Last Updated on 17 November, 2020 by Samuelsson
There are many types of chart patterns out there that are used by traders to predict the future movements of a market. Often they resemble some type of geometrical shape or form in an attempt to point out market tops and bottoms. Others make use of definitions that try to quantify the market psychology that occurs around market tops and bottoms. The double bottom is such a trading pattern!
A double bottom is a bullish reversal trading pattern that consists of two market bottoms that form around the same level, which are followed by a breakout to the upside. In other words, the double bottom is a bullish reversal pattern that forms in an ongoing bearish trend.
In this guide to the bullish double bottom pattern we are going to cover all the essential aspects of the pattern, and then some more!
Here are some things you’ll get more familiar with:
- How many traders trade double bottoms
- The psychology behind the pattern
- Some notes on the reliability of double bottoms
Having so much to cover, it’s time to get started!
What Is the Double Bottom Pattern?- Definition
Like we mentioned briefly above, a double bottom signals that there is a change going on in the market, from bearish to bullish market conditions. The pattern is typically quite easy to identify once you’ve got the hang of it, but it may still be beneficial to go through the conditions in more detail. After all, there some things worth noting!
Below we cover the anatomy of a double bottom. You may reference the image above where each point has been marked for convenience.
- The first bottom: The first bottom forms the lowest bottom of the on-going bearish trend to date. At this stage, you see no signs of a double bottom forming, since the new lower close blends in perfectly with the prevailing bearish trend. Typically, market sentiment is bearish, but there is some room for positive swings as the security has become quite oversold. This leads us to the next part of the pattern…
- The trough: Having become oversold, the market now bounces back and recovers some of the losses of the last period. A common number that’s often mentioned when determining an optimal size of the trough, is around 10%-20% between the low of the first bottom and the peak of the trough. This makes sure that we have a real, visible dent that’s big enough for many people to notice, while it’s of a size that won’t offset the meaning of the pattern going forward.
- Another Bottom: With the market having performed the trough, most people now expect that the bearish trend is going to continue, in line with the preceding bearish trend. This assumption holds true as the market turns around and heads towards the previous low. However, unexpectantly it stops around the same price as the previous bottom and reverses. This shows that the first bottom is now acting as support, which in turn tells us that buyers have started to become stronger. This is a positive sign!
- The upturn: With the market having shown strength, more people are becoming convinced that there might be some positive price swings worth catching going forward. As such, buying pressure increases, and drives the market upwards.
- The Breakout: This is the final part of the double bottom pattern, where we see a breakout above the high of the trough, which acts as a resistance level. In essence, the breakout acts to confirm that bulls have finally won the fight, as bears didn’t have the strength to keep the market from advancing past the resistance level. If the market doesn’t fall back quickly below the breakout level, we’ve had a double bottom pattern according to the original definition.
The Direction of the trend
In addition to the pattern itself, it’s worth noting that there needs to be a bearish trend to turn around for the pattern to occur.
According to the original definition, there should be a clear uptrend that should have been on-going for some time. This is to increase the chance that we’re entering trending market conditions, where there is a bigger chance that the coming bearish move will be of significant size.
The Psychology of Double Bottoms
We have already included some details about how market players may reason as the pattern forms, and how it can impact and actually lead the market forward. Just keep in mind that every scenario is different, and that it’s always hard to know exactly what made a market move as it did.
Nevertheless, the most important psychological aspects are the breakout that occurs at the end, and the fact that the second bottom doesn’t go lower than the first low. Both simply show how bears retreated and made room for bulls to enter the scene.
Do Double Bottoms Work?
The most important question you should ask yourself before trading any pattern or strategy, is if it actually works, or just is a figment of one’s imagination.
In general, different types of patterns in technical analysis don’t work that well when just implemented on a random market and timeframe. In other words, you’ll have to find the conditions in which a pattern works before making any decision.
This, of course, applies to the double bottom as well, and the best way to find out if it works with your setup is to study its past performance. Either you choose to manually point out those times when a pattern occurred in the past, or you make use of backtesting to quickly receive a report on the pattern’s historical performance.
Here follow some important tips when it comes to validating and testing the historical performance of any pattern!
1. Remember that definitions vary
Keep in mind that many trading patterns won’t live up to the exact rules of their original definition. As such, the process of finding patterns can be highly arbitrary, which means that the results you get may vary a lot depending on which patterns that meet your conditions, and which ones that don’t.
Keep in mind that it can be very tempting to rule out patterns that weren’t profitable with the advantage of hindsight. However, in reality, it remains highly likely that you would have taken those trades anyways, which is a fact that could render your performance statistics useless!
