Thursday, March 23, 2017

Major Reversal Pattern - Double Top

This article was written in 2007. 

At every start of a major decline, it was observed that certain price patterns will occur on the chart.  They are historically proven to at least influence the immediate trend if not the mid to long term trend.  While most of the investors will be caught off guard as the downtrend persists, traders who are able to identify reversal patterns will be in a better position to avoid massive losses.  This article will discuss one of the major top reversal pattern known as the double top pattern.

As the name suggests, in-order to reverse a trend, there should be a significant uptrend prior to this reversal pattern.  The price will move to a new high and pulls back to form a trough before another peak fails near the old high of the first peak.  Many traders and investors may jump to a premature conclusion that a double top pattern has been formed.  However, a double top pattern is only considered formed after the the price has broken the support at the low of the trough between the two peaks.  There are many variations of this pattern and thus a savvy trader or investor has to be flexible in applying the techniques to identifying the pattern.  As the wise saying goes, “History likes to repeat itself, but it can repeat in many forms”
After the brief introduction to the price movement of the double top pattern, we shall now explore the technical specifics of this pattern.  There are guidelines to identify the best double top pattern. They are, prior trend, price peaks, volume, duration and support turns resistance. 
#1 Prior trend: There must be a significant uptrend prior to the double top pattern.
#2 Price peaks: The second peak will not be resisted at the first peak exactly. As a rule of thumb, the difference between the second peak and the first should be within 4%, either more or less. We should not restrict the second peak to be lower than the first peak.
#3 Volume: The average volume traded at the second peak should be lower than the first peak.  This signifies that when the market retest the old high, there is an obvious lack of participation as shown by the lower average volume.  Without strong participation, the rally in price will not sustain.

#4 Duration: The best pattern will take anything from 1 month to 3 months to form.  However, as mentioned, we should expect variations of the double top pattern and hence some may take a longer duration to form. Most importantly the essence of the formation must be present.

Figure 1: Example of a double top pattern found in STI chart.

Let us look at Figure 1 which shows a double top pattern found in STI chart.  We had a significant uptrend from the low in August which ends with the first peak formed in October.  A trough then forms in late October which leads to a price rally that took us to the second peak in early November.  However, a quick check on the average volume shows that the second peak has a lower average volume as compared to the first peak.  Once the price broke the low of the trough, the double top pattern is confirmed.  Figure 1 also shows that the formation took about one month to complete.
We can also derive price target base on the double top pattern.  This will give the trader or investor an idea of where the price is likely to head to.

Figure 2: Example of projecting a price target

As seen in Figure 2, to project the price target of a double top pattern, firstly we measure the height of the peak to the low of the trough.  Lastly, we project the height downwards from the low of the trough and derive the price target.  With the price target derived, we will know the potential decline of the price.

Figure 3: Example of support turns resistance

When the double top pattern is confirmed and price had broken the low of the trough, investors can look forward to a retest of the low of the trough as a resistance.  As seen in Figure 3, the low of the trough in May 2000 was a support before the second peak was formed.  Once broken, that support has been retested as a resistance in May 2001.  This retest if fails, offers an opportunity for investors to break jail before another leg down.

This article had discussed how to identify a double top pattern which is one of the major reversal patterns by paying attention to prior trend, price peaks, volume and duration.  We also learn how to derive price target from the pattern and look out for a retest of the low of the trough from a support as a resistance.

This article first appeared in Smart Investor in 2007. 
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