Forex Trend Reversal: The Double Top and the Double Bottom Patterns

The double top and the double bottom formations represent another well-known pair of trend reversal patterns that are commonly found on forex charts.

Double Top Trend Reversal Pattern

The double top reversal pattern is characterized as being highly reliable and can be found at the peaks of an upward trend. It includes two tops that have approximately equal heights and depicts the following currency price movement:

1. The currency price rises to a peak, which when reached faces resistance and then a drop to a level of support follows.
2. Another peak at the same level as the previous one follows, and then another drop.

A resistance line connects the two tops and a line parallel to it (a support line) is drawn. The double top chart pattern is considered confirmed and complete when the price drops below the support level, thus marking the reversal of the upward trend.

In order for this formation to successfully develop, the break through the support line should occur under the condition of a heavy market volume. Additionally, forex traders should not be alarmed if in the newly established trend a return to the new resistance level (former support level) occurs. This is known as a "throwback" move. It is considered to be a test of the reversal formation and its success helps to strengthen the pattern and the new trend.

Several weeks to several months are needed in order for the double top to develop. What is more, the intraday chart patterns are considered of a less reliable nature.
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." 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. Bulkowski estimates the double top has a failure rate of 65%. 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. 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.

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. 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. 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.
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.

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." 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.

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. 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.

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.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. 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. 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.

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."

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).

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.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.

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

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.

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.

Double Bottom Trend Reversal Pattern

A mirror image of the double top formation is the double bottom chart pattern. This means that the same characteristics as well as potential draw

As in the double top, large market volume is required. Additionally, a relationship between the length of time needed for the double top or double bottom to develop and the significance of the reversal pattern exists.

A double bottom occurs when prices form two distinct lows on a chart. A double bottom is only complete, however, when prices rise above the high end of the point that formed the second low.
The double bottom is a reversal pattern of a downward trend in a stock's price. The double bottom marks a downtrend in the process of becoming an uptrend.

Double bottoms are often seen and are considered to be among the most common of the patterns. Because they seem to be so easy to identify, the double bottom should be approached with caution by the investor.

According to Schabacker, the double bottom is a "much misunderstood formation." Many investors assume that, because the double bottom is such a common pattern, it is consistently reliable. This is not the case. Bulkowski estimates the double bottom has a failure rate of 64%, which he terms surprisingly high. If an investor waits for a valid breakout, however, the failure rate declines to 3%.
The double bottom is a pattern, therefore, that requires close study for correct identification.

What does a double bottom look like?
A double bottom consists of two well-defined lows at approximately the same price level. Prices fall to a support level, rally and pull back up, then fall to the support level again before increasing.
The two lows should be distinct. According to Edwards and Magee, the second bottom can be rounded while the first should be distinct and sharp.The pattern is complete when prices rise above the highest high in the formation. The highest high is called the confirmation point.

Analysts vary in their specific definitions of a double bottom. According to some, after the first bottom is formed, a rally of at least 10% should follow. That increase is measured from high to low. According to Edwards and Magee, there should be at least a 15% rally following the first bottom. This should be followed by a second bottom. The second bottom returning back to the previous low (plus or minus 3%) should be on lower volume than the first. Other analysts maintain that the rise registered between the two bottoms should be at least 20% and the lows should be spaced at least a month apart.

There are a few points of agreement, however. Investors should ensure that the pattern is in fact comprised of two distinct bottoms and that they should appear at or near the same price level. Bottoms should have a significant amount of time between them - ranging from a few weeks to a year depending on whether an investor is viewing a weekly chart or a daily chart. Investors should not confuse a consolidation pattern with a double bottom. Finally, it is crucial to the completion of the reversal pattern that prices close above the confirmation point.

Why is this pattern important?
According to Murphy, the double bottom is one of the most frequently seen and most easily recognized. 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 increase between the two lows, and the time the pattern takes to develop on the chart.
Murphy explains that bottoming patterns may have smaller price ranges than topping patterns and often take longer to build. "For this reason, it is usually easier and less costly to identify and trade bottoms than to catch market tops."

It is quite common after prices reach a new low for a rebound in prices to occur. A retest of the low then usually follows. According to Bulkowski, a retest occurs when prices return to the low and test to see if the stock can support itself at that price level. "If it cannot, prices continue moving downward. Otherwise, the low usually becomes the end of the decline and rising prices result."

