is essentially a hammer where the price opens and closes at the high for the day. Hammers and dragonfly dojis are reliable trend reversal indicators.

Key Reversal Days

To qualify as a key reversal day, three primary criteria must be met: 1. the day must be preceded by an exponential decline in price. 2. volume should exhibit a parabolic increase. 3. prices should open below the previous day's close and rise significantly during the day, often closing above the previous day's close.

Outside Days

An outside day is a key reversal pattern where the day's trading range completely engulfs the previous day's trading range (i.e. the day's intraday high is higher than the previous day, and the day's low is lower than that of the preceding day as well.) The closing price should be higher than that of the preceding day as well. The greater the intraday volatility during an outside day and/or the greater the number of preceding trading days that are "engulfed" by the pattern, the greater the predictive value for a trend reversal. Inside days often follow outside days. As their name suggests, the trading range on an inside day is completely engulfed by that of the previous session (the outside day). Key reversal days are typically much more significant when followed by an outside day and an inside day.

Grant Robertson, B.B.A.

Disclaimer: The author is not a registered investment advisor. Accordingly, this article is presented for educational and information purposes only. Those seeking specific investment advice should consult a registered investment advisor. You are urged to consult your investment advisor before embarking on any new investment strategy as the strategies depicted in this article may not be suitable for all investors.