During market downturns, investors and traders alike strive to identify the end of a downward movement and the formation of a bottom on the charts in order to buy assets at the best price. Such an approach is entirely rational, as it can yield significant additional profit. However, determining the local minimum can be quite challenging. How can you tell when stocks have bottomed out and it’s time to buy?
Why Search for the Market Bottom?
The task of buying stocks at the bottom is quite complex. Why then do investors and traders attempt to solve it when it’s much easier to enter the market during an already established upward movement? For those working in the long term, there may not be much sense in this. However, for traders and investors aiming to maximize profit in the short term, entering at the bottom is indeed crucial.
How to Find the Bottom
Understanding when stocks have bottomed out can be quite challenging. However, this task cannot be considered unsolvable. A comprehensive approach and the application of various analysis methods will help find the best entry point.
Fundamental Analysis
The objectives of fundamental analysis in searching for the market bottom depend on the asset the investor is working with:
- Stocks at the bottom are usually either undervalued or demonstrate values of key multiples below historical averages or industry averages. Therefore, it is worthwhile, for example, to calculate the current values of P/E or EV/EBITDA. However, drawing conclusions solely based on calculation results is incorrect; it is necessary to analyze what led to such a decline.
- Stocks may demonstrate abnormally high dividend yields.
- Discrepancy between the dynamics of stock prices and the company’s performance. It often happens that due to changes in the economic situation, product prices are already rising, while stock prices continue to decline. Such divergence can also be a good signal of an imminent change in direction.
Fundamental analysis does not allow determining whether the bottom has been reached and whether it is time to buy securities. However, it allows judging the emergence of prerequisites for a reversal.
Technical Analysis
Unlike fundamental analysis, technical analysis allows for pinpointing the exact moment to enter the market. Of course, receiving a buy signal at the bottom does not guarantee that a reversal has already occurred and that prices will not return to the minimums or move to explore the next bottom. However, utilizing these signals, firstly, allows for profit even during a short-term upward impulse, and secondly, even in the event of a negative development, significantly reduces the drawdown of the deposit.
Signals indicating the achievement of another bottom by the price chart include:
- Renewal of historical or recorded at a significant historical period (e.g., multi-year) lows. Such levels are usually considered by market participants as powerful support levels. This is based on a logical assumption: if an asset has not been priced so low for a long time (or ever), it is unlikely to remain priced so low. The probability of a rebound from strong support is quite high.
- Touching or breaking through the 200-day (week) moving average. Most market participants are well aware that the likelihood of a rebound from it is much higher than the likelihood of its confident breakthrough. Therefore, many use this moving average as dynamic support.
- Formation of a double bottom. The double (and generally multiple) bottom is considered a classic reversal pattern. Therefore, starting to “catch” the bottom after the formation of the second trough is a quite rational decision. Of course, the risks are quite high, but this approach allows limiting them by using a short StopLoss.
- Signals from oscillators indicating entry into oversold territory. This works best on higher time frames (daily and above). At the same time, it is better to use boundaries of the oversold zone empirically determined on historical data rather than those recommended by the developer.
- When trading intraday, a significant and rapid drop with simultaneous volume increase. This often indicates the triggering of margin calls on large positions. As a result, margin trades are closed, and in many cases, the stops placed by traders are triggered. For some time, the market’s ability for sellers to further push the price down significantly decreases. This is a good moment for buyers who can make a substantial profit in a very short period of time.
Sentiment
Analyzing the behavior of market participants or sentiment also allows conclusions to be drawn about the price reaching the bottom. Although capturing the market sentiment can be challenging, with experience, the probability of achieving positive results steadily increases.
Indicators of approaching the bottom include:
- News background and expert reviews. The closer the asset is to the bottom, the more negativity there is in the information space.
- Increasing demand for defensive assets. For example, as the American market and its indexes (S&P 500 and NASDAQ 100) approach the lows, investors are increasingly buying gold and treasuries.
- Imbalance in the perception of positive and negative news. Positive news is almost unnoticed by market participants, while negative news triggers an overly intense reaction. This indicates the onset of the period of greatest pessimism, which is likely to be followed by growth.
- Consolidation at lows before the release of news or reports. In many cases, released data turn out to be better than pessimistic forecasts, and the price rebounds.
- Divergence between market movement and individual stocks. Cases where, for example, the stocks of many companies in the sector have already begun to rise, while some are still falling, are not uncommon. At this point, it is essential to ensure that all reasons for the decline have already been considered, and the upward movement of leaders is only due to increased market interest in them. Then the falling stocks have every chance of giving a sharp upward impulse.
Don’t Forget About the Risks
Opening a position at the bottom and making significant profit in one trade is a very attractive prospect. Often traders who are confident that the price will no longer decrease enter a long position with substantial funds, and using leverage is not excluded.
However, it is worth remembering that buying stocks at the bottom often leads to a double bottom scenario.
To avoid ending up in a substantial drawdown and incurring significant losses, it is essential to use strict risk management rules.
- Clearly outline actions in the trading plan in case of negative developments. Set a Stop Loss, consider averaging down, tolerate drawdowns – any options are acceptable as long as they do not lead to complete capital loss. However, each of them should be planned in advance: at what level to set Stop Loss, where and with what volumes to average down should be decided before opening a long position.
- Equally important is to precisely plan behavior in a positive scenario. Should you close the position when a certain profit level is reached? Should you hold it until strong target levels or use Trailing Stop? These questions should also be answered by the investor before entering the market.
Overall, those who want to find the bottom in stocks or indices should conduct thorough comprehensive analysis and summarize all the arguments indicating the achievement of the minimum and the potential for opening a long position. If enough evidence is gathered, the decision is likely to be justified. If the opinion is based only on one signal, the trader is likely to mistake wishful thinking for reality. However, even with a well-founded decision, it is essential to consider potential risks and plan protective measures.