Double and Triple Tops and Bottoms
There is a story used in the description of the process of doing Zen meditation where the practitioner says that after first learning to meditate, trees were no longer trees and mountains were no longer mountains but after many years of practice, trees and mountains were again simply trees and mountains. There is an analogy in this to my own practice of technical analysis. When I first learned about double tops and bottoms as possibly indicating an end of a trend, I saw many instances of the expected outcome for this reversal pattern and I was seeing markets in a different way. After more time spent observing market trends, I saw exceptions develop where for example, a second top was exceeded and I began to anticipate the exceptions to the rule and to pay less attention to the expected outcome for these patterns. I had become too sophisticated to believe necessarily in the probability that a second top was an indication for a future downside reversal. After still more time, I began to see the potency of double tops and bottoms and realize that while these patterns sometimes failed to bring the expected result, they were very good signals after all. For me, double tops and bottoms became double tops and bottoms again.
Double and triple tops are, as the term implies, situations where a high or low fails to exceed the price area of a prior significant top or bottom, on two or three occasions. It should also be noted that the second or third top or bottom does not have to occur at the exact level as the previous high or low as long as this subsequent high or low is in the same general price area as the earlier peak(s) or bottom(s) (e.g., within 5%). A significant prior high or low would be one that was the extreme point of an advance or decline to date. A stock or futures market that makes tops or bottoms in the same approximate area on more than three occasions is considered to be in lateral consolidation or trading range—a subsequent breakout above or below this range can also establish an upside or downside reversal of the trend but this is a different pattern.
We need only think about the concepts of support and resistance to understand what is happening in a double top or bottom, which is more common than the triple top or bottom. Support is a price area where buying interest is such that there are more willing buyers than sellers, and this buying will drive prices back up. Resistance is a price area where selling interest is strong, and sellers will overwhelm buyers and drive the price down.
Double bottoms form in a price area where in the initial bottom there was an abundance of willing buyers. If the potential buyers were strongly interested once in a particular area and there is no great change in the market outlook, they will be interested again in the same price zone and this buying will cause a rebound. Double tops form in a price area where the would-be sellers are in control because of their numbers and willingness to sell most or all of what they own of a stock or other financial instrument— this may also be an area where there is willingness to sell short.
It is when the outlook for a stock or other financial instrument changes, that a prior high will be exceeded, as enough buying interest develops to keep prices moving through the prior high. The reverse is true when prices sink through a prior bottom—there are too few buyers this time around. The significance for you, and a significant value in technical analysis, is that the price pattern alone will tip you off as to whether the most knowledgeable participants in the stock or other instrument find the value proposition to be different on the second or third time around for prices at the previous swing low or high. Generally the more time that separates the twin (or triple) tops or bottoms, the more significant is a subsequent trend reversal.
A confirmation is also required to determine whether a double or triple top or bottom is in place and the dominant trend has reversed. You’ll recall that the definition of an uptrend is a series of higher highs and higher reaction lows. It is not the failure of prices to exceed a prior peak (this could always happen later), but a decline that exceeds a prior reaction low that initially confirms that a trend reversal has taken place. A double bottom is confirmed when a prior significant upswing top (in the decline just ended) is exceeded after the apparent double bottom. Another related confirming indicator, while secondary to exceeding a prior swing low or high, is having volume action in synch with price action. For example, on a break of any prior significant swing low or high, volume will normally expand significantly relative to before this break. We would also expect that the on balance volume or OBV line would move in the same direction as the breakout. Volume offers good secondary confirmation and should be looked at also. If there was no volume confirmation to price action and there is only a slight closing break of the prior low or high, it’s usually a good idea to wait for a second consecutive close above or below the swing low or high in question.
It’s useful to also remember the psychology involved in tops and bottoms that form in a repeat fashion over time. Market participants become convinced that a price floor or ceiling has been established. There is then more belief in the staying power of the trend after the double top or bottom has formed and more people get into the market, stock, or other instrument, which then helps keep the trend going.
The pattern of double or triple tops is a very useful one as a guide to getting into or out of the market for both traders and investors. I especially like entry at such points as I can then take a relatively small risk, as liquidating stops can be set just above or below the second or third top or bottom.
Because of this, I will not necessarily wait for confirmation of the double top or bottom reversal pattern, which is achieved only when prices also go on to exceed a prior upswing high or low as described previously. This strategy assumes the risk of a pattern failure in exchange for a more favorable risk-to-reward ratio, which is especially relevant to traders. Investors looking to take a long-term position may wish to wait for the confirming price action. It is always important to pull together all aspects of trend analysis. If there is one to two years between the second low or top, this is more significant than a double top or bottom that formed over one to two months. Look also at what volume and the overall market are doing. It’s quite relevent if the major market averages have bottomed or peaked. Remember Dow’s adage that a rising tide lifts all boats. Conversely, swimming against the tide is only for the most powerful swimmers.
Further upside or downside potential can be guessed at when evaluating the possibility that a trend may be vulnerable to a reversal or is just consolidating. One way of setting at least an initial objective based on a double or triple top or bottom is to assume that the minimum objective is equal to the height of the trading range formed by the multiple tops and bottoms that form in the topping and bottoming process that occurs after a run in prices. For example, a stock trends higher until it hits $100. The stock drops back to $75, then goes back up to $100 and maybe back down to the $75 area again. The trading range at this point is $25. If the stock breaks out above $100, thereby confirming a double bottom (at $75), a minimum upside potential is probably to $125. Conversely, a break of $75, would suggest further downside potential to $50, where the stock would also complete a 50 percent retracement.
The risk-to-reward equation should be worked out, if those parameters are in your favor, at potential tops and bottoms. If long at a possible double top, your risk of giving back a substantial portion of any unrealized gain is generally higher than the reward potential of a further up leg. At such a juncture, it is not necessary to exit your position, as the old top may certainly be exceeded, but raising your exiting stop to just under the last prior significant downswing low is warranted. In the case of an investor with reason to anticipate the start of a primary trend reversal, waiting for confirmation of a double bottom is a good strategy. A more aggressive stance, especially if the prior downswing low is far under the possible double top, is an exit at the probable double top, especially if the prior top was a major one, while being prepared to assume a new long position if prices push through the most recent high by a significant amount (e.g., more than 5%) and on strong volume.
Use of a buy stop above the prior high can put you into a new long position. An exiting sell stop can then be set not far under this new entry point, as the risk (exit) point ought to be just below the old high that was just exceeded. This prior top should now offer support on pullbacks—prior resistance, once exceeded, becomes support—if this is not the case, a bull trap reversal is a definite possibility (i.e., a push to a new high, followed by a downside reversal).
Read More : Double and Triple Tops and Bottoms As Reversal Patterns
