It is widely believed that you have to remain invested for a long time to multiply wealth through the equity markets. While investing for the long term does have its benefits, it is not the only path to succeed financially. Trading with proper knowledge, research and risk management strategies can be rewarding. To trade successfully, you need to have a keen eye to spot different patterns and understand their meaning. While most patterns are exclusive to the candlestick chart, the double top pattern can be found in line charts and bar charts, besides the candlestick chart.
A pattern in itself is not helpful if you do not have an idea of the action to be taken. Patterns can be broadly categorised into two, continuation pattern and reversal patterns. The double top chart pattern is a strong bearish reversal pattern. It signals the end of a long rally. As the name suggests, a double top chart consists of two highs with a low in between. The double top pattern is confirmed once the price falls below the support level after the second top. The support level is the low touched between the two tops.
Meaning of double top pattern
It is easy to spot the formation of the double top pattern on technical charts. However, double top formation is one of the most misunderstood patterns. The double top pattern has to be confirmed after the formation of the second top. Let us understand the double top meaning to get a clear idea of how to act if the pattern is spotted.
The formation of the tops is clearly a sign of bulls being in control of the market. The bulls push the price higher forming the first top, which is followed by a normal correction. The correction results in the low between the two tops. After the fall, the bulls take control and drive the price higher, forming the second top. The pattern becomes interesting after the formation of the second top. An important feature to note in the case of the double top chart is that the high of the second top is almost equal to the first top, signalling the waning dominance of the bulls.
How to trade?
The formation of the second top is an inflexion point for the double top pattern. There can be two possibilities after the formation of the second top. If the bulls are able to regain control and do not let the price fall below the support level, the double top pattern doesn’t form. However, if the bears dominate and the price falls below the support level, which is the level touched during the low between the two tops, the double top pattern is confirmed. It is a signal of extreme reversal and one should ideally short the security.
While taking action based on double top formation, it is important to take a few factors into consideration.
Broader trend: The double top formation is a bearish reversal trend. It is effective only if it is formed after a broader bullish trend. The bullish trend preceding a double top formation should be a long one i.e. of a minimum of three months. A double top pattern after a short rally should be avoided.
Height: A double top formation should have a distinct height and depth. While there is no well-defined parameter of the height or depth of a double top pattern, a difference of 10% is desirable. Double top patterns with deeper lows are considered a stronger signal of reversal. But deeper patterns may take a longer time to form.
Width: The tops can be easily identified only if the time difference between the formation of the tops, also known as the width, is wide enough. While the difference between the two tops can span months or years, there should be a minimum difference of one month.
Volume: The volume of the trade is one of the strongest signals that confirm the formation of the pattern. The volume of the second top is generally lower than the first top. If the volume of the second top is higher or equal to the first top, the reversal may not sustain and the rally may continue.
The double top pattern can help traders and investors exit a position before the value of the asset undergoes a significant decline. Action can be taken on the basis of the double top chart pattern only in consonance with other indicators like volume, height and width.