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.
Formation
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.
Advantages and Disadvantages of a Double Top Pattern
A double top pattern is an extremely bearish reversal pattern, and by understanding its advantages and disadvantages, you can incorporate it effectively into your trading strategy.
Advantages of Double Top Pattern
Reliable trend reversal signal: The double top is a strong trend reversal pattern and indicates a weakening of buying pressure. When the price fails to break through the second peak, traders can capitalise on the momentum change by exiting their long position.
Well-defined entry and exit points: The double top gives clear indications of where traders can enter and exit their trades. Traders can place a stop-loss just above the second peak for effective risk management.
Easy recognition: Double top is a distinctive pattern. Traders can easily recognise a double top formation in a candlestick chart from consecutive peaks separated by a trough.
Versatility across time frames: The double top is a versatile pattern that can be applied to various time frames. It is a reliable reversal pattern to analyse the movements of various assets like stocks, indices, commodities, or currencies.
Compatibility with other technical tools: When combined with other technical tools, the double top can provide accurate and reliable trend reversal signals. Traders often combine moving averages, trend lines, or oscillators to confirm the reversal signal provided by the double top pattern.
Disadvantages of Double Top Pattern
By being aware of the drawbacks of the double top pattern, traders can make informed decisions and avoid potential pitfalls. These are the key disadvantages of the double top formation.
False signal: In some cases, the price chart may form a pattern that resembles a double top, but the anticipated change may not occur. Traders must exercise caution and confirm the trend reversal before confirming.
Subjectivity in pattern identification: The effectiveness of a double top candlestick pattern is subject to interpretation. The double tops and troughs may not be perfectly symmetrical or evident, leading to inconsistency and misinterpretation.
Difficulty in timing: Timing the entry and exit points with a double top can be challenging. Traders must determine the optimal moment to exit a long position and enter a short position to capitalise on the momentum. Mistiming when to enter or exit a trade can result in financial losses.
Limited effectiveness in a strong uptrend: A double top is an extremely bearish reversal plan that forms in an uptrend. However, during strong market rallies, the pattern may have limited effectiveness, leading to false signals.
Overlapping with other patterns: Sometimes double tops can appear overlapped with other complex patterns, making it difficult to identify or interpret.
Conclusion
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.
FAQs
What is a double top pattern?
A double top pattern is a candlestick chart pattern that appears in an uptrend, indicating a trend reversal from bullish to bearish. The double top consists of two peaks of the same height, separated by a trough.
How can I identify a double top pattern?
A double top is a distinctive pattern formed by two peaks of similar heights and a trough between them. The peaks are formed approximately at the same price level, indicating a resistance level.
What does a double top pattern indicate?
A double top chart pattern indicates a trend reversal from bullish to bearish. It indicates the buying pressure has weakened, and the sellers are taking control, leading to a potential downtrend. Traders use the double top pattern as a signal to exit long positions and initiate a short position.
What are the entry and exit strategies for trading a double top pattern?
For trading in the double top, traders usually set an entry point just below the trough after the pattern is confirmed. A stop-loss limit is typically placed above the second peak, and a profit level is fixed at the level of the trough.
Are there any limitations to consider when using the double top pattern?
Sometimes a trend reversal doesn’t occur even after a double top appears in the chart. To avoid such pitfalls, traders must consider additional confirmation by combining other technical tools to analyse a double top.
