Double Tops and Bottoms – One of the Most Reliable Chart Patterns to Trade
The main thing to remember with double tops and bottoms, is that they are located – and are most powerful – at the end of a rising or falling trend. They are in fact, well known as classic reversal patterns. There is also a psychology behind this pattern which we will discuss, but first, let’s look at a double top sample on a chart.
We can readily observe in this example that we have a double top at the end of a rising trend. We can begin to look for this pattern as soon as we see a change in direction. In our chart example here, that point is the far left yellow mark. The next thing we look for is the low point, which in our chart is the middle yellow mark. From here on, we are only interested in whether it will be a double top if the subsequent rise respects the resistance level of the left yellow mark. If it breaches that level, we forget about the Double Top pattern and reassess the situation for a possible continuation in the trend.
If the aforementioned resistance level is respected (indicated by a reversal day which breaches the up-trend line), you will need to decide whether to trade this stock on the basis that it is now in a potential sideways channel, or whether to wait and see if the neckline (the middle yellow point) is to be breached.
If there is enough room in the pattern to trade a sideways channel, then you might consider either purchasing at-the-money put options, using a bear put debit spread, or a bear call credit spread above the resistance level, on the assumption that the underlying security is about to trend down to a support level.
If there is not enough room in the pattern to indicate a potential sideways channel, then you will have to wait for the breach of the neckline, supported by good volume. In our sample chart, we were never given the chance to trade it as a channel as the first down session respected the channel’s support and would not have been an entry signal (second last bar). The next session (last bar on the chart) breached the neckline, confirming the Double Top pattern and this would now cause a lower trough to be formed.
We are also looking at a trend reversal in the making. The (lowest) horizontal blue line below the last session is the potential price target and since it is at a support level, you have more validity for this expectation.
So what is the psychology behind double tops and bottoms? Firstly, in the case of a double top, you have the bulls that drive the price up initially. After a while, the bears start coming in by forcing the price down. This will form the left mark. But following the pullback the bulls see a buying opportunity they may have missed out on, driving the price north again.
This forces the price back up towards the resistance level. As the enthusiasm dwindles among the Bulls as they approach the resistance level, the Bears again get the upper hand and force the price down again. As this is now the second time that this level has been respected, the Bulls are losing motivation and submit to the Bears who will now dominate the market. If the Bears create a trading gap, this usually means that the Bulls are rolling over and leaving the market. So the Bears now have free reign until such time that the Bulls once again see a buying opportunity.
Double tops and bottoms are essentially an argument between the Bulls and Bears (i.e. Fear and Greed). Whoever wins will dominate this security’s new direction.
When the above scenario happens in reverse, we’re looking at a double bottom. The down trending security finds support twice, then breaches the neckline to reverse direction so that price action goes north.
There will be times when you will see a breach of the neckline on double tops and bottoms, but with poor looking sessions. For example, the open and close of the session is not in the opposite third of the bar or candle. If you add lower volume to these apparent breakouts then beware – they may only be short lived and not produce the desired target but in fact, turn around and retreat back within the sideways channel.
There will be times when you can observe double tops and bottoms in mid-trend and that is why we must always wait for validation prior to placing a trade. The following samle chart of mid-trend patterns has been provided to show you that they do not always mean a trend reversal but quite the opposite – a strengthening of the trend.
In this chart we can see a great sample of serveral Double Bottom patterns that failed. This is the main reason why we do not pre-empt any trade but always wait for good validation. If you do not have a market move that is supported by volume, you could be entering a trade that will be short lived and stop you out fast.
Double Tops and Bottoms – Additional Validation
The RSI indicator is a powerful ally when it comes to double tops and bottoms. In particular, we refer to bullish or bearish divergence.
Looking at this chart, we can see the additional weighting of evidence for a double bottom reversal, by a strengthening of the RSI. If we observe an increase in the RSI between the two bottoms, this indicates divergence and provides extra validation that a reversal may be imminent. The same goes for a double top, only the RSI would decrease over the two tops. It is especially good if the first RSI peak was above the 70 level.