Capital.com Research TeamDouble tops and bottoms are charting patterns used by traders to identify potential trading signals. They signify a reversal from the prevailing trend. These patterns are among the most popular indicators in the field of technical analysis.
Double top patterns are used to profit from downward movements in price while double bottom patterns help to generate profits from upward price movements.
What is a Double top pattern?
A bearish reversal indicator, a double top pattern has an “M” shape that indicates that the price of the security has rebounded from a lower point twice. Once this happens and the security breaks its support level (which is the lowest point between the two peaks, also known as the neckline) the price of the security should continue dropping for a while.
One of the most convenient aspects of a double top indicator is that it can be identified even by amateur traders. Nevertheless, it is important to note that there are effective and failed double tops.
An effective double top is one that has broken the support level after the two peaks have been reached and the result should be a strong decline in the price of the security.
Double top traders usually use this pattern and open open a short position at the level of the second peak, predicting the bearish reversal (see the red line on the image below).
A failed double top, on the other hand, occurs when the trader assumes that a double top is about to occur just because the two peaks have been formed, even though the support level hasn’t been broken yet.
A failed double top could translate into losses due to misjudgment while an effective double top could translate into profits if it is identified at an early stage, which is price level close to the one where the support level has been crossed.
What is a Double Bottom?
A bullish reversal indicator, a double bottom pattern can be identified in a given chart as the letter “W” that results from two consecutive price drops below the resistance level followed by an upward movement.
In case of a double bottom, the neckline level is the middle peak within the “W” and once this level has been passed after the second drop the price of the security should start going up significantly.
Many traders prefer entering a long position at the price of the second low. The bullish reversal is shown by the green arrow on the chart below.
Same as with double tops, double bottom indicators are very popular due to their simplicity, even though traders must be patient enough to wait for the neckline level to be broken to confirm the existence of the pattern.
How to Trade Double Tops and Double Bottoms?
Double top and double bottom patterns are used as trading signals and the profitability of any transaction made by using these indicators largely depends on the moment in which the trade is made.
Double Top Trading
A double top is a bearish indicator, which means that it intends to predict a potential drop in the price of a security.
To profit from a double top, a trader must take a short position on the security, which means selling the asset at a higher price to buy it back in the future at a lower price.
A “safe” double top trade should be initiated by short selling the security once the support level has been broken. On the other hand, the exact point at which the trader should exit the position is hard to determine as it depends on how deep the price drop may go.
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Conservative traders tend to be content with 2 - 4 percent returns on their trades, which means that a successful double top trade may be exited once this level of profitability has been reached as the exact moment of a trend reversal may be hard to identify.
Double Bottom Trading
A double bottom pattern is a bullish indicator as profits can be made by entering a long position that aims to take advantage of the resulting upward movement in the price of the security.
The maximum profit from a double bottom is realised if the trader manages to enter the position at the moment that the price breaks the neckline level and exits the positions before the trend is reversed.
A trader can take advantage of the full upward price movement of a double bottom by setting a trailing stop order that sets a maximum percentage decline in the price of the security, which could be the indication that a trend reversal is taking place.
Examples of double top and double bottom patterns
Double top and double bottom indicators help traders to identify possible trend reversals. Still, in both cases the reversal is not proved until the prevailing trend has formed the second peak or the second low, prior to turning in the opposite direction.
As with any other chart pattern and technical indicator, the double top and double bottom are often used alongside other indicators, such as the Relative Strength index or Parabolic SAR, to confirm the trend before opening a trading position.
Example of a double top pattern
As evidenced in the graphic cited above, a double top pattern frequently starts with a sustained upward price movement that is about to be reversed.
The appearance of a double top can be, on the one hand, a signal to a trader who has been profiting from the bullish price movement that points to an upcoming reversal.
The “neckline” is a straight line that indicates the support level of the double top. Once the price surpasses that line after the second peak, it is understood that the double top has been confirmed and a sustained drop should take place afterwards.
Example of a double bottom pattern
The graph shown above indicates a clear double bottom setup that comes from a downward price movement, subsequently followed by a first rebound that creates the first bottom.
The following movement should be a price decline followed by another drop of similar proportion and this creates the “W” pattern along with the “neckline” that will ultimately provide confirmation of the existence of a double bottom pattern.
Once the price surpasses the the neckline price point the price of the security should start going up consistently until the trend is reversed.
Bottom Line
Double tops and double bottoms are chart patterns used to identify potential trading signals. Traders employ these indicators to profit from potential upward and downward price movements that occur once the neckline level of each pattern has been crossed.
You can profit from a double tops and double bottoms with CFDs, as they enable you to go long or short on an underlying market.
Therefore, with a double top pattern you can open a short CFD position after the second peak, and with a double bottom you can open a long CFD position after the second low.
