Double Top Pattern in Trading: Meaning and Factors

In our previous chapter, we discussed the head and shoulders pattern, a popular technical analysis pattern used by traders to identify trend reversals. Continuing our exploration of chart patterns, let’s now dive into another significant pattern known as the double-top pattern. 

Before we get into that, you already know that in financial markets, two primary forces control the direction of prices - Bulls (buyers) and Bears (sellers). These opposing forces continuously battle for control, resulting in price movements. Here, chart patterns like double-top allow traders to spot the shift between bears and bulls. 

The double-top pattern occurs after a prolonged uptrend and is a bearish reversal pattern characterised by two peaks and troughs. The pattern suggests that the bullish momentum is waning, and the bears may be getting control. 

Let’s explore the double-top pattern in depth and its interpretation in depth below. 

What Is the Double-Top Pattern?

The double-top pattern is a popular technical analysis pattern traders and investors use to identify trend reversals in financial markets. It is characterised by two distinct peaks that are approximately equal in height, separated by a trough. You can also read a double-top as a bearish reversal pattern where the stock price forms a top at the same resistance point twice. 

The pattern looks like the alphabet ‘M’ and is often spotted in daily and weekly charts. 

Now, let’s study each component of this pattern in detail. 

1. First Peak: The double-top pattern begins with the formation of the first peak, which represents the end of an existing upward trend. The peak occurs when the price reaches a certain level and encounters strong selling pressure, causing it to reverse its upward movement. This peak is often accompanied by high trading volume and is the highest point in the pattern, indicating increased market participation. 
2. Trough: Following the first peak, a price decline occurs, leading to the formation of a trough. The trough represents a temporary pause in the downward movement and can be seen as a consolidation phase. Typically, the trough does not drop significantly below the previous low, indicating a potential reversal in the price trend. 
3. Second Peak: After the trough, the price attempts to rally again, reaching a similar level as the first peak. This forms the second peak of the double-top pattern. Like the first peak, the second peak is characterised by a strong resistance level, where selling pressure intensifies, and buyers struggle to push the price higher. Mostly, this resistance level is seen as a psychological barrier for market participants. 
4. Second Trough: Following the second peak, the price declines again, forming the second trough. The second trough usually drops below the previous trough, confirming the failure of the price to break above the resistance level. This decline signifies a shift in market sentiment from bullish to bearish as selling pressure becomes dominant. 
5. Support and Resistance:

By connecting the two peak points, resistance levels can be established. The low point of the first trough can be connected with the breakout point of the second trough to create the support level or neckline. The pattern is confirmed if the second trough breaks below the neckline level. 

To understand all these elements better, look at this image below –

Note these additional points – 

1. An uptrend should be in place for a double-top pattern to form.
2. Unless the second trough occurs, the pattern cannot be confirmed
3. The period between 2 peaks can range from a few days to weeks or months. The time gap is a significant factor; the longer it is, the stronger the pattern
4. The deeper the first trough, the stronger the chance of the formation of a double-top pattern. 

How To Interpret Double-Top Patterns in Trading?

Understanding how to interpret the double-top pattern can help find entry or exit points, set stop losses and calculate target price. We’ll try to interpret the double-top pattern with an example. But before that, here are three things to keep in mind

1. Identifying the Double-Top Pattern: To identify the double-top pattern, you should look for two price peaks that are approximately equal in height, with a valley separating them. The peaks must be followed by a price decline for the pattern to be confirmed. 
2. Setting Stop Loss: After identifying the double-top pattern, it is crucial to set appropriate stop losses because there is no guarantee that the pattern will pan out. For instance, if the price breaks above the neckline, it can suggest that the pattern has failed, and the uptrend may continue. 

In this pattern, the stop loss is placed slightly above the neckline.

Calculating Target Price: As explained in the previous chapter, the target price is the level at which investors achieve their ‘target’ or lock in profits. To calculate the target price for this pattern, you need to measure the distance between the peak and the neckline. Then, subtract this distance from the breakout point. This will give the potential downward movement of the stock. 

Now, let’s study this pattern with an example. Assume a stock trades at ₹400, and it rallies to form its first peak at ₹650. Now, imagine the stock dips and forms its first trough at ₹520. The stock again rallies to ₹645, forming the second peak. The resistance is formed by joining the two peak points. The stock is now experiencing a decline again, this time breaching the previous trough. That point becomes our breakout level. 

The pattern is confirmed as the price continues to break through its neckline level. Now, to calculate the target price, we do the following calculations. 

Distance between first peak and neckline = 650 - 520 = ₹130

Breakout level = ₹520

Target price = Breakout level - Distance = 520-130 = ₹390

So, as per this example, the target price for this double-top is ₹390. 

Factors To Consider When Trading Double-Top Pattern

Trading double-top patterns will require careful analysis and consideration of various factors to increase the chances of success. The factors are as follows – 

• Confirmation:

Before initiating a trade on the double-top pattern, it is critical to wait for confirmation. This is because prices can retract and move in any direction, at any time, based on innumerable factors. Formation of 1/4th or ½ of the pattern may sometimes not translate into a full pattern. 

A double-top pattern is confirmed when the price breaks below the neckline, indicating a change in trend and the takeover of bears. Traders must wait for the breakout to occur and avoid premature trading. 

• Volume:

Volume as a parameter is of utmost importance when dealing with most chart patterns, and the double-top is no different. Ideally, the first peak is characterised by high volume, and the second peak is comparatively lower volume. 

Also, a surge in volume during the breakdown strengthens the validity of the pattern, indicating selling pressure and the onset of bulls. 

• Timeframe:

A very critical parameter to account for when dealing with a double-top is timeframe. A short time period cannot accurately display supply and demand, and the pattern formation in such times is generally short-lived and unreliable. 

Patterns that develop over a longer timeframe tend to be more reliable and have a higher probability of success. Traders may avoid placing excessive emphasis on patterns that emerge over shorter time frames and can ideally look at weekly and monthly patterns for more valid patterns. 

And with this, we end the chapter on double-top. Remember to consider factors such as volume, time frames, and support and resistance levels before trading any patterns. Now, we move on to the next chart pattern - double bottom.