Today we will be discussing the formation or pattern known as a double top and how to go about trading using the information it provides us with. Double top patterns are one of the many pillars of technical trading structures you must learn and incorporate into your trading knowledge base.
Double top identification and understanding can further enhance our technical analysis when trading the forex market by helping us see more than just support or resistance levels.
WHAT IS A DOUBLE TOP?
So what exactly is a double top? The classic double top pattern will include two high points within a market, which generally signifies an impending bearish reversal.
There will normally be a decline in price between the two high points, after the first peak is formed, there will then be a retracement to some degree before another rally occurs to the upside, the second peak usually fails to rise above the first indicating to us that there is unsustainable buying pressure and reversal is likely. What we generally want to see around the second peak is a loss of momentum and buying pressure, it’s possible that the second peak can go higher than the first, although briefly, and still qualify as a double top.
Next, We see the neckline is formed between the price low of the valley between the two peaks. When price breaks below and establishes beyond this neckline, it will confirm the double top pattern. In this case, our bearish confirmation is presented after this level is broken at the low point between the tops.
On the opposite end of the scale, double bottom patterns are identical in every way, except they are the complete reverse. The same exact rules apply, but it is simply the mirror image of the double top and would offer us a bullish signal after the neckline was broken. As always, these patterns are extremely important and play into the psychology of market participants. Because The formations are so widely known traders often look to execute market entries after the neckline is broken, which can cause colossal movements in price.
So to sum up firstly, we need to identify the two distinct peaks which have almost equal width and height.
Secondly, we should make sure that the peaks are not too small, as they generally occur on larger timeframes, we normally wouldn’t be looking for double bottoms and tops on a 15-minute chat for instance, as this is far too short term for significant reversals.
Thirdly we will want to establish the neckline support or resistance level and observe for candlesticks behaviour breaking and establishing beyond this level.
We may want to use other technical indicators such as oscillators to help us confirm changes in momentum, and simply identifying these patterns is not a standalone strategy.
The greatest criticism of technical pattern trading will always be that setups look obvious when looking back over historical data, but identifying them in real-time is actually very difficult. I’m sure this has happened to many of you, and it is incredibly frustrating when you’re always missing the mark. Double tops and double bottoms are no exception to this; these patterns appear almost daily and identifying and trading the patterns is no simple matter.
There are two ways to go about solving this problem, and both have their pros and cons. We can either anticipate the formation before it occurs or as we have discussed await confirmation to trade the potential reversal.
This is completely down to your appetite for risk, your personality as a trader and most importantly, your competence at understanding the nature of the forex market.
Reactive traders who are playing the safer game have the advantage of physically seeing the pattern occur and trading it accordingly, the downside to this is that part of the potential move has already been missed, this equates to larger potential stop losses and less pips to claim as the move continues.
Traders that have gotten into the sell in anticipation of a double top occurring can afford a tighter stop loss as well as being able to claim more pips. The downside to this is there is no confirmation of the double top occurring, and they may be stopped out due to incomplete analysis and lack of confirmation.
Once the neckline of the double top or bottom has been broken, the expected momentum can cause Price to move an equal amount of distance as the peaks themselves. We have previously discussed Candlestick behaviour surrounding prominent support and resistance levels, and at the peaks, we are looking for those candlesticks that suggest reversal such as the tweezer tops, Doji formations or long wicks, these are all additional clues that we may be seeing the start of a double top or bottom formation.
Once the neckline has been properly compromised we now revert to our breakout strategies, we want to see candlesticks breaking the established levels, retracing to them and showing significant rejection as confirmation to enter the sell or buy trade.
I hope you have enjoyed our educational session today ladies and gentlemen, please take some time to analyse your charts for the study of double top and bottom formations and contemplate what you have learned here today, please remember contemplation is the key to learning.