CHAPTER

W-TYPE BOTTOMS

From here on out well be using M and W patterns to describe whats going on with price action. All the patterns are laid out on two pages of your reference card (which is bound into the back of the book), Ms on the left and Ws on the right. Pull it out (if you havent already done so) so you can consult it easily when you need to.

Well start with bottom formations. They are generally cleaner, clearer, and easier to diagnose than top formations. The difference lies in the underlying psychology; bottoms are created in an environment of fear and pain, quite different from the environment of euphoria and hope in which tops are formed.1 Thus we expect bottoms to be sharper and more tightly focused, to take less time and be more dramatic. Pain is, after all, a more insistent emotion than joy. Likewise we expect tops to be more prolonged affairs, typically more diffuse and harder to diagnose. Investors

Chapter 12: W-Type Bottoms

simply do not feel the need to act at tops in the same urgent manner they do at bottoms.

In the process of researching a recent project, we tested the characteristics of price patterns at intermediate lows and highs. Double bottoms and triple tops were the rule, and the time spent forming tops was greater than that spent in bottoms. This confirmed Wall Street lore that "down is faster" and agrees with what one would expect from a psychological perspective.2

Stocks rarely transition from a declining phase to an advancing phase in a crisp manner. Rather, they most often recover a bit, fall back to test support, and then rally. The pattern this process creates is called a double, or W, bottom (see Figure 12.1). The W is the most common bullish transition type, but it is not the only one. Though they are relatively rare, there are examples of stocks that plunge to new lows, turn on a dime, and rocket away. A stock making a V bottom may have stumbled across unexpected good fortune, or good news may suddenly be released, breaking the downtrend and instantly reversing the stocks fortunes. More common is the stock that falls to a new low, then trades sideways for a long time, then turns higher-"base building" in the parlance. This is often a stock that has had fundamental problems

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Figure 12.1 The ideal W, drawing. Typical W-the average stops the first rally but not the second.

Part III: Bollinger Bands on Their Own

and needs time to get its house in order. However, most frequent of all is the W bottom, a low followed by a retest and then an uptrend. This is typical of a stock completing a correction where the stream of fundamental facts about the company is not in question, where the questions are relatively minor, or where the questions are resolved in favor of the company before serious damage is done.

Ws can be formed in any number of ways, each with their own emotional color. The right-hand side of the formation can be higher than (Figure 12.2), equal to (Figure 12.3), or lower than (Figure 12.4) the left side. Each can be categorized as a Merrill pattern, and each depicts a distinct psychological pattern. Where the right side of the W is higher, frustration is the main emotion when investors waiting for a "proper retest" are left standing at the door as the stock rallies away from them. W4, W5, and W10 patterns are good examples of this. When the lows on the left and right sides of the formation are equal, satisfaction is the main emotion as investors buy into the retest without much trouble and are rewarded quickly. When the low on the right-hand

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Figure 12.2 W higher, New York Times A, 200 days. Retest at a higher level.