Double Top Pattern: Overview and Trading Rules
A double top is a popular technical analysis pattern that usually appears before a reversal in an uptrend. Its one of the most common patterns and it can be found on any timeframe of any asset. Still, some traders confuse its signals. In this FXOpen article, we will explore how to spot the double top formation on a price chart and use it to build your own trading strategy.
What Is a Double Top Pattern?
In technical analysis, a double top pattern meaning refers to a chart pattern that consists of two swing highs with a trough in between, and the two highs should be at the same or almost the same level. Some traders confuse a double top with a double bottom formation. Therefore, the question Is the double top bullish or bearish? is common. The double top pattern appears at the end of an uptrend, and its always bearish. Conversely, the double bottom setup occurs at the end of a downtrend, and its always bullish.
Another common question is, What does double top mean in stocks? Regardless of the market, the double top appears before a trend reversal. You can find this formation when trading currencies, stocks, commodities, and cryptocurrencies*.
What Does a Double Top Indicate?
Understanding a pattern's psychology may help you learn how to spot it on a price chart and read its signals. As a double top is a bearish formation, it occurs only in an upward trend. The first high indicates that the trend is in place. However, the second high, which appears at the same level, shows that bulls don't have the strength to push the price up further. Therefore, traders expect an end to the uptrend.
How Traders Use the Double Top Pattern
The double top pattern's entry and exit rules are relatively simple. Although they may vary depending on the timeframe you use or the trading approach you implement, the standard points can be considered fundamental.
Entry
The two tops arent as important as the trough between them. This serves as the threshold that signals whether a trend reversal is occurring. A trader draws a horizontal line (neckline) through it and waits for the price to fall below it after the second high is formed.
There are several options that traders can consider before entering the market. They can sell just after the breakout occurs; this is at the double tops breakout candlestick, so usually, they wait for the candle to close. Additionally, they can wait for at least two candles to be formed in the breakout direction.
The choice depends on the timeframe and the risk approach. Its risky to enter the market as soon as the breakout occurs because of a fakeout, the situation when the price turns around after the breakout and continues to move in the same direction. The chances the breakout is valid increase when the candle closes below the neckline. If the timeframe is high, traders can even wait for the price to form a few candles. However, measuring the take-profit target and considering trading volumes is vital.
Take Profit
A take-profit level is typically determined by measuring the distance between the tops and the neckline. The theory states that the price will go the distance equal to the height between the neckline and the tops.
Stop Loss
A stop-loss level is typically calculated using the risk/reward ratio. The ratio is determined by considering the current market conditions, but most traders believe that it should be at least a third of the take-profit target. Additionally, the common rules state that it should always be placed above the neckline.
Note: there is a common rule that a support level becomes a resistance after the price falls below it.
This means that the neckline will turn into a resistance level after the breakout. A rise above it will signal either a market consolidation or a continuation of an uptrend.
Double Top: Trading Examples
The chart above reflects a double top chart pattern formed on a 5-minute chart of the GBP/USD pair. The price tested the neckline after the breakout candlestick closed (1). However, if a trader used a stop-loss, they wouldnt worry about the retest. The take-profit target would equal the distance between the tops and the neckline (2). As the tops arent high, a 1:2 risk/reward ratio would be large, so a trader could use a 1:3 ratio (3). If fundamental analysis and high trading volumes confirmed a continuation of a price fall, a trader could use a trailing take-profit order and place the second target at the nearest support level (4).
The Difference Between a Double Top and a Failed Double Top
However, a double top pattern may fail like any other pattern or technical indicator.
On the chart above, the price forms a double top pattern at the end of an uptrend. The RSI indicator has a bearish divergence with the price chart, which is supposed to confirm a price decline (1). After the second top, the price breaks below the middle line of the Bollinger Bands indicator (2), which is also a sign of a price decline. However, the pattern doesnt work, and the price doesnt reach the target (3).
How Can You Confirm a Double Top Chart Pattern?
The example above confirmed that the double top formation cant provide signals that are 100% accurate. Moreover, it showed that even implementing additional tools when confirming the signals will not guarantee effective trades. Therefore, traders should practise constantly.
You can use the TickTrader platform to practise various combinations of the double top setup and technical analysis tools that can help confirm signals effectively.
Confirming a double top pattern involves using various technical indicators to ensure its reliability. Here are the most common technical analysis tools traders use to catch reversal signals.
- Volume Analysis. A significant increase in selling volume when the price breaks below the neckline may confirm increased downward pressure.
