Bottom Patterns and Channel Trading

        

Earning Channel

 

 

In this article we will discuss how to look at bottoms using channels, and when and how to act around the bottoms.

Summary

  • Channel lines can provide earlier and more accurate indications if a long-term down-trend has been broken, and thus the forming of a bottom.
  • Earning Channel can provide optimal timing for
    • profit taking and cleaning the short position.
  • Earning Channel can prevent you from
    • lacking the courage to buy until the stock is too expensive or even approaching the top.
    • taking up a long position too early and being trapped by a false bottom fishing.
    • being trapped by short squeezing.
    • panicking buying and selling without logical judgment.

“We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.” said Mr. Warren Buffett.

Almost every investor heard of this. But how can you be greedy when others are fearful?

  •  First, you must have the money to be able to fulfill your greed.

That is you must have sold some stocks and reserved some cash along the way from the previous top. This also means you need to be able to recognize the tops and to take proper actions. Please refer to “Topping Patterns and Channel Trading”.

  •  Second, you must have the skill to be able to identify real bottoms and to take proper actions.

If you don’t, you will probably often be caught in bottom fishing.

When you often play with all-in, or highly leveraged, you’ll be out of the game in no time. Don’t be greedy. We believe, Mr. Buffett used the term “greedy” to simplify the explanation. He always read his cards carefully and calculated every bet.

Mr. Buffett also said, “The most important investment you can make is in yourself.” So, let’s discuss some skills for handling bottoms, hope you will find them useful and put them into practice.

First, let’s define what is a channel and the 5 common types of bottoms.

For those of you who are familiar with the characteristics of channel and channel trading, you may want to skip this part. This review is for you to equip with necessary skills in taking proper actions using channel trading at bottoms.

A channel is a specific form of an obvious trend.

  • A channel is formed when the price moves in a waveform and has at least two peaks and dips (troughs) touching the resistance and supporting lines, and these two lines are about parallel.
  • A channel indicates, in the period of time, people (little guys as well as institutions) think and act alike and are not in a panicking mode (the price movement is not straight up nor straight down).
  • The longer the channel, the more touches the peaks and dips, the more reliable the channel is.

Notice that the definitions above are the same for an up-channel and a down-channel.

A long-term monthly down-channel of a stock often reflects that the company has been doing really poor for quite a long time. More touches mean the supporting and resistance lines have been tested several times and are withstanding.

However, different from the top, it is more dangerous to short a stock that has been falling a lot from its top, or when it has become a penny stock. It is more likely to be caught by short squeezing. Please refer to our discussion on “How to handle short-squeeze, DIY?

In addition, since the price moves in a waveform within a channel, we should have already excluded the skyfalling stocks, advised to be avoided by many gurus.

For ordinary investors, we recommend sticking to Earning (the fundamentals) and Channel (the price movement). We developed a tool, called Earning Channel to assist ordinary investors in selecting targets and in trading based on the principles of channels.

Principle 1: Stock picking

Choose the stocks whose fundamentals match the price movements, and especially those forming channel shapes.

There are thousands of stocks, you can use the channel to quickly narrow down the candidates that could give you better profits with fewer risks. You can add earning criteria or other criteria to further narrowing down the candidates in Earning Channel. For shorting a stock, you would put criteria opposite to those you would for buy-and-hold candidates.

But how to make use of the channel to trade?

We added four trading lines and two trading points. A short line and a cover line are within the boundary of the two walls of the channel. A channel short point is reached when the price touched the upper wall and bounces back to the channel short line. A channel cover point is when the price touched the lower wall and bounces back to the channel cover line. A channel short point is the optimal timing for you to build up a short position. A channel cover point is a time for you to regulate your short position, and to take some profits.

The two lines, channel breakout upward (break-up) and downward (break-down), are used mainly to guard the trading either for establishing a long position with an up-channel or a short position with a down-channel.

Please notice that all four trading lines are related to the channel lines, and thus when the price touches these lines it has nothing to do with your personal cost. It has to do only with the cost of all participants that moves the price. The default values of these lines in Earning Channel are percentages of the channel width.

Although the trading should be based mainly on the channel and not on your personal cost, the lines could be adjusted to better suit personal conditions. For instance, when you already have a major gain, you have a better tolerance to avoid minor overshoots and undershoots, then, you may want to set the break-up and break-down line wider apart. On the other hand, if you just established or are establishing your short position, you may set the break-up tighter. In fact, for shorting, it is better to always set the break-up line tight to protect yourself from short-squeezing. Short-squeezing happens when you can’t buy back the stock you need to. It is terrifying just thinking about it.

Principle 2: follow channel trading for optimal timing.

Rule 1: A channel must have two peaks and two dips. Don’t act before a channel is formed.

Rule 2: Go away, when a channel is broken. Back to rule 1.

Rule 3: Don’t establish positions in the wrong direction. Don’t buy on the way down. Don’t short on the way up.

