A double-top reversal is a bearish pattern that could signal the end of an uptrend. As the name suggests, a double-top pattern is characterised by two price peaks at around the same level.
The price level at both these peaks represents a key level of resistance.
Understanding the double top
After rising to a peak as part of an existing bullish trend, the price then pulls back. However, the price subsequently recovers again, as the upward momentum persists. Another pullback takes place from the next peak, creating another price trough.
The price has peaked at around the same price level twice but was unable to move past this level, indicating that this is a point of major price resistance.
Two horizontal lines can be drawn; one intersects the two peaks across the top of the pattern, while another can be drawn horizontally through the lowest price point along the bottom, where the price retraced.
A breakout to the downside below the bottom horizontal line is generally viewed as a sell signal, indicating a shorting opportunity. As ever, it’s important for us to observe that the breakout is accompanied by higher trading volume. This should lower the odds of us acting on a false breakout.
Trading the double top
As an example, suppose we are tracking the price of Facebook shares. As part of a recent steady bullish trend, we see the price of Facebook’s stock peak at $135 before suffering a fairly steep pull back to reach a trough of $113.
We then see the price rise again as buyers come into the market to take advantage of the lower price. However, once it reaches $135, the price pulls back yet again, signalling that this is a major level of resistance.
The price subsequently zigzags down to $116 but then rises again to $126, though far from the earlier higher levels of the double top. Facebook’s stock then trades briefly in a narrow range, before dropping sharply, in a near vertical drop on higher trading volumes.
The usual way to calculate a profit target for a double top is to subtract the height of the pattern from the breakout price level. In this case the height of the pattern is: $135-$113= $22
The profit target is therefore: $22-$113=$91
We have initiated a sell order at $112, just below the $113 price level denoted by the bottom horizontal line of the chart pattern. We exit the trade two days later, highly pleased with the result, when the price has met our profit target and is trading at $91.
As always, we should seek to set a stop-loss order for the trade, just in case there is a price bounce and there proves to be a false breakout. In this example, $126 could be a reasonable level at which to set a stop-loss order as this was a high point that we observed during the consolidation phase.