A trading set-up: Bottom-fishing 📉🎣📈

For quick trading profits and/or to add long term positions on the dip

Photo by stephen momot on Unsplash

Bottom fishing trades occur when stocks drop sharply. Before we bottom fish, we need to ascertain a few things:

  1. What causes the drop? Is it caused by economic, political, industry or company-specific news?
  2. What are the segments/companies that are affected by the news? How significant is the impact (impact to revenue/profit and time period of impact affected)?
  3. Or, is the drop a FUD (fear, uncertainty and doubt) that traders, leveraged trades, weak hands and noobs selling/profit-taking and it causes a stampede to exit (herd mentality)? Are people panicking about the price drop and just selling without knowing how the news affects the companies?

Search for collateral damage to bottom-fish

A good opportunity to bottom fish is to identify high-quality companies whose share prices fell more due to FUD and panic-selling/profit-taking (analogous to the “baby” that got thrown out together with the bathwater) than the news actually posing a material impact on their long term potential. The market is “inefficient”. It is time to buy low. Here are examples of such situations:

  1. Financial results: The company misses the expectations by a small percentage, yet the share price plunged.
  2. Accidents and recalls with no long-term impact and we expect the company will learn and improve
  3. Introduction of governments’ policies and regulations that have little or no impact
  4. Minimal or no impact due to the announcement of economic data
  5. Minimal or no impact due to changes in interest rates, inflation, currencies, bond, oil, commodities, etc.
  6. Minimal or no impact due to some political news (change of government. political tensions/wars)

I will identify the less affected great companies to bottom fish to add for long-term hold or a quick trade. I will validate the impact of the situation on these companies with their earnings results, and earnings outlook and compare them to their competitors to ensure their sustainable competitive moat.

Do we have an edge?

Many may focus on the companies that are directly affected by the news as their share prices have fallen much more and look cheap. The question is whether we understand the extent of the actual damage to the financial performance of companies better than the market. Do we have an edge? Do cast the net wider and further in considering companies to buy and evaluate the risk-reward of the trades.

After identifying the companies, I would look for 3 technical signals with examples in the later part of the post for opportunities to bottom fish.

1. Price supports with Volume Profile indicator

The Volume Profile will show the price range where the stock was most traded within a period and where demand and supply concentration is. These are the price range where most buyers are holding and act as possible support levels. It is more reliable and accurate compared to a simple support line.

2. 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 is able to (a) absorb the selling and (b) strong enough that bid up the share prices to buy more shares. Reversals can be caused by some positive news. Hence, the resulting effect will be bullish candlestick patterns such as hammer and bullish engulfing as signs of reversals.

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 loss 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.

3. Signs of oversold with technical indicators

Technical indicators can be used to assess the extent of oversold and whether it is due for a rebound. I mainly use Culter’s RSI* for simplicity. I would look for the extent of the oversold. Sometimes, I will use MACD to further confirm especially when the pullback has been deep and prefer more confirmations.

To ensure the reliability of the technical indicator, I would validate how the previous lows of RSI/MACD in various time frames (daily or weekly)** would coincide with the lows and the subsequent rebounding of the share price.

* 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.

** 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.

Time frames

I would toggle between daily and weekly time frames. When the news/incidents are deemed to have a serious and macro impact and stocks are having a nasty prolonged fall, signals on a longer time frame (weekly) are more reliable.

It will be great to have all the 3 signals happening. Sometimes, we may not have all the 3 signals happening. We may not have 2 signals and 1 signal quite close and we do want to lose the opportunity to add a great company on a dip. So, if we set a rule to buy $x when we have 3 signals occurring, we have may $0.8x in a less than perfect situation.

Using technical analysis

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 already reflects all publicly available information and news. It attempts to understand the market sentiment behind price trends by looking for patterns and trends,

Not 100% reliable

Unexpected news and events can come in drips and can twist and turn which can affect share prices. Other factors may come along later that exacerbate the crash further. Our thesis can be incorrect too that the news/event does have a much more impact than we first anticipated.

  • If we are still convinced that we are right, continue to add at lower prices when the opportunities of the set-up arise.
  • If we turn out to be wrong, sell.

Example 1: NASDAQ

Above is the weekly NASDAQ chart from 1995 to 2022. We use 2 criteria to look for bottoming: (1) MACD < 0 and (2) RSI < 30%. The blue vertical lines show those that meet the 2 criteria. It does act as a reliable signal that it was the bottom or near the bottom. A more specific entry point can be done using candlesticks and trading volume.

As explained in the earlier section, it is not 100% reliable. See the first 3 vertical lines drawn between Dec 2000 to 2001, it was not reliable and was exacerbated by September 11 (2001) attack and the Enron scandal.

Example 2: 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.

TTD, daily chart (TD Ameritrade)

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.

TTD, weekly chart (TD Ameritrade)

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 2 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 the rise in interest rates and the fall was exacerbated later due to its earnings and announcement of share split which should not be a concern at all.

Low can get lower and we know the “real” low after the rebound (hindsight is 20/20). If we are convinced that the stock is right, we must be prepared to average down if need to. I first added at USD 70 before adding again at USD 49.

Example 3: 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.

SHOP, daily chart (TD Ameritrade)

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 a good opportunity to add as evidenced by the Volume Profile indicator.

SHOP, weekly chart (TD Ameritrade)

The share prices hovered around the support, attempted a few times to go up but fell back to support. A weekly bullish candlestick was formed before a good run.

Again, we may have entered earlier. As it is a great company and we entered at support, it will be fine.

Example 4: Topchoice Medical (SSE: 600763)

It is China’s leading dental hospital operator; listed on Shanghai Stock Exchange, China.

Topchoice Medical, daily chart (aastocks.com)

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.

Topchoice Medical, weekly chart (aastocks.com)

The weekly chart shows significantly high trading volume as the stock fell with the volume peaked at the bottom. At the price support, a bullish candlestick (hammers) appeared at a bottom where it reversed and rallied.

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, rebounds can take weeks or months to happen.

Be patient, don’t get too excited.

We can also get fearful as we are unsure how the future will unfold. We become unsure and keep setting lower price levels arbitrarily as the share price falls. Here, we have to build our conviction in the companies and our trading approach.

When to exit

When trading, I would take profits when the set of signals shows up in a reverse manner:

  1. Volume Profile Indicator shows resistance
  2. Bearish candlestick patterns
  3. 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 set-up to add to a long-term position as shown below.

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