Rule 4: Within a channel, use channel short point and cover point to conduct shorting and covering in building up a short position.

Rule 5: Use channel break-down to take proper profits from a long-term down-channel.

Rule 6: Always use channel break-up to stop losses for a down-channel.

With the basic understanding of down-channel and channel trading, we are now ready to use them to handle bottoms.

Now let’s see what is a bottom?

  • A bottom must be preceded by a long downward trend. “A prerequisite for any reversal pattern is the existence of a prior trend.” ”A market must obviously have something to reverse.” said John Murphy.

So for our stocks that have channels, before reaching the bottom, there must be a long monthly or weekly down-channel, preferably a monthly down-channel.

  • A bottom is formed when the price movement is running out of steam. Those who already gained multiple times from shorting would be ready to cover at any slightest alert to prevent from being squeezed. When most ordinary guys already sold their stocks, and no more stock available. When the government printed and pumped in the money. When the company has a breakthrough.
  • Different scale of stocks (or index), different ways of reaching the bottoms, and different fundamentals (or economy or policy), lead to different ways of exhausting the downward movement, and thus the forming of different bottoming patterns.
  • Common bottom patterns are
    1. Head and Shoulders bottoms
    2. W bottom or double bottoms
    3. Triple bottoms
    4. Round shape or Saucers bottom
    5. V bottom

A bottom is considered completed when the price rises above the neckline of the previous head. The neckline is the connection of the two (or three) peaks of the major wave.

Head-and-shoulders bottom and W bottom are the two most common bottoms. A triple bottoms can be considered as a variation of head and shoulders. These bottoms are most common, because they follow nature laws, what goes down too low must come up, unless they are dying.

Regular bottoms also happened on the bottoms of economic cycles. Many novices are fooled by just looking at the P/E. Since at the lowest of an economic cycle, the company or an industry is losing a lot of money, the earning (EPS) is bad, so the P/E is very high or even negative. Seems like the company is dying or the world is coming to an end. But then, there is only one way to go, which is upward, when the economic cycles turn up. This is why Peter Lynch would buy the leaders in not so hot industry and wait for the recovery, or buy the leading recovering companies. Therefore, one should learn both the Earning as well as the Channel to make money in stock.

Opposite to a round top, a round bottom is more naturally formed, especially for major market or for huge companies. Because it takes time for the company (the economy) and the investors to regain their strengths from the bottom either financially or mentally. “Topping patterns are usually shorter in duration and more volatile than bottoms.” said John Murphy.

For instance, Microsoft forms a round bottom from 2001 till 2014, almost 14 years. It took really a long time for a great company and its shareholders to recoup.

A V-bottom is not unusual for individual stocks. V bottoms often happened to companies with small cap and low volatility. They could be manipulated by insiders or big players. The most unfortunate situation is to be caught in a short-squeezing V bottom.

However, when a V shape appeared in the main market, it was often caused by human interference or by government policies. It is almost like drinking poison to quench thirst. It may be good or necessary to save a burst bubble, but why then letting it becoming a bigger bubble and with greater inequality?

Maybe those in power have similar mindsets as most of big company CEO’s and high managements – do what’s better for the short term, to benefit the big shareholders, the board of directors, and themselves during their reigns.

V shapes were formed in 2003 and 2009. The V-turn in 2003 was intended to save the internet bubble. But, then why it became a bigger bubble in 2007 than in 2001? How about the even bigger one from 2009 till now? Was it just to save the subprime crises? Or, has it been exploited (controlled) by those who can get their hands on the money released by QE’s. It seems an enormous bubble has been formed for our offspring to deal with, and the new government seems to keen on making it even bigger. The major problem of the society seems to be the inequality and not lack of money.

The huge bubble affects all of us. As an ordinary guy, we have little power to impact the policy. The most important thing we can do is to stay away from dangerous when possible. There are a couple of things we can do.

  1. As the outcomes of the new policies are uncertain, and the stakes are high, major indices are really unpredictable. So, it is better to stay away from ETFs based on the indices. Even though they might have made you a lot of money in the past few years.
  2. One has better come back to the basic, to buy company stocks, as suggested by most successful masters. “Buy Wonderful Companies.” said Buffett. “Buy the company you know.” said Lynch. Buy the companies and not the market.
  3. Learn to short and earn in a regular base, and not jumping into short upon crises. Increase your arsenals and basic skills from frequent practices.

Now let’s use the channel to interpret the five types of bottoms and to see when to make a trade.

At or near the bottom, one should

  1. Buy-to-cover, and clean your short position.
  2. Buy and hold, start building up your long position.

Let’s look at the simplest one, the V-bottom, first. The V will definitely break-up the original long-term down-channel. If you have not already shorted such a stock, don’t short it. It is often the last leg and is approaching the bottom.

