Trading: How to trade by reading the Dow Pattern (Part 3)

How do you place your trade by looking at the Double Bottom Formation

This Double Bottom basic is the follow-up to our previous article on the Double Top pattern. Now, let’s take a few seconds of refresher with what we’ve learned about The Dow Theory so far.

Refreshing our understanding of the Dow Theory

Under the Dow Theory, a few basic rules may indicate if the Dow Pattern is forming, i.e., it tells you if it’s a good time to buy, sell, or hold — much like trying to see if it’s going to rain, the sky gets dark, the air feels humid, and clouds are forming! So, here are the 6 basic tenets of Dow Theory:

The ones that we will cater to the most during the pattern identification process are the first and second tenet. How? Let’s find out together as we go.

Double Top Pattern

A double bottom formation signals a reversal of a downtrend and the beginning of an uptrend in a financial instrument’s price. It is considered a bullish reversal pattern and is often used by traders and analysts to identify potential buying opportunities.

The double bottom pattern typically consists of two distinct troughs or low points on the price chart, separated by a peak or a brief rally in between. The pattern looks like the letter “W.”

What happens during a double bottom formation?

The key characteristics of a double bottom formation include:

First Trough (Lows): The price of the asset reaches a low point, forming the first trough.

Rally or Peak: After the first trough, the price experiences a rally or upward movement, forming a peak.

Second Trough (Lows): Following the peak, the price declines again, forming the second trough. This low is usually at or near the same level as the first trough.

Confirmation: The pattern is confirmed when the price breaks above the high point (peak) that occurred between the two troughs. This breakout is often seen as a signal that the downtrend is losing momentum, and a new uptrend may be beginning.

How to trade?

Long Position:

Traders typically enter a long (buy) position when the price breaks above the neckline, confirming the completion of the double bottom formation and signaling a potential trend reversal. This is when you place your buy. Some traders may wait for a pullback or a retest of the breakout level before entering to ensure that the breakout is valid.

Just in case things don’t work out, where do you place your stop loss? You’d usually want to put your stop loss just a bit below the second trough.

Where can you start taking profit? The key is to draw a line vertically to measure the distance between the neckline and the height of the two valleys.

In this case we can see that the distance between the two price levels is at around 11.6%. So, if you bought it at the breakthrough price, which is $13.92, then 11.6% of that would be around $15.54.

In this case, you’d be holding for shy than a month before taking profit.

Additional notes:

This trend and double top trend would usually occur within a period of at least 28 days, or around 2 weeks for each valley/mountain (because they look like two mountains).
Pay attention to trading volume. A breakout with higher-than-average volume can provide additional confirmation of the pattern’s strength. Volume should ideally increase during the breakout, signaling increased buying interest.
Assess the risk-reward ratio before entering the trade. Ensure that the potential reward justifies the risk taken.

Bottom line

The Double Bottom formation is a bullish reversal pattern, characterized by two troughs separated by a peak, resembling a “W” on the price chart.
Wait for confirmation through a breakout above the peak and enter a long position.
Set a stop-loss below the second trough.
Determine a target profit based on the distance between the neckline and the height of the pattern.
Pay attention to trading volume during the breakout, as higher-than-average volume strengthens the pattern’s confirmation.
Consider the risk-reward ratio before entering the trade.

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