Last Updated on 30 March, 2020 by Therobusttrader
In trading, there are a lot of patterns that are used to predict the future moves of a market. Some resemble geometrical figures, like ascending and descending triangles, while others try to define patterns that occur when a market has gone too much up or down. One such pattern of the latter kind, is the double top!
A double top is a bearish reversal trading pattern which shows that buyers are losing control and retreating. It occurs after a period of bullish price moves and signals that the bullish trend soon will turn into a bearish one.
This complete guide to the double top pattern will cover everything you need to know to consider using it yourself. We’ll look at:
- The definition of double tops
- The market psychology of the pattern.
- How you should approach chart patterns in general
- How many traders choose to trade double tops
With all this to cover, let’s begin with the basics, namely how you define and spot a double top!
Double Top Definition- What is the Double Top Pattern?
As said, a double top signals a change in the direction of the trend from bullish to bearish. While it’s quite easy and quick to recognize once you’ve seen it a couple of times, there are a couple of conditions that apply, which might be good to know.
Here are the different stages and conditions of a double top:
- The first Top: The first top simply marks the highest point of the ongoing bullish trend, and is where the pattern starts to form. However, at this stage, there is no way to make out the pattern, and most people don’t even expect the trend to turn around, even if the market may be quite overbought at the moment. In that sense, some people may think that it’s due for a short term correction, but nothing more.
- The Trough: The next part is when the market turns down and performs the trough. Just as with the first top, this isn’t that strange, considering that the market came from quite overbought conditions already. However, the size of the fall might be a little bigger than most market participants had expected. A rule of thumb is that it should be big enough to make a visible dent, in the sense that it doesn’t appear too small. Some people say that it’s appropriate with a size of around 10%-20%, measured as the distance from the top to the bottom.
- Another top: Once the market has performed its trough it now goes on to make a new high again. After all, most market participants remain fairly bullish given the previous bullish developments and therefore contribute to form the upswing. However, as soon as the market approaches the high of the previous peak, it becomes apparent that buyers are losing in strength. The market simply doesn’t have the stamina to break out to the upside. As such, we’re starting to witness a serious threat to the continuation of the on-going bullish trend, in the form of declining buying pressure.
- Decline: As the market heads down, more people have become worried about the lack of strength, and decide to get out of their positions. This usually results in a fast decline that occurs under heavy volume. Gaps are common as well, which further adds to the newly arisen bearish sentiment.
- Breakdown: The final part of the pattern is the breakdown below the low of the trough. This signals that bears finally have won the fight, and that buyers are nowhere to be seen. If the market doesn’t recover quickly we have now seen the start of the new bearish trend, according to the original definition of the pattern.
Another important aspect of the double top is the preceding bullish trend. According to the original definition of the pattern, there should be a defined and clear uptrend, that should have been on-going for quite some time. Otherwise, there is a risk that we’re trying to pick reversal in markets that simply don’t trend well enough. This, in turn, means that the following breakout to the downside might have a smaller chance of turning into a longer trend worth catching.
Psychology of Double Tops
As you might notice in the description of the pattern above, we have included some notes on how market participants are likely to reason as the double top pattern forms. Still, it’s important to note that it’s very hard to know exactly what happens in a market, since the circumstances change all the time and no situation is exactly like another.
With this said the main weight with regards to psychology lies in the fact that the second top doesn’t manage to break the high of the previous top. In combination with the bearish breakout, we are shown that the market isn’t behaving as a bull market is expected to. This in itself begets more selling pressure, as has been described earlier, and fuels the new bearish trend.
Do Double Tops Work?
Many people assume that they may take any patter and just apply it on any market and timeframe with no issues whatsoever.
Unfortunately, it isn’t that easy. The performance of any pattern will vary greatly with the market and timeframe chosen.
The only way to figure out if a market works well with your timeframe and market is to study its past performance. Either you could go back and manually point out those times when the pattern formed, or you use backtesting to quickly get an idea of the performance on your market.
Here are some tips to consider when you’re looking to assess the historical performance of a chart pattern.