If you are lucky to have already shorted such a stock before the nosedive, you should take some profits at channel break-down. You should take most if not all of your profits when the price went up and back to the channel break-down line. If you still haven’t clean up your short position, please do so when the price falls back to the original long-term channel. The price broke-down like a knife, mostly likely, it will break-up like a knife as well.

If you still hesitate, you should at least clean all your position at channel break-up. The stock has become very volatile, it is better to stay away. If you can’t find better candidates to invest (which you often can using Earning Channel), just stay on the sidelines. For volatile stocks, we do not recommend to either long or short.

Please refer to “How to handle short-squeeze”.

Now let’s come back to the most common bottoms, head and shoulders, and W-Bottom.

Conventionally, a bottom is confirmed when the price breaks the neckline. However, it is hard to take a proper action using the conventional neckline, since, there are variations. For instance, a double bottoms may become a triple bottoms, and sometimes even multiple bottoms.

Let’s look at the bottoms using channels.

The channel break-up on a long-term down-channel gives a clear, and most of the time earlier, signal than the conventional neckline. Notice that, the channel break-up breaks the previous long-term down-channel, thus the reversal of the longer-term trend. One should focus if the previous trend is broken and not the recent price movement around the bottom.

In case a double bottom or a right shoulder is stretched to form multiple bottoms, the action to be taken here is still the same, to clean the short position when the price reaches the channel break-up line.

If you want to start building a long position, you should follow channel trading rule 1: wait for the forming a new channel, with at least two peaks and dips. With this protection, you will be much less likely to be trapped by bottom fishing.

Another important factor to exam the bottoms using channels is that the first bottom often breaks down the long-term down-channel. This is a natural cause, other than the round shape, for the following reasons:

  1. Most people want to get out. The last blow of desperation.
  2. The market movers or major players (insiders, institutions) want to buy it lower, and the price is reached.

Therefore, when there is a break-down near the bottom of a long lasting down-channel, it is time to take profits from the short position. In addition, when the profit is substantial, one can move the break-down line higher to have an earlier trigger for the profit taking.

Actions to take near the bottom:

  1. Cover, take profit from the short position
  2. Clean short position
  3. Stay on the sidelines
  4. Wait for a new channel to form for either up or down direction

Following channel trading the actions are as below.

1. Take major profit when the last dips break-down the original long-term down-channel.

  1. Move the break-down closer to the channel wall, when the gain is substantial.
  2. Take profit on three occasions
    1. The first time the price touches the channel break-down, cover some.
    2. Cover most, when the price broke through the break-down line, and comes back up sharply to the break-down line.
    3. Buy-to-cover some at the channel-cover-point, in case the price did not touch the break-down line.

2.Clean position

  1. When price passed through the channel break-down and come back sharply to the channel, then cover most of the position at the channel cover point.
  2. Clean the position at channel break-up line of a long-term down-channel.

3.When the price reaches the channel break up, the original channel is considered broken. When you want to buy or short, you need to follow rule one of channel trading – wait till a channel is formed. So, for a while, you should be standing on the sidelines and watch. For major market or index, you just wait. For stock, you should just look for other opportunities using Earning Channel.

4.When a new channel is formed, you can establish a new position. As pointed out by John Murphy and others.

  1. The larger the pattern, the greater the subsequent move.
  2. The minimum expectation of the upside will be the distance from the dip to the neckline.
  3. The maximum is rising to the beginning of the trend (channel).

Clearly, there is a chance to start establishing a long position.

In “What to buy now? How about Coca-Cola?” We have discussed how to find candidates for buy-and-hold, or even just range bound trading.

In the previous articles, we discussed techniques for handling long positions using channels. We also urged ordinary investors not to buy those already gain a lot (near their tops), not to buy without protection, not to buy without mechanisms, not to buy without looking at both the fundamentals and the price movement.

Since we are now discussing bottoms, when a long-term down-channel has been reversed, it represents a good chance to long. The maximum expectation is the height of the full down-channel. Of course, the real maximum is unlimited.

Still, one needs to reconfirm the opportunity with the fundamentals and to estimate if the stock may go far and high. A good candidate to long would be a company or an industry, which is clearly on a major recovery or breakthrough.

Once you confirm with the company fundamentals, then it is a good time to long when

  1. The price movement forms at least a daily up-channel (two peaks, two dips).
  2. The peak of the daily up-channel must break the long-term monthly down-channel’s break-up line.
  3. You can then start to build up a long position at the channel buy point of the daily up-channel.

Hope this discussion is useful to you.

Good luck on your investment.

The Earning Channel software, as well as the articles, tutorials and suggestions in the website and social media, are provided as tools and references to help users develop their own market analyses and make their own investment decisions. Users are ultimately responsible for the way in which they use this information to invest in the stock market. Nothing associated with the Earning Channel or the information presented in articles and tutorials should be interpreted as direct advice on buying or selling of securities.