Is volume important in a double bottom?
Investors should pay close attention to volume when analyzing a double bottom.
Generally, volume in a double bottom is usually higher on the left bottom than the right. Volume tends to be downward as the pattern forms. Volume does, however, pick up as the pattern hits its lows. 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 bottom is valid. Schabacker insists that the volume rule must be applied quite strictly in the case of a double bottom. Elaine Yager,
Director of Technical Analysis at Investec Ernst and Company in New York and a member of Recognia's Board of Advisors, strongly agrees with this point. The first low must be made with noticeably high volume. The second low must also experience high volume but it need not achieve the level of the first low.

Bulkowski explains that volume tends to rise substantially at the time of breakout.

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

1. Downtrend Preceding Double Bottom

As mentioned previously, the double bottom is a reversal formation. It begins with prices in a downtrend. Bulkowski cautions that on their way down, prices should not drift below the left low of the pattern.

2. Time between Bottoms

Analysts pay close attention to the "size" of the pattern - the duration of the interval between the two lows. Generally, the longer the time between the two lows, 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 lows. Analysts suggest that investors should look for patterns where at least one month elapses between the bottoms. It is not unusual for a few months to pass between the dates of the two bottoms. Murphy mentions that these patterns can span several years.Yager notes, however, that tracking of bottoms that run for several years can become cumbersome and difficult. Bulkowski suggests that best gains come from formations where bottoms are approximately 3 months apart.

3. Increase from First Low

Some analysts argue the increase in price that occurs between the two bottoms should be consequential, amounting to approximately 20% of the price. Other analysts are not so definite or demanding concerning the price increase. For some, an increase of at least 10% is adequate. Yager strongly agrees with this point. The rise between the lows tends to look rounded but it can also be irregular in shape.

4. Volume

As mentioned previously, volume tends to be heaviest during the first low, 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. This means that it is perfectly normal market action for prices on a downtrend to fall to a support level a couple of times, rise back up, and then resume that downtrend. It is a challenge for the analyst to determine whether the rise from the bottom is the indication of the development of a valid double bottom or simply a temporary setback in the progression of a continuing downtrend.Analysts, therefore, advise cautious investors to wait for the price to rise back up and break through the confirmation point before relying on the validity of the pattern. Many experts will maintain that an investor should wait for a decisive breakout, confirmed by high volume.

6. Pullback after Breakout

A pullback after the breakout is usual for a double bottom. Bulkowski estimates that in 68% of double bottom patterns, price will throwback to the breakout price.

How can I trade this pattern?
Begin by calculating the target price -of the minimum expected price move. The double bottom is measured in a way similar to that for the head and shoulders bottom.
Calculate the height of the pattern by subtracting the lowest low from the highest high in the formation. Then, add the height of the pattern to the highest high. In other words, an investor can expect the price to move upwards at least the distance from the breakout point plus the height of the pattern.

For example, assume the lowest low of the double bottom is 220 and the highest high is 290. The height of the pattern equals 70 (290 - 220 = 70). The minimum target price is 360 (290 + 70 = 360).
Murphy cautions the terms "double tops and bottoms" are greatly overused in the markets. Most of the patterns referred to as double bottoms 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.Watching the volume throughout the development of the pattern can help determine whether the pattern is a valid double bottom.

Yager notes that the key for this pattern is for the investor to have patience and wait for confirmation. Too often investors see double bottoms everywhere.

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

Because so many double bottoms 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.Bulkowski estimates that the average time for prices to return to the breakout price is 11 days. Throwbacks that occur 30 days after the breakout are not throwbacks at all, but simply normal price fluctuations.

Bulkowski offers advice for both short-term and long-term investors. Because only approximately 68% of double bottoms meet their price targets, he advises short-term investors to be ready to take profits as price nears the target. In other words, sell as prices get close to the target.Long-term investors, he suggests, can hold onto the stock for an extended upward move but should keep watch on the fundamentals to determine whether they are justified in continuing to hold the stock.

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

Two Lows at Different Levels

Sometimes the two lows comprising a double bottom are not at exactly the same price level. This does not necessarily render the pattern invalid. Analysts advise that if the second low varies in price from the first low by more than 3% or 4%, the pattern may not be a double bottom.

source : www.recognia.com