Introduction What does a double top look like? Why is this pattern important? Is volume important in a double top? What are the details that I should pay attention to in the double top? How can I trade this pattern? Are there variations in the pattern that I should know about?

Introduction

A double top occurs when prices form two distinct peaks on a chart. A double top is only complete, however, when prices decline below the lowest low - the "valley floor" - of the pattern.

The double top is a reversal pattern of an upward trend in a stock's price. The double top marks an uptrend in the process of becoming a downtrend.

Sometimes called an "M" formation because of the pattern it creates on the chart, the double top is one of the most frequently seen and common of the patterns. Because they seem to be so easy to identify, the double top should be approached with caution by the investor.

According to Schabacker, the double top is a "much misunderstood formation."¹ Many investors assume that, because the double top is such a common pattern, it is consistently reliable. This is not the case. Schabacker estimates that probably not more than a third of them signal reversal and that most patterns which an investor might call a double top are not in fact that formation.² Bulkowski estimates the double top has a failure rate of 65%.³ If an investor waits for the breakout, however, the failure rate declines to 17%.

The double top is a pattern, therefore, that requires close study for correct identification.

What does a double top look like?

As illustrated below, a double top consists of two well-defined, sharp peaks at approximately the same price level. A double top occurs when prices are in an uptrend. Prices rise to a resistance level, retreat, return to the resistance level again before declining.

The two tops should be distinct and sharp. The pattern is complete when prices decline below the lowest low in the formation. The lowest low is called the confirmation point.

Analysts vary in their specific definitions of a double top. According to some, after the first top is formed, a reaction of at least 10% should follow. That decline is measured from high to low. According to Edwards and Magee, there should be at least a 15% decline between the two tops, on diminishing activity. The second rally back to the previous high (plus or minus 3%) should be on lower volume than the first.⁴ Other analysts maintain that the decline registered between the two tops should be at least 20% and the peaks should be spaced at least a month apart.⁵

There are a few points of agreement, however. Investors should ensure that the pattern is in fact comprised of two distinct tops and that they should appear near the same price level. Tops should have a significant amount of time between them -ranging from a few weeks to a year. Investors should not confuse a consolidation pattern with a double top. Finally, it is crucial to the completion of the reversal pattern that prices close below the confirmation point.

Why is this pattern important?

According to Murphy, the double top is one of the most frequently seen and most easily recognized.⁶ However, analysts agree that this can be a difficult pattern to correctly identify. Investors must pay close attention to the volume during the formation of the pattern, the amount of decline between the two peaks, and the time the pattern takes to develop on the chart.

A double top often forms in active markets, experiencing heavy trading. A stock's price heads up rapidly on high volume. Demand falls off and price falls, often remaining in a trough for weeks or months. A second run-up in the price occurs taking the price back up to the level achieved by the first top. This time volume is heavy but not as heavy as during the first run-up. Stock prices fall back a second time, unable to pierce the resistance level. These two sharp advances with relatively heavy volume have exhausted the buying power in the stock. Without that power behind it, the stock reverses its upward movement and falls into a downward trend.

Is volume important in a double top?

Investors should pay close attention to volume when analyzing a double top.

Generally, volume in a double top is usually higher on the left top than the right. Volume tends to be downward as the pattern forms. Volume does, however, pick up as the pattern hits its peaks. Volume increases again when the pattern completes, breaking through the confirmation point. .

Monitoring volume is a key aspect of determining whether or not a double top is valid. Schabacker insists that the volume rule must be applied quite strictly in the case of a double top.⁷ The first top must be made with noticeably high volume. The second top must also experience high volume but it need not achieve the level of the first top. In fact, Schabacker points out that the second top is often made on only a slight increase over the average volume during the interval between the tops.⁸

Bulkowski explains that volume does not need to be high on the breakout. When a breakout occurs with high volume, however, prices tend to decline further.⁹

Elaine Yager, Director of Technical Analysis at Investec Ernst and Company in New York and a member of Recognia's Board of Advisors, notes that the right-hand side of the pattern is the area to watch most closely. She watches for diminishing volume until the confirmation point at which point the volume should increase. However, Yager notes that this pattern is often traded with or without the volume increase on the right hand peak.

What are the details that I should pay attention to in the double top?

1. Uptrend Preceding Double Top

As mentioned previously, the double top is a reversal formation. It begins with prices in an uptrend. Analysts focus on specific characteristics of that uptrend when searching for a valid double top. The trend upwards should be fairly long and healthy. Bulkowski maintains that an investor will want to see prices trending up over the short to intermediate term - approximately 3 to 6 months. Further, he states that "the price trend should not be a retrace in an extended decline but generally has a stair-step appearance."¹⁰ Schabacker confirms this approach, explaining that if the stock has been in a long, healthy uptrend, the double top is more likely to develop into a reversal. If the uptrend is short, the double top may not hold and the uptrend will continue.¹¹

2. Time between Tops

Analysts pay close attention to the "size" of the pattern - the duration of the interval between the two tops. Generally, the longer the time between the two tops, the more important the pattern as a good reversal. Schabacker warns investors off of a pattern where only a few days intervene between the two peaks.¹² Analysts suggest that investors should look for patterns where at least one month elapses between the peaks. It is not unusual for a few months to pass between the dates of the two tops. Murphy mentions that these patterns can span several years.¹³

On the other hand, Yager notes that patterns that are too long may be unmanageable, and she looks for tighter, shorter patterns. Yager believes that shorter patterns are viable as long as you can see the volume in the right top forming.

