3.7 Double-Top Pattern
A double top is an important reversal pattern that usually forms when either an uptrend is about to exhaust itself or a big consolidation in the trend is on the cards. It signifies the fear of further upward gains and is made up of two distinctive price peaks which are more or less at the same price level..
Formation of a Double-Top
The following picture shows the formation of double tops:
As you can see, the pattern is formed by prices rising to a peak, falling on meeting resistance, again making an attempt to rise past the earlier peak, failing and then going into a significant decline. This forms two well-defined and distinctive peaks (or ‘tops’), hence the name of the pattern.
The second, failed offensive by bulls to take out the earlier top is a clear indication that their firepower is on the wane, and a strong signal that a reversal is imminent.
An imaginary line drawn through the trough between the two peaks is called the ‘neckline’. The pattern is confirmed when prices fall through the neckline.
How to Trade Double-Top Pattern?
One may trade this pattern by going short just below the neckline. The price may be expected to decline from the neckline by the same distance as that of the double-tops' height above it.
You can place a stop-loss order around 75% of the distance between the neckline and the second peak. Stop-loss order level would also depend on the height of the peaks and the momentum of the drop. If the downward momentum is strong then the stop-loss can be narrower.
Please note that, unlike the chart above, many times there will be some pull-backs after the price breaks below the neckline and hence it may be a good idea to wait for some time to short-sell at slightly higher price.
The first profit target would be at least equal to the distance from the neck-line to the level of the double tops as indicated in the above Forex chart.
How to decide stop-loss level while trading with double tops?
Many times a double-top pattern may extend to a triple-top. Considering this the safest stop-loss order is slightly above the level of the tops. However, this makes the risk-reward worse than 1:1 and hence should be avoided. As mentioned above that keeping the stop-less at 75% distance of neckline to the peaks would result in a risk-reward ratio of 1:1.33. There are always exceptions when we can go for a worse risk/reward ratio more safely. Please refer the following chart:
The above Forex chart is a classical example of consecutive double tops. After the first double-top pattern completion the price action continued downwards. On the downside a double bottom formation took place and the then the currency pair formed another double-top pattern. The important point to be observed is that the subsequent peaks were at a lower level than the previous peaks. This fact indicated that the market is not ready to retest the previous levels. In such case we can safely put the stop-loss slightly above the double tops for better chances of meeting the profit target without hitting the stop-loss level first.
- Trading with Double-Top Pattern