A test of the low is a phrase that describes one of the few ways in which the bottoming process is carried out. The completion of the bottoming process will often create a pattern, called the reversal pattern, that is easily recognisable, such as double bottom, triple bottom, rounding bottom, head & shoulder, diamond formation and V-spike. Of these reversal patterns, the double bottom is fairly common and it comes about because the market has dropped to its recent low and bounced back (which is a successful test of the low).
A test of the low is grounded on fairly sound psychological reasoning. After a market has bounced off a low, the market is still encumbered with a lot of "trapped" investors who are waiting for the market to go higher before disposing their shares. Some will sell their shares as the market inches upward while other will sell after the market has reached its apex and started dropping. The selling will gain momentum as recently acquired shares are also offered for sale. At this stage, fear will takeover and the market is well on its way to test its recent low.
On the other hand, there are also a group of potential investors who missed buying any shares when the market made its last low. These investors will begin to buy into the market when the prices started to drop closer to their desired entry level. At the recent low (or, somewhere near the recent low), these buyers and sellers will meet & their supply & demand will determine whether we have a successful test of the low or a failed test of the low.
Example of a Test of the Low
From the chart below, you can see that I have highlighted 2 recent tests of the low, other than the present test of the low. The first one was in August 2004 when the CI dropped to a low of 802, which is quite far from the preceding low of 769 recorded in May 2004. In this case, the buyers out-numbered the sellers & the prices recovered long before they reached their recent low. The next test of the low was in May 2005 when the CI dropped to a low of 860, which was the exact level of the preceding low in April 2005.
From this, we can say that the test of the low may not necessarily end at the preceding low before a re-bounce happens. It may recover before hitting the recent low and, in the case of a failed test of the low, it will surpass the recent low.
When is a Test of the Low successfully completed?
I would considered a test of the low successfully completed when the index recovered above the 20-day MA. If you want to be more stringent, you may want the index to surpass the preceding high. So in the example of the test of the low in August 2004, the 20-day MA is 828 while its preceding high was 858. For the test of the low in May 2005, the 20-day MA was at 885 while its preceding high was at 906. The current test of the low would be deemed successfully completed if the CI can surpass its 20-day MA at 920 level or its recent high of 928.
Can you buy at lower level before a Test of the Low has been successfully completed?
Yes, you may buy at (or, near) the recent low but you need to exercise good money management & "cut loss" if the index dropped below the recent low by a pre-determined percentage.
Chart: CI's weekly as at July 17
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