- Moving Averages. The most popular types of moving averages are simple and exponential. When the price moves below an MA after forming a second peak, it may be a signal of a potential change in the trend direction.
- Momentum Indicators. Momentum indicators such as the Relative Strength Index, Stochastic Oscillator, and Moving Average Convergence Divergence provide divergence signals that can strengthen the reversal signal. Additionally, overbought conditions on top of an uptrend on high timeframes may confirm a decline in the price.
- Fibonacci Retracement Levels. The most significant retracement levels, 50% or 61.8%, near the neckline can act as a confirmation level. A break below them strengthens the pattern's validity.
- ADX (Average Directional Index): ADX rising above 25 during the downtrend after the second peak indicates a strong bearish trend.
By combining these indicators, you can confirm a double top pattern, potentially reducing the risk of false signals and improving trading decisions.
Advantages and Limitations of the Double Top Formation
Although the double top is used by traders around the globe due to its reliability, it has limitations that you should consider when implementing it into your trading strategy.
Advantages
Reliability. The double top is considered a reliable indicator of a potential trend reversal, especially when confirmed with other technical indicators.
Clear Entry and Exit Points. The pattern provides clear entry points for short positions (break of the neckline) and exit points (targets based on the height of the pattern).
Easy to Identify. The formation is relatively straightforward to spot on price charts, making it accessible for traders of all experience levels.
Works Across Timeframes. The double top pattern can be applied to various timeframes, from intraday charts to weekly or monthly ones, making it versatile for different trading strategies.
Limitations
False Signals. Like all technical patterns, double tops can produce false signals, especially in volatile or choppy markets.
Subjectivity. The exact level of the peaks and the neckline can be subjective, leading to differences in interpretation among traders.
Trend Dependent. The pattern is most effective in the context of a preceding uptrend. In a sideways market, the pattern's reliability decreases.
Potential for Late Entries. Waiting for confirmation might result in late entries, causing traders to miss the optimal entry point and reduce potential returns.
Double Top and Other Chart Patterns
Chart patterns are essential tools in technical analysis, helping traders identify potential market movements. Here are the patterns that the double top is commonly confused with.
Triple Top
The triple top pattern indicates a stronger potential reversal from an uptrend to a downtrend, suggesting even more bearish sentiment in the market compared to the double top pattern. This is because the bulls failed to break above the strong resistance twice. The pattern is confirmed when the price breaks below the neckline with increased volume.
Head and Shoulders
The head and shoulders pattern signals a potential reversal from an uptrend to a downtrend and has similar trading rules, where traders wait for a break below the neckline (drawn through the lows between the head and shoulders) with increased volume. However, it consists of three peaks: a higher peak (head) between two lower peaks (shoulders). So, it can be said that its more complex than the double top but is also considered a reliable reversal pattern.
Takeaway
A double top trading pattern is one of the most common formations that can be found on the price chart of any asset. Open an FXOpen account and examine how it works in over 600 markets. Choose between the award-winning MT4 and MT5 platforms, FXOpen's advanced multi-asset platform, TickTrader, or TradingViews platform with numerous technical analysis tools.
FAQ
How Do You Identify a Double Top in Trading?
To identify a double top in trading, look for two distinct peaks at approximately the same price level, separated by a trough. This pattern forms after an uptrend and suggests the price is struggling to move higher. Confirmation occurs when the price breaks below the neckline with increased volume.
What Does a Double Top Mean in Stocks?
A double top in stocks indicates a potential bearish reversal. This means that the upward trend may be ending, reflecting that buyers are unable to push the price higher past the resistance level established by the two peaks. Its worth saying that the pattern means the same on any asset, including currencies, commodities, and indices.
What Is the Target for a Double Top Pattern?
The target for a double top pattern is typically calculated by measuring the vertical distance between the peaks and the neckline and then subtracting this distance from the breakout point below the neckline, providing an estimated price level to which the price may fall once the pattern is confirmed.
What Is a Double Top Entry Strategy?
A double top entry strategy involves identifying the pattern and waiting for confirmation by entering a short position only after the price breaks below the neckline with increased volume or when technical indicators confirm a price fall.
*At FXOpen UK and FXOpen AU, Cryptocurrency CFDs are only available for trading by those clients categorised as Professional clients under FCA Rules and Professional clients under ASIC Rules, respectively. They are not available for trading by Retail clients.
Read more: https://fxopen.com/blog/en/a-comprehensive-guide-to-double-top-pattern-trading/
Text source: Forex Trading Blog