3. Decline from First Top

According to Schabacker, this element is even more significant to the validity of a double top than volume. He argues the decline in price that occurs between the two peaks should be consequential, amounting to approximately 20% of the price. In fact, he states that it could even be more than that but should not be much less.¹⁴ Other analysts are not so definite or demanding concerning the price decline. For some, including Yager, a decline of at least 10% is adequate. All agree, however, that the deeper the trough between the two tops, the better the performance of the pattern.

4. Volume

As mentioned previously, volume tends to be heaviest during the first peak, lighter on the second. It is common to see volume pick up again at the time of breakout.

5. Decisive Breakout

According to Murphy, the technical odds usually favor the continuation of the present trend.¹⁵ This means that it is perfectly normal market action for prices on an uptrend to peak at a resistance level a couple of times, retreat, and then resume that uptrend. It is a challenge for the analyst to determine whether the decline from a peak is the indication of the development of a valid double top or simply a temporary setback in the progression of a continuing uptrend.¹⁶ Analysts, therefore, advise cautious investors to wait for the price to fall back and break through the confirmation point before relying on the validity of the pattern.

Many experts maintain that an investor should wait for a decisive breakout, confirmed by high volume. Others, like Bulkowski, are not so reliant on high volume at the time of breakout but do agree that the higher the volume at the time of breakout, the further the decline in prices that the pattern will register.¹⁷

6. Pullback after Breakout

A pullback after the breakout is usual for a double top. Bulkowski argues that the higher the volume on the breakout, the higher the likelihood of a pullback. "When everyone sells their shares soon after a breakout, what is left is an unbalance of buying demand (since the sellers have all sold), so the price rises and pulls back to the confirmation point."¹⁸

How can I trade this pattern?

Begin by calculating the target price -- the minimum expected price move. The double top is measured in a way similar to that for the head and shoulders top.

Calculate the height of the pattern by subtracting the lowest low from the highest high in the formation. Then, subtract the height of the pattern from the lowest low. In other words, an investor can expect the price to move downwards at least the distance from the breakout point less the height of the pattern.

For example, assume the lowest low of the double top is 230 and the highest high is 260. The height of the pattern equals 30 (260 - 230 = 30). The minimum target price is 200 (230 - 30 = 200).

Given the sometimes weak performance of the double top, Bulkowski suggests dividing the height in half before subtracting from the breakout point. In the above example, this would mean a target price of 215 (230 - 15 = 215).¹⁹

Murphy cautions the term "double top" is greatly overused in the markets. Most of the patterns referred to as double tops are, in fact, something else. Because of this, Murphy advises investors to make their investment decisions only after prices have broken through the confirmation point, completing the reversal pattern.²⁰ Watching the volume throughout the development of the pattern can help determine whether the pattern is a valid double top.

Edwards and Magee explain that patterns where the tops are close together in time are likely not valid double tops but are, in fact, a consolidation area. ²¹

Generally, analysts like to see deep troughs between the two peaks. Bulkowski advocates a valley that is at least 15% lower than the peaks.²²

Because so many double tops pullback after breaking through the confirmation point, it is often possible to wait for the pullback to place a trade and then watch prices decline for a second time.²³

Are there variations in the pattern that I should know about?

1. Two Peaks at Different Levels

Sometimes the two peaks comprising a double top are not at exactly the same price level. This does not necessarily render the pattern invalid. Murphy points out that investors should be less concerned if the second peak does not hit the high of the first peak. If the second peak is higher than the first, however, investors should show caution because the pattern may be in the process of resuming its uptrend. Analysts advise that if the second peak exceeds the first by more than 3%, the pattern may not be a double top. Similarly, if the second peak stays higher than the first peak by more than a couple of days, then the pattern may not be a true double top.

¹Schabacker, p.107
²Schabacker, p. 107
³Bulkowski, p. 197
⁴Edwards and Magee, p. 676
⁵Bulkowski, p. 199
⁶Murphy, p. 117
⁷Schabacker, p. 109
⁸Schabacker, p. 109
⁹Bulkowski, p. 199
¹⁰Bulkowski, p. 199
¹¹Schabacker, p. 108
¹²Schabacker, p. 109
¹³Murphy, p. 125
¹⁴Schabacker, p. 109
¹⁵Murphy, p. 124
¹⁶Murphy, p. 124
¹⁷Bulkowski, p. 199
¹⁸Bulkowski, p. 209
¹⁹Bulkowski, p. 210
²⁰Murphy, p. 122
²¹Edwards and Magee, p. 158
²²Bulkowski, p. 210
²³Bulkowski, p. 210