For quick trading profits and/or to add long term positions on the dip
Yes, it is not possible to time the bottom reliably. Nobody has the crystal ball to predict the market well. Unexpected events bring the market further down.
Technical analysis is a study of supply and demand forces as reflected in the market price movements of a stock. It assumes that the stock price reflects all publicly available information and news; and it attempts to understand the market sentiment behind price trends by looking for patterns and trends.
An alternative approach would be Dollar Cost Averaging (DCA). Here, the investor divides up the total amount to be invested across periodic purchases of a target asset to reduce the impact of volatility on the overall purchase. It aims to avoid making one lump-sum investment that may be poorly timed (i.e. timing the market).
We can DCA in several ways:
- Invest a fixed capital within every predefined period; buy $x every month
- Invest a fixed capital with every % or dollar drop in the market; buy $x whenever the share price drops x% or $x
- Invest a fixed capital whenever there is a technical signal
Alternative 3 is what we will cover in this post. What we are aiming for is not to get to the bottom but near the bottom; with better average cost prices than the other alternatives.
Do read this related post: Market crashes are opportunities not to be wasted!
Here are four technical approaches to finding the market bottom.
1. Signs of oversold with technical indicators
Technical indicators can assess the extent of oversold and whether it is due for a rebound. I mainly use the weekly* MACD and Culter’s RSI**. The criteria are:
- Weekly RSI < 30%
- Weekly MACD Signal < 0
Depending on the extent of the oversold, MACD can be used as a confirmation, especially when the pullback has been deep and additional validations are preferred.
To ensure the reliability of the technical indicator, I would validate how the RSI/MACD signals in various time frames (daily/weekly/monthly) would perform with the lows and the subsequent bottoming and rebounding of the share price.
* I am more of an investor than a trader. I prefer swing trades on longer time frames (daily and weekly) and can be less precise on my entries and exits.
** Cutler’s RSI is calculated based on a simple moving average of the upward change (U) and downward change (D) instead of the exponential average. The RSI used in most charts is Smoothed RSI.
Example: Hang Seng Index (HSI), monthly
Below is a 30-year monthly chart of the Hang Seng Index. Due to Covid restrictions, China tech clampdown, the debt issues of China property, etc., HSI has fallen more than 50% from the high to 2009 levels breaking long-term support at 18,240. Using the monthly RSI and MACD criteria, the signals (the blue vertical lines) have appeared for the fifth time and have been fairly accurate.
Example: Nasdaq Composite, monthly
Below is a 30-year monthly chart of the Nasdaq Composite. Due to the huge rally duing Covid and the several interest rates increases thereafter to fight the inflation, the index fell about 35% from the high. Using the monthly RSI and MACD criteria, the signals (the blue vertical lines) have appeared three times and have been fairly accurate..
2. Price supports with Volume Profile indicator
The Volume Profile will show the most traded price range. It is more reliable and accurate compared to the support and resistance lines.
Example: Shopify (NYSE: SHOP)
An e-commerce company based in Canada that offers online retailers a suite of services including payments, marketing, shipping and customer engagement tools.
The support at USD 1,000 has been well-tested and previously a resistance level. As it hit USD 1,450 and fell to USD 1,000 (a fall of 31%), it is an opportunity to add; indicated by the Volume Profile indicator.
The share prices hovered around the support area, and attempted a few times to go up but fell back to support. A weekly bullish candlestick was formed before a good run.
Example: The Trade Desk (NASDAQ: TTD)
A global technology company that markets a software platform digital ad buyers use to purchase data-driven digital advertising campaigns across various ad formats and devices.
It fell from a high of USD 96 to the price support of USD 50; a drop of 48% in almost 5 months. Daily RSI hit a low of 30.
Bullish weekly candlesticks appeared at the bottom. Trading volume was the highest as it bottomed and rebound; a sign of capitulation.
As shown in the daily chart, there were two previous price supports with oversold RSI that we may have entered. The fall was caused by a general correction of US technology stocks due to rising interest rates and exacerbated later due to its earnings.
Low can get lower. We know the low after the rebound (hindsight is 20/20). If we are convinced that the stock is unfairly punished, we can average down. I first added at USD 70 before adding again at USD 49.
4. Signs of reversal with bullish candlestick patterns
While share prices may have fallen to support levels, it may not mean they will do a U-turn and rebound. Reversals occur when there is strong buying interest that can (a) absorb the selling and (b) strong enough that bid up the share prices to buy more shares. Reversals can be due to unexpected good news. Hence, the effect will be bullish candlestick patterns such as hammer and bullish engulfing as signs of reversals.
Example: Topchoice Medical (SSE: 600763)
It is China’s leading dental hospital operator; listed on Shanghai Stock Exchange, China.
In a widespread market correction after a strong rally, it fell from a high of RM 390 to the price support at RMB 230; a drop of 41% in 2 weeks. Daily RSI hit a low of 30 which was hit about a year ago. It is also lower than the previous lows seen in recent months.
The weekly chart shows significantly high trading volume as the stock fell with the volume peaking at the bottom. At the price support, a bullish candlestick (hammers) appeared at the bottom where it reversed and rallied.
4. Moving averages
Adam Khoo uses 3 criteria to determine market cycles. For bull market and using the daily chart,
- The index market is up 20% from the low.
- The market closes above 200MA and slopes upwards.
- The 50MA crosses 150MA from below and they are flat or going up.
When any criteria is met, he starts to add. He does not wait for all the criteria to be met as it can be much higher by then.
Watch his video for the explanation and examples: The Bull Market Has Begun
Trading volume as an added signal
Usually, the trading volume tends to drop as the share price drops. During reversals, investors will become fearful as the share prices drop and their losses widen. Many give up hope, get capitulated, cut losses and sell. An increase in trading volume during a reversal is a bullish signal. Depending on the impact of the news and investing/trading timeframe, we can toggle between daily or weekly candles.
Time frames
I would toggle between daily and weekly time frames. When the news/incidents are deemed to have a serious long term impact and stocks are having a nasty prolonged fall, signals on a longer time frame (weekly and monthly) are more reliable.
Not 100% reliable
Unexpected news and events can come in drips and can twist and turn, affecting share prices. Other factors may come along later that exacerbate further. Our thesis can be incorrect; the news/event has a greater adverse impact than we first anticipated.
- If we are still convince that we are right, continue to add at lower prices when the opportunities of the setup arise.
- If we turn out to be wrong, cut loss and sell especially if we have bought speculative and poor-quality assets.
Use a few approaches
Use more than one approach for more confirmations. It also helps to stack our buys as there are more signals.
Backtesting
Backtest the technical approach to validate their reliability. They do not work all the time and on all charts. Backtesting for their reliability will build up our confidence and convictions of our tools.
Be patient, stay calm and wait for the opportunities to bottom fish
Patience is a competitive advantage.
As we are interested to buy when stocks are down, we can get excited or fearful. Be patient and calm to avoid making any unnecessary behavioural mistakes. One way is to develop a trading plan when the market is closed.
We can get excited when the companies we have been waiting to buy start to fall. We skip the signals and rush in to buy. Depending on the severity of the sell-off, it takes time to settle down before a rebound happens. As shown in the examples above, bottoms can take weeks or months to form. Be patient.
When to exit
When trading, I would take profits when the set of signals shows up in a reverse manner:
- Volume Profile Indicator shows resistance
- Bearish candlestick patterns
- MACD/RSI showing overbought signals
As I am more of a long-term investor, I may trim some and hold the rest or just hold the entire position using the trading setup to add to a long-term position as shown below.
