When it comes to the chart pattern of double tops, traders often look for perfection. I would like to advise against perfection; and, instead, introduce how to search for the taste of a “good enough pattern.”
Imagine that prices progress in an uptrend and then suddenly find resistance. Prices pull backs then turns north again, but they are unable to break the resistance level once again. It is easy to see, as the second peek forms, so the double top became a popular trading pattern – even more so than another household name from the catalog, the head and shoulders.
Have you noticed that double tops are rarely ever equal highs; and, what is more, when they are actually identical, they have a better chance to become busted? Textbook double tops with the most obvious look have a tendency to turn out to be losers. Why?
When a double top forms at the highest point in a trend it is usually signifying a complex sideways corrective pattern, like a flat or triangle, or a double-three in Elliott terms. That can be the case as often as 80% of the time. In other words, the second high has a better chance to be a corrective B or X connector wave instead of a larger degree fifth wave high which is later followed by a significant reversal.
Downward targets are missed and surprising price surges happen to the upside in the course of a correction in an existing bull trend. Why would one focus on short selling into a temporary setback as opposed to trying to trade long when a double top appears? Perhaps it’s a lack of understanding of the larger picture context.
“When a double top forms at the highest point in a trend it is usually signifying a complex sideways corrective pattern…”
On the other hand, the large pack of traders feeding upon the popular, and oftentimes superficial, technical analysis books may only spot the equal highs. Rookies would like to learn something that’s easy to discover and something that almost always works. Two equal peaks seem to qualify, especially when the novice trader can google hundreds of descriptions to the pattern in the matter of seconds. If double tops were reversal patterns, every trader would be super rich quite fast. But they are not. In reality, the more weak hands who are eager to trade counter to the broader trend inversely affects the worshipers of a popular belief like a double top . The main source of their weakness is that they trade against the existing trend, based on their double top belief, which is frankly not true.
In this series of two posts I would like to show you something that is easy to follow and does not require Elliott wave studies. Before we get to the point, here are two plain charts without even the name of the instrument(s). No labels, or time frames, nothing, just a retracement depth indicated. What are the markets behind the chart?
You might have an educated guess that they are two different stocks from the same industry. But that is not the case. The chart on the left is the daily S&P500 index as of the Thursday close triggering a double top. The one on the right is an hourly S&P 500 from Monday, November 30th. It is the magnified picture of the chart detail marked with a pale green rectangle in the middle section of the daily. We can consider the two chart patterns as fractals, especially as the RSI panel mimics the pattern the same way (check the red circle). Regardless of the label we attach to it, there is another discovery we can make. We already know that the double top on the hourly (right) has failed the following day (Tuesday) when the market took out the highest point on the left side of the hourly double top. That Tuesday push squeezed out the early hourly shorts banking on the double top pattern, because they placed their stop loss order at or above the previous high at about 2,096.
Does this pattern failure mean that the market will surprise and shake out this week’s sellers by reaching a new high? Although the logic of the fractal suggests so, I would abstain from predicting another fake-out above Tuesday’s 2,104 maximum. I just don’t get as excited as Jim Cramer when he sees a larger than average bar, regardless of the direction and significance. Traders don’t predict, rather, they identify a situation and follow a script that is optimized action plan for that specific context.
Would you get even more thrilled if I continued on with the even larger degree version of this fractal? Because the weekly time-frame features just that! This last figure below also a current S&P500 chart where the daily double top above appears as the two week dip on the right side of this one larger magnitude double top (red mark).
For a trader any of these twin peaks is just an orientation point on the chart – like I said business as usual.
Next week, in part two, I will share my script about how to approach double top situations – step by step. Happy trading until then…
The time zone we reference on our charts is Pacific Standard Time. Therefore, the U.S. cash market opens at 6:30 AM PST and closes at 1:00 PM PST.