What is the Double Top pattern?
The Double top pattern is a noteworthy technical trading structure to learn and integrate into a trader’s arsenal. A double top is an extremely bearish technical reversal pattern that forms after an asset reaches a high price two consecutive times with a moderate decline between the two highs.
After retracing a small portion of the first peak, the market then bounces back towards the high of the first peak. Although, the market strength weakens and does not sustain above the first peak.
The double top chart patterns are used by traders as sell/bearish signals. The double top charts provide examples while they use both markets as references to observe how the pattern can be used in different ways regarding trade entry and exit points.
Basics of Double Top pattern
There are two main components in this pattern, as the name suggests two tops that are highs in their respective trends. Other than these two components there are few other basic components which are explained in detail:
- Prior Trend: With any reversal pattern, there must be an existing trend to reverse. In the case of the Double Top Reversal, a significant uptrend should be in place.
- First Peak: The first peak should mark the highest point of the current trend. It should indicate that the first peak is fairly normal and the uptrend is not false at this time.
- Trough: After the first peak, there is generally a decline usually of 10-20% with the volume on the decline from the first peak is usually inconsequential.
- Second Peak: The advance off the lows usually occurs with low volume and meets resistance from the previous high. Resistance from the previous high should be expected. Even after meeting resistance, only the possibility of a Double Top Reversal exists. The pattern still needs to be confirmed.
- Support Break: Even after trading down to support, the Double Top Reversal and trend reversal are still not complete. Breaking support from the lowest point between the peaks completes the Double Top Reversal. This too should occur with an increase in volume and/or an accelerated descent.
- Support Turned Resistance: Broken support becomes potential resistance and the price might test the resistance level with a quick reaction rally. Such a test can offer a second chance to exit a position or initiate a short.
- Price Target: The distance from support break to peak can be subtracted from the support break for a price target. This would infer that the bigger the formation is, the larger the potential decline.
Interpreting the pattern
The double top pattern entails two high points within a market which signifies an impending bearish reversal signal. A measured decline in price will occur between the two high points, showing some resistance at the price highs. After retracing a portion of the first peak, the market rallies back towards the high of the first peak however, strength in the market is waning and is unable to sustain a break above the first peak.
The neckline is formed between the price low of the valley between the two peaks. A break below this neckline will confirm the double top pattern. The bearish confirmation is specified by a break in the key price support level (neckline) situated at the low point between the ‘tops’.
How to trade using the Double Top Pattern?
The most important part of the pattern is to let the pattern complete itself and plan your trades ahead of time so that you’ll be ready once the breakout is confirmed by breaking the support line.
Traders can use the pattern breakout from two different points, one as the price breaks the neckline support and another trade can be implemented when the price tests the support line that turned into resistance.
The pattern can be used to trade by going short open when the breakout is observed with price breaking the neckline support and short close once the price is nearing the target.
The support line turns into resistance once the price observes a breakout and might test it back with a reaction rally, where traders can go long open after the target price has reached expecting the price to increase and get rejected from the support line that turned into resistance, closing long when the price reaches that level.
Advantages/Limitations of Double Top Pattern
There are few advantages as well as limitations to the pattern, explained below:
- Double top formations are highly effective when identified correctly but can be extremely harmful if identified incorrectly
- Sometimes the peaks or the trough could be just normal resistance than long-lasting change
- Might get converted to Triple top, so pay attention to the volume carefully