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Saturday, May 23, 2009

DOUBLE TOP PATTERN – Part 2: Important Characteristics

Go back to Part 1: Double Top Formation

Important Characteristics of Double Top Pattern

Existing Trend:
There should be an established existing UPWARD trend. The uptrend should be fairly long and healthy (at least about 3 to 6 months). “Healthy” uptrend means the price trend has generally moving upwards with some moderate retracements in between (forming a “stair-step” shape) and should never undergo a retracement in an extended decline.
The longer the price has been in a healthy upward trend, the more likely the pattern to develop into a reversal pattern. If the uptrend is short, the pattern has lower probability to work out, and the upward trend is more likely to continue.

Shape of Double Top Pattern:
1) The Two Peaks:
* The peaks / tops can be either sharp & narrow (like inverted V) or a bit rounded looking & wider. Ideally, the price peaks should be the same. However, some difference in the price peaks is still acceptable.
Although the price peaks do not necessarily need to be exactly the same, but it should appear near the same price level. The price difference between the two peaks should be less than 3%.
* If the high of the 2nd peak does not hit the high of the 1st peak, it is less worrying.
However, if high of the 2nd peak is even higher than the high of the 1st peak, we should be more cautious, as the probability that the uptrend would resume is still higher.

2) The Trough:
The depth of the trough between the two peaks should be around 10% - 20% from the peak (It could be even more than 20%, but it should not be less than 10%).
In general, the deeper the trough between the two peaks, the better the performance of the pattern.
If the two peaks are not exactly the same, the lower peak should be used as the benchmark for the depth measurement.

The duration of time period between the two peaks may vary from a few weeks to many months (generally about 1 to 3 months).
Basically, the longer the time duration between the two peaks, the more likely the pattern could work out as a reversal pattern.
However, we should be extra cautious if a pattern only has a few days apart between the two peaks.

Even when the price has declined from the 2nd peak, the pattern is not completed yet. The chances that the existing uptrend will continue are still higher that the chances of reversal to take place, as it is normal during an uptrend for the price to peak at a resistance level a few times, then retreat, and then resume the uptrend again.

Double Top pattern is only completed and confirmed when the price declines and closes below the lowest point of the trough in between the 2 peaks, which serves as the key support level in this pattern. This lowest point is called the “Confirmation Point”.

Remember that we should always assume the existing trend (i.e. in this case is uptrend) is in force unless proven otherwise.
Therefore, it is important to wait for the price to make a decisive breakout by breaking through and closing below the Confirmation Point (preferably with an increase in volume), in order to avoid jumping the gun and/or prevent deceptive Double Tops pattern.

Nevertheless, sometimes the price may also make a deceptive/invalid breakout whereby it touches below the Confirmation Point, but then it moves back up again & resumes uptrend.
One possible way to prevent this is by having certain criteria to confirm if the breakout is a valid one.
A minimum penetration criteria for a breakout should be the price closes below the Confirmation Point, not just an intraday penetration.
Some traders may apply certain price criteria (e.g. 3% - 5% break from the Confirmation Point depending on the stock’s volatility) or time criteria (e.g. the breakout is sustained for 3 days) to confirm the validity of the breakout.

Usually, volume is lower during the formation of the right peak than the left peak, showing an indication that the demand is drying up.
In general, volume tends to be diminishing as the pattern is forming. The volume may pick up when the price hits the 2nd peak, but it is often only a slightly higher than the average volume during the trough.
During the breakout of the Confirmation Point, the volume should preferably increase again, although not always necessary to be so.
However, when the breakout occurs with high volume, the price decline tends to drop further and it may provide higher chances that the pattern is a reversal pattern.
(It is even better if during the decline from the 2nd peak, the price experiences an accelerated drop, perhaps with a gap down or two).

Potential Price Target:
1) Compute the depth of the trough: The distance between the peak (resistance) and the Confirmation Point (support).
If the two peaks are not the same, the lower peak should be used for this calculation.
2) To compute the potential price target: Subtract the result from the Confirmation Point.

Hence, the above formula implies that the deeper the trough between the two peaks, the larger the potential of the decline.

In general, any price target should only be used as a rough guide. To determine the price target, other factors, such as previous support / resistance levels, Fibonacci retracements, or long-term moving averages, should be considered as well.

Return to Breakout Level:
After the breakout occurs, it is common that prices may return to the breakout level for an immediate test of this new resistance level before continuing their moves in the direction of the breakout. (Remember that the support now has become a new resistance level).
This could actually offer an opportunity to participate in the breakout with a better reward to risk ratio.

To find out more about other Chart Patterns, please refer to:
Learning Charts Patterns

Analysis Tool:
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Related Topics:
* Learning Candlestick Charts
* Options Trading Basic – Part 1
* Options Trading Basic – Part 2