2. Scroll the chart!
To not rule out trades solely based on that they turned into losers, try to make sure that you never see the moves that followed the pattern, before you decide whether it should be included or not.
This rules out those instances when you unconsciously decide to not include one occurrence just because it turned out to not work well. In other words, scroll the chart and stop as soon as you spot a new pattern. As soon as you’ve decided whether to take or leave the trade, you may scroll on and see the outcome!
3. Backtesting definition
Those of you who are using backtesting to detect historical patterns will have to come up with a rules-based definition of the pattern. Even though it might sound like a more reliable method, it’s very hard to come with a definition that works well consistently, and manages to detect the patterns in a reliable manner. This is a major concern that must be considered carefully!
Another consequence is that you need to be very careful with external data about the performance of any trading pattern. Since there are so many ways you could define one single pattern, the data provider might just have tried countless combinations of rules until he stumbled upon something promising. In other words, in such a case they’ve just curve fit the rules.
How to Trade Double bottoms
Having covered the basic definition, psychology, and whether the pattern is reliable, let’s now look at how some traders choose to incorporate the double bottom pattern in their trading. There is especially one tweak that is considered vital in order to remove as many of those signals that aren’t reliable and only would result in losses.
Let’s have a look at it!
Step 1: Identify the emerging double bottom
Identifying the double bottom should, in theory, be done easily with the help of the criteria you’ve been presented with. However, in the heat of the moment, you don’t have the benefit of hindsight, which will make it somewhat more difficult.
Step 2: The Retest
Once the double bottom has been finalized, we’re adding one more condition to improve the accuracy of our trades.
The extra step involves waiting for the market to retest the breakout level. If it holds, it shows us that buyers still remain strong, and are ready to fuel the coming positive trend.
The image below shows this very setup.
Ways to Improve Double Bottom
Now, with this covered, we wanted to show you some extra tips to deal with false signals. These are techniques that we have used successfully in a lot of our own trading strategies, and that we believe can work well with the double bottom pattern as well!
Let’s look closer at them!
1. Comparing lows
If we go back to the original definition of the pattern, it was the fact that two lows occurred around the same level, that gave us the hint that the bearish forces weren’t strong enough to cause a further decline in the market.
With this in mind, a case where the second bottom even recovers earlier than the first bottom, would indicate an even more bullish market state. At least that’s the way some traders choose to interpret such conditions!
The image below shows an example of such a case, where the first low was lower than the second one.
2. Volume patterns and conditions
While a double bottom by its original definition is helped by declining volume throughout the pattern, this doesn’t prevent us from adding more conditions related to volume, to help improve the hit rate.
One example of a common application of volume, conditions is to demand that the breakout which finishes the pattern, is carried out with an extra burst of volume. That way we can become a little more secure that a majority of market participants took part in the move, and are going to support the longer-term market move that might form.
Another approach could be to watch how the volume develops around bottoms and peak. In case there is a lot of activity seen around the lows, with the second low being formed with less volume than the first one, a lot of traders will choose to regard that as a sign that the trend might actually revert soon!
In the image below you see an example of a setup:
3. Adding extra distance to the breakout level
In breakout trading, the biggest concern traders face, is false breakouts. And considering that the double bottom pattern includes a breakout, this is one of the major issues we’ll be facing here as well.
Earlier we discussed how you may use a revisit to the breakout level as confirmation, to help mitigate this issue. Another common approach that’s used by many, is to add some distance to the breakout level. With the added distance, the market is given more room to carry out its sometimes random swings, and will, therefore, be less inclined to hit the breakout level due to random swings.
To calculate the distance you should be adding, one common approach is to use a multiple of the Average True Range. That way you adapt the breakout distance to the current situation with regards to market volatility, which could be quite beneficial in many cases!
Bearish Double Top
The double top is an inverted double bottoms pattern and signals the end of the current bullish market trend.
Our article on the double top pattern covers this pattern in-depth!
In this article we have looked closer at the double bottom pattern and how many traders choose to make use of it in their trading. In addition, we’ve covered more techniques that you may use to improve the hit rate and performance of the pattern!
Now, as a final note, we’d like to one more time put emphasis on the importance of never taking anything in trading for granted. It’s essential that you always perform your own tests, to ensure that the methods you rely on actually have an edge. Unfortunately, many traders never come this far, and continue to trade losing trading strategies as a result!
Here are some great resources if you want to learn more about building your own trading strategies, and becoming a profitable trader!