The market you’ve been following just tanked. It’s hit a new low. But now, you see a glimpse of a potential rebound. It looks like a significant decline, but still, there’s no way to guarantee that it’s the bottom you’re looking for. As you know, one of the riskiest things to do is to predict bottoms and tops. Yet getting in on a position near a bottom (going long) or a top (going short) is the only way not to miss out on a significant portion of a trend reversal – or so they believe. In this case, thinking that this might be The Bottom, what might you do?
There’s Nothing Wrong with Bottom Fishing (just don’t get eaten by the fish)
“Bottom fishing” is a nice metaphor. And in a market context, the fish will devour you if you fall off the boat, proverbially speaking. Another metaphor describing this phenomenon is “catching a falling knife.” You don’t want to do that unless you’re a longer-term investor who doesn’t mind getting nicked here and there amid a dollar-cost-averaging strategy.
But as a trader, you want your long entries to be tight and precise. And that’s what “bottom fishing” is all about. So, that’s what we’ll cover–a sound method for catching a market when it appears to be bottoming out.
The Bottom Fishing Trading Method
The Bottom Fishing method is geared toward the long side of a trade. It works best when the longer-term trend is up, meaning that it can work exceptionally well after pullbacks or major corrections.
A Note on Stop Losses When Bottom Fishing
When bottom fishing, we’re looking for a certain type of Double Bottom.
- If you place your stop loss below the first bottom, you’re likely to sustain a deeper loss (so you compensate by taking on a smaller position size depending on you % risk). But your return rate may also be greater.
- If you place your stop loss below the second bottom (a higher level), your likelihood of getting stopped out may be greater and your performance numbers may not be as profitable as it might be with a deeper stop loss.
The rationale behind bottom fishing is that the lows in a declining market are failing to break lower. The second “retest” of the low is failing to match the level of the first swing low. So, you end up with a W in which the second low is higher. What it means is that sellers are beginning to drop out, and buyers may be entering the market, possibly reversing the trend.
A quick snapshot of what you’re looking for:
That’s the model. Here’s what it looks like in the live market. Note how reality can vary from the model. This example in the GBPJPY took several days between lows.
GPBJPY Daily August 15 to December 20, 2019
In the AUDCAD, the second low wasn’t very pronounced, and it falls between the categories of a V and W bottom. However, the second low gives you enough room to justify a trade setup.
AUDCAD Daily January to June 2020
CNYUSD Daily August 2019 to January 2020
The CNYUSD isn’t a very liquid currency pair to trade. But if you’ve been following the US-China trade tensions, the fundamentals might have given you enough confidence to trade this pattern. The technical setup would’ve made for a nice tactical setup.
Now that you know what to look for, the next thing you probably want to know is how to trade.
Setting Up Your Bottom Fishing Entry
Step 1: Find an ugly double bottom
We just covered a bunch of them. Let’s use our first example.
Ugly enough? We see one bottom followed by a second. In real-market cases, the bottoms can be closer or further apart. It doesn’t really matter, as long as you can identify two bottoms. The next part is critical with regard to this particular setup.
Step 2: The Second Bottom is Higher than the First
For the sake of the setup, we’re looking for a second bottom that’s 5% to around 20% than the first. Although the best test results come from this range, in some cases, the second high maybe even greater than 20%. You have to determine this using your own judgment–whether the reward is worth the risk.
What we’re looking for in this second low is an indication that selling pressure is being canceled out (or overpowered) by buying pressure.
Step 3: Calculate the height of the chart and determine your price target
- The first low [A], is the bottom of the pattern.
- The high after the first low [C], is the top of the pattern.
- The second low [B] indicates that buying pressure is more prevalent than selling pressure; it also serves as an alternate stop loss (for those that choose this level for a stop).
Calculate the height between A to C. You have to decide the multiple of this height (75%, 100%, or more) based on the technical or fundamental factors you see before you (resistance ahead, fundamental conditions, etc.) in order to decide which multiple you want to use. In other words, you have to use your discretion to customize your target.
Add your preferred multiple to C to get your price target for the completion of this candlestick pattern.
Step 4: Place your entry order, take-profit order, and stop-loss
- Trade entry should take place once the price action has closed above [C].
- Once you’ve entered your position, place an order to sell at your target.
- Place a stop loss at the bottom of your pattern [A].
- Alternatively, you can place a stop loss below [B], but be aware you may be stopped out more frequently than if you were to place a stop below [A] which, if violated, cancels out the pattern.
Step 5: Complete the Trade
The last part is pretty easy. Allow your trade to complete itself at a profit or loss. Hopefully, you’re allocated the right percentage of risk to your position, not more or less. If your target is 100% or more the height of the pattern, then you can consider either raising your stop loss to [B], or close to a breakeven point to limit your losses. At this point, you’re on your own, but at least you have several options for managing your trade.
Let’s look at this trade from a real market scenario, using some of our examples above.
Example – GBP/JPY Trade
The height of the pattern between [A] and [C] = 9.10 (or 910 pips). You would add this to the top of the pattern at [C], or 135.74, to get a target of 144.85.
You enter a long position at the close of the breakout candle at 137.11. Since your target is 100% of the pattern height, you exit your trade at 144.85 for a profit of 7.74 to 774 pips.
Example – AUDCAD Trade
Similar to the example above, you enter the trade at the close of the breakout candle at 0.8718. You exit at 100% of the pattern at 0.9315 for a profit of 597 pips.
Example – CNYUSD Trade
By now, you probably get the picture.
The Bottom Line
Bottom fishing trading is essentially an attempt to time the market. And one thing that’s certain is that most traders and investors are unsuccessful timing the markets. But what matters is not necessarily your win rate, but that your positive payoffs are greater than your losses. In other words, you can lose several times but make back your losses and hopefully more on fewer wins. And although there are many different ways to ‘bottom fish,” this technique is one sound way to keep your setup objective, measurable, and flexible enough for adjustment, should the situation (technical or fundamental) call for it.