A double top pattern signals a downtrend. Although it is pretty easy to notice, there are a few criteria that a pattern must fulfill to be a double top pattern.
What is a double top pattern?
A double top pattern looks just what it sounds like. The stock price creates a top and falls down. It then gathers enough momentum to reach this top via another move. Thus, the second top is approximately at the same level as the first top. But the price falls down again.
Hence, the double top pattern looks like two mountain peaks with a deep gorge/ valley in between.
Note these important details:
- If the two peaks are close to each other, the pattern does not qualify as a double top. Any two peaks that are less than a month apart fall in the same consolidation move. They do not form a double top pattern. Most double tops develop two or three months apart or more.
- The price decline between the tops should come down at least 20% from the top. However, there are exceptions.
- In general, the time element described in point (a) is more important than the depth described in point (b).
- It is possible that a small head and shoulders pattern or a descending triangle may develop in the second top.
- The best double tops have a long, dull, but deep reaction (price fall in between). The stock loses movement/enthusiasm while forming the second top. This signals that the stock has become weak and price may decline.
If the above criteria aren’t satisfied, the pattern may just become a minor consolidation and the uptrend will continue.
Also, if the above criteria are weak/unsatisfied but the downtrend is due anyway, the stock shows more “movement” than just a double top before finally falling.
Both cases show that criteria fulfillment is a necessity and gives a more reliable signal.
These are other helpful tips:
- The second top might be slightly higher than the first. However, if the price cannot penetrate decisively upwards, it is still a double top and signals a downtrend.
- After breaking down, the price may pullback to the level of the valley. This is common. Take it as a final gasp and not as an uptrend signal.
The rationale behind the pattern
The stock soars up for some reason. However, at the peak of the first top, enough supply comes and takes the price lower. The price then retraces down and reaches the “valley.”
However, immediately after the price falls, a huge demand is seen. A huge demand means the volume will be higher than during the downfall. This demand will absorb the existing supply and take the price higher. A minor hesitation is always waiting at the top when this happens. Thus, the price will be pushed down again.
If you draw a rough sketch from the description above, you will see that the two tops make a horizontal resistance level and the valley makes horizontal support.
In a double top, the stock has more probability of breaking down the support level than breaking above the resistance level. This is why a double top predicts a decline in the stock price.