As technical analysis traders, we look at chart patterns (showing price against time) in order to make our trading decision. We react to whatever the market does.
This week we’re going to offer you some advice on how to identify and trade what we call
How To Identify a DOUBLE TOP
A double top is found at the end of an up trend. We are looking for an “M” shape on our chart where we can see that the price has peaked twice. Basically, the market has come up to a certain area, tested a range, found resistance and has bounced back down to a support area. The price then reverses back up again to the same area of resistance as the previous top. After this, the price gets rejected again from that area and retreats back down to the support area. Once the price has dipped down below that initial support area (i.e. the middle of the “M”), our double top is confirmed. The “M” will look like it has a tail on the right hand side, hanging down below the middle dip.
How To Identify a DOUBLE BOTTOM
A double bottom is the exact opposite of a double top. In other words, the price goes down to a support area, bounces back up to the resistance area, gets rejected, bounces back to the support area, and then bounces back up again to the resistance area. This time the pattern looks like a “W”. When the price breaks through the original resistance area, you have confirmation of a double bottom. This time you are looking for when the right-hand arm of the “W” goes higher than the middle peak.
What Do These Patterns Mean?
A double top or double bottom shows us a clear picture of a battle between buyers and sellers. In the double top scenario, buyers are trying to push the price up through the resistance area for a continuation of the upward trend. When this happens a couple of times, with a dip in between, buyers become dubious and some liquidate their positions. As buying dries up, sellers start entering the market and take the stronger hold. This eventually pushes the price down below that second support area and we get our “double top confirmation”. The reverse is true for the double bottom, where sellers are trying to push the price down. After the price hits the support area for the second time, buyers step in and take control, which pushes the price back up, eventually above that original resistance level.
How Do We Trade When We See These Patterns Emerge?
Taking the double top pattern (apply the opposite to the double bottom pattern), it’s good to look for a sharp loss in the momentum indicators as the price goes up. This shows the market is becoming exhausted up into this resistance zone. Volume can also play an important role (with the exception of when you are trading Forex, of course), especially if the second peak is slightly higher. This could be an indication of a false/fake break out. When the market retreats, volume should increase as the sellers take hold. The least aggressive way to trade this pattern is to wait until you have confirmation of the pattern (i.e. the price breaks the original support area) and you see a dramatic increase in volume. This is the point at which you place your trade.
Another Potential Opportunity
Once you’ve had confirmation of the double top, it’s also quite common for the price to come back up and test that support area (what we call the neckline support) again. In other words, this support area now acts as an area of resistance. This could present another trading opportunity.
Risk Management When Trading These Patterns
Because of the way that the market sometimes reacts to these double top and bottom patterns, retail traders are advised to put more emphasis on position sizing rather than tight stop placement as a way of limiting risk. This gives the price more leeway to go in the direction you were anticipating. For some retail traders, this means going down to very small position sizes. In any case, when you are learning to trade it is always advisable to stick to small position sizes until you become consistently profitable. And always remember that you should never risk more than 2-3% of your entire capital on any one trade.
Keep looking at your charts to identify these patterns because they can be quite lucrative… especially if you catch them at exactly the right time!