Japanese candlestick patterns can be useful to identify potential price reversals. Previously in this column, we discussed bearish reversal patterns. This week, we discuss a two-candlestick bullish reversal pattern called tweezer bottom.
Asymmetric payoff
The first candle in a tweezer bottom is a bearish candle. The second candle has a same low or near-same low as the first candle but closes higher. This indicates that the bulls may be fighting to regain control, pushing the stock up from its day’s low. Note that a green candle (read bulls) only indicates that the closing price is greater than the opening price. It will be difficult to determine after a trading day whether the high or the low formed first.
As with any trading plan, you must have three price points to initiate a trade. In this case, the entry price must be the high of the first or the second candle, whichever has a higher high. The stop loss is the low of the first or the second candle, whichever has a lower low. Your price target can be 38.2 per cent of the Fibonacci retracement of the previous downtrend or an immediate overhead resistance level, whichever is lower. Absolute gain per share can also be used as a price target.
You must consider the following before initiating a trade: First, the bullish reversal will be more effective if you observe a series of bearish candles- five to seven red candles. The last bearish candle becomes the first candle of the tweezer bottom pattern.
Second, a tweezer bottom can come in several variants. For instance, it can be a hammer or an inverted hammer. A hammer lends more confidence than an inverted hammer. The strength of the intraday break on the third candle before you initiate the trade is important. For instance, a rising window (gap-up) or high volumes.
Third, the trade is best initiated with near-week and near-month options than with futures. This is because options have asymmetric payoff; the maximum you can lose is the option premium. You could setup a bull call spread if you can identify a strong resistance level. Your long call can be the immediate out-of-the-money (OTM) strike, and the short call should be one strike above the resistance level.
Fourth, going long on a call is preferable to going short on a put. Note that an entry into the trade is based on the underlying breaking the higher of the two candles intraday, not on a closing basis, as the trade is setup to make small gains in quick time. This exposes a short put position to high risk, as the underlying can reverse quickly and continue its downtrend.
Best bet
Trade is best initiated with near-week and near-month options than with futures as options have asymmetric payoff
Optional Reading
Using a Fibonacci retracement as price target is optimal when the downtrend prior to the bullish reversal is sharp. Note that you must read the underlying’s price chart for trading equity options and the futures price chart for trading index options.
(The author offers training programmes for individuals to manage their personal investments)