Chart Patterns: Double-Top

Introduction: 

The principles discussed in last month’s articles on chart patterns, the overview and the head and shoulders, underlie reversal chart patterns in general. They apply to this article’s topic as well: the double-top reversal pattern

Perhaps the most common mistake when identifying patterns is neglecting to consider the preceding trend. This is akin to neglecting the context. To emphasize an important point made in the overview article: 

“Chart patterns are divided into two main groups: reversal patterns which occur at the end of a trend, or continuation patterns which reside within the trend. It logically follows then that a prerequisite to any chart pattern is the existence of a prior trend.” 

A price movement is not a certain chart pattern just because it looks like it, as if we are playing find the horsey in cloud. Analyzing chart patterns involves a critical process of applying a set of criteria drawn from a rationale based on investor psychology. Invariably, the first step is to identify the prior major trend. Let’s look at a real example.

The Prior Trend: 

Figure-1 is a weekly chart of the 2003-2009 S&P500 (SPX). The uptrend preceding the 2007 double-top began in 2003. After leveling out to a more sustainable rate in 2004, the uptrend accelerated again in 2006, forming a minor trend within the four year major trend 1. The 6-month double-top defined a transitional sideways move, reversing the 2003 cyclical uptrend. 

S&P500, 2003-2008

Figure 1: Major uptrend in S&P500 from 2003 - 2008

After the 2000-2002 bear market, volatility (VIX) settled down below 20%. Then it rose suddenly through resistance in 2007 as the first top was forming. Volatility remained range bound between 20%-30% for the duration of the double-top. In late 2008 volatility spiked to nearly 80%, after nearly a year and a 50% drop since the double-top formation.
 

The Double-Top: 

The double-top is a reversal consolidation pattern very similar to a head and shoulders. As the name suggests, the double-top is comprised of two tops that share the same resistance level. Like most reversal patterns, the double-top occurs both at the top and bottom of a major trend in somewhat mirror images 2. It forms almost identically in both individual stocks and indices. 

Figure-2 is weekly chart of SPX in 2007 including volume overlaid with a simple moving average for reference. The wave from March 2007 to point-A set a new bull market high. It was partially retraced by wave A-B on heavier and above average volume. Point-B completes the first top after breaking the minor uptrend. Volatility rose noticeably as described earlier by figure-1. 

S&P500 Double Top 2007, weekly

Figure 2: Double-Top in S&P500, 2007.

Point-B forms the neckline, a critical support level which, if broken, can become major resistance. This is later evidenced by point-H. 

Wave B-C begins the second top, testing the first 3. Interest waned as evidenced by the lower volume as the 2003 cyclical bull market came to an end. The sell-off from C-D is again accompanied by heavier and above average volume, this time retracing the entire preceding rally. 

Our example finds support near the neckline followed by a brief rally from D-E on lower volume. This rally is not a requirement for the pattern; the breakdown could have happened at point-D. The market falls from point-E towards the neckline as volume increases sharply 4.
 

Completing the Pattern: 

The double-top reversal pattern is complete only after the neckline is decidedly breached on a closing basis (point-F). Characteristics of this breach include: 

  • the day’s close is decidedly below the neckline 5
  • heavier and preferably above average volume
  • a wide intraday price range (volatility)

The higher highs and higher lows that defined the prior major uptrend have been replaced with a lower high and a lower low from C-D-E through F. An occasional minor bounce on low volume back to neckline-resistance is characteristic, but not a requirement for the pattern.
 

Price Objective: 

The height of the pattern gives us a glimpse into the degree of decline. Measure the price differential between the apex and the neckline, then subtract it from the neckline for the minimum price target. Using volatility to determine the minimum price target is a general principal in technical analysis. 

In figure-2, the pattern is about 129 points tall. Subtracting 129 from neckline gives us a minimum price target of 1304. Price can decline well below the minimum target as our example illustrates in figure-1. The price objective is met by point-G, and then significantly exceeded below point-J.
 

A Closer Look: 

Figure-3 is a daily bar chart of the second top in the SPX as 2007 comes to a close. The second top began on August 16 with a reversal day 6. The rally occurred on mostly below average volume. The last two weeks of the rally came on steadily declining and below average volume including October 5 and 9 which set new closing highs in the major uptrend. 

S&P500 Double Top 2007, daily

Figure 3: Daily bar chart of the S&P500, 2007

The 2003 bull market ended on an intraday high on October 11, also a reversal day. Volume was the highest in three weeks and above average. The single day’s swing from high to low measured 1.88% of the previous close. The right side of top #2 was marked by several distribution days 7 in close proximity.

Conclusion: 

Caution: Falling Stocks AheadThe aforementioned harbingers appeared before the pattern itself was complete. The preponderance of the evidence behooves the trader or investor to take shelter if not take advantage:

  • Volatility breaking out during the first top
  • Pattern of rising volume in down legs, waning in up legs
  • Concentration of distribution days
  • Leading stocks breaking out of poorly formed late stage bases and failing

The double-top reversal pattern is very similar to the head and shoulders. It is identified by distinct criteria and characteristics. The consolidation forms over a period of weeks to months, not days, and certainly not intraday. It is a rare but reliable pattern that when spotted, take note, and take action!

Thank you for reading this article. Your comments are welcomed! 

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Footnotes: 

  1. A major uptrend often ends by accelerating away from its mean as if escaping its gravitational hold, only to revert back to the mean. This is sometimes called a blow-off, and is especially evident at the end of a secular trend like 1982-2000.
  2. The double bottom is similar to the double-top with a few important differences. Lack of buying pressure is enough to allow prices to move lower. The double bottom usually takes longer to form. A significant increase in volume is needed for a market to break out of the neckline.
  3. The action of the second top is often described as “testing” the highs. When the second top slightly exceeds the first, it is often called a “bull trap” (bear trap in a double-bottom), or a false breakout. Sometimes the second top falls just short of the first. The two tops are generally within 3% of each other.
  4. In our example, the decline from point-E towards the neckline occurred during the Christmas holiday, skewing the volume lower. Volume rose back above average after the holidays.
  5. About three closes or a 3% decline below the neckline are added confirmation.
  6. Reversal day: a sharp single day price reversal. In an uptrend, new highs are set intraday, and then close near the bottom of the day’s range. Wider price range and heavier volume increase the probability of a short term trend reversal.
  7. Distribution day: a significantly lower close on higher volume. The larger the percentage-decline relative to average volatility and the higher the volume, the more significant the distribution day. Churning is also a type of distribution day marked by higher volume with almost no change in the day’s close.

Sources: 

  • Murphy, John J. Technical Analysis of the Financial Markets. Paramus: NYIF, 1999
  • Pring, Martin J. Technical Analysis Explained, 3rd ed. McGraw Hill, 1991
  • O’Neil, William J. How to Make Money Selling Stocks Short. Hoboken: Wiley, 2005
  • Kaufman, Perry J. New Trading Systems and Methods, 4th ed. Hoboken: Wiley, 2005
  • Edwards, Robert D. & Magee, John. Technical Analysis of Stock Trends, 7th ed. Boca Raton: St. Lucie, 1997

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  1. Chart Patterns: Head and Shoulders | Sargon Y. Zia, merging fundamental analysis with technical analysis — August 31, 2010 @ 11:38 pm

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