Definition: Chart patterns often consist of quite loose definitions, and with the benefit of hindsight, it can be irresistible to rule out patterns as some you never would have taken in live trading. However, in the heat of the moment, it remains likely that you would have acted on those very patterns that were just ruled out.
Remain extremely careful and don’t make too optimistic assumptions! Many traders might hesitate about including one occurrence of the pattern in their testing, and decide to throw it out if it leads to a loss, but keep it otherwise.
Backtesting definition: If you use a backtesting software to see how the pattern fared on historical data, you’ll have to come up with a rules-based definition. You’ll find that the results you get vary greatly depending on the definition used, which is a major concern that needs to be dealt with carefully!
This also is the reason why you should be careful when somebody presents statistics on a particular trading pattern. It may be that they have just tried many combinations over and over again until they find something that works out of random chance. In other words, they’ve just curve fit their definition of the pattern.
How can I validate a pattern myself?
If you want to learn more about using backtesting to validate strategies and patterns, our definitive guide to backtesting is an invaluable resource!
How to Trade Double Tops
With the basics of the pattern covered it’s time to look at some practical examples of how many traders go about to trade the pattern. There are a lot of things you need to be aware of, and there are many techniques that may be employed!
The goal of most of these techniques is to avoid false signals, where the market breaks below the low of the first trough and then rebounds with the positive trend continuing.
False breakouts are one of the most challenging aspects of breakout trading, and will render many strategies unprofitable if not dealt with correctly.
So let’s now first look at the most common technique used by traders. Then we’ll take a closer look at some other techniques that may be useful to know
The most common way to trade double Tops!
Once you have identified that a double top is about to form, it means that we have identified the first and second top, and now wait for the market to break out below the low of the trough.
However, it’s quite common to see the market rebound shortly after the breakout, and this is something that is often taken advantage of.
By watching the rebound and making sure that the breakout level is respected, we get a type of confirmation and may decide to go short. If the market doesn’t respect the breakout level, we instead consider it a false signal.
In the image below you see this very setup. The market broke down below the low of the pattern, revisited the breakout level, and then continued down.
With this technique covered, we now wanted to share three other powerful techniques we have used ourselves!
Let’s have a look at them!
1. Comparing the highs
Like we covered earlier in the article, the fact that the two tops occur around the same level shows us that the market wasn’t bullish enough to continue up.
Now, what if the second high didn’t even manage to make it up to the level of the first top? Wouldn’t that show that the conditions are even more bearish?
Some traders would surely choose to interpret such a setup as extra bearish. Below you see how the second top didn’t quite make it up to the first one.
2. Volume Patterns
The original definition of a double pattern does state that it’s beneficial if the last move down from the second top is carried out with heavy volume.
In addition to that rule, you may choose to include more conditions to gauge the likelihood of a positive outcome.
For instance, you could look at the volume around peaks and bottoms to see how market participants react to those levels. If there is a lot of activity going around the highs, with the second high having less volume than the first, it’s generally considered a positive sign.
Here is an example of such a setup.
3. Add some distance to the breakout level
The breakout level we’re watching, which is the low of the pattern will be breached quite often without the market taking off in any direction. We discussed this issue earlier, and also introduced a solution in the form of waiting for a revisit and confirmation of the breakout level.
Another common technique among breakout traders that could be applied to the double top, is to add some distance to the breakout level. This provides some room for random market moves and means that our entry signal will be triggered less often. Hopefully, this results in less false breakouts!
If you go for this approach, we recommend that you use a multiple of the ATR reading to come up with the distance that should be added! That way the distance is adjusted for the volatility of the market!
Bullish Double Bottom
The double bottom pattern simply is an inverted double top pattern. In other words, it occurs at the end of a bearish trend and signals its reversion.
Our article on the double bottom pattern is a great resource if you’d like to know more!
In this article we’ve had a closer look at the double top pattern and how it can be used in trading.
Now, before ending the article, we just wanted to once again stress the importance of not taking anything for granted in trading. Always perform your own tests to ensure that your strategies and methods work well with your timeframe and strategy. Most traders never come this far, and subsequently, trust strategies that have no edge whatsoever. According to use, this is perhaps the biggest reason why so many traders fail.
The following resources are great to start with if you want to learn more about building and validating strategies.