When following currency trends, there are several instruments to determine reversals of price movements. Among visual indicators, the double top and double bottom are considered amongst the most convenient and reliable for trying to predict a turnaround in price tendencies.
Analysts note that the appearance of double tops or double bottoms indicate a point of market exhaustion, where traders lose confidence that an asset price will continue on a trend upwards or downwards. For experienced traders, the patterns will show up as familiar M and W shapes on charts, with two price peaks or price troughs of nearly equal magnitude.
The Double Top: Where The Uptrend Peaks
The double top will appear at the finalisation of an upward price trend, where price reaches a point of resistance at the first peak of the formation on the chart. From there, it falls back to a level of support, which is considered the midpoint of the pattern.
There is no pre-established size for these movements, because they will depend on the momentum of the trend determined by the market. From the midpoint trough, traders can look for the price to move upward as bullish market participants seek to take advantage of falling prices. The formation of a second peak at the same level of the first is considered confirmation that the market has reached a point of exhaustion, and that a further upward trend is unlikely.
From there, traders can expect the price to make a definitive downward movement toward the level of support established following the formation of the first price peak. As with any technical analysis of price chart formation, an exception to this behaviour may appear with changes in fundamental market conditions, such as an unexpected news or data announcement that helps break the tendency of the pattern. Once the price drops to the level of the support line established by the lowest point of the trough in the middle of the pattern, traders will have confirmation that the pattern has been completed. They can then expect a breakout in a downward direction.
Trading A Double Top
A common method for trading on a double top is to enter a short trade, placing a stop slightly above the previous high as protection against a reversal. After that, one profit target can be set at the level of support and a second profit target can be set at twice the distance between resistance and support seen in the double top formation. The idea behind this trade is that once price has reached the second peak of the formation, it will most likely gain a downward momentum barring any unforeseen market surprises.
The Double Bottom: Finding The Floor
The double bottom will appear at the finalisation of a downward price trend, where price reaches a point of resistance at the first trough of the formation on the chart. It will then rise back to a level of resistance to form the midpoint of the pattern. From the mid-point trough, traders can look for the price to move downward again as bearish market participants continue to promote falling prices with selling activity.
At this point, buyers will likely move in amid bargain hunting as prices become more attractive. As with the double top, the formation of a second trough at the same level of the first is considered to be confirmation that the market has reached a point of exhaustion, and that a further selling trend is unlikely. Traders can look for the price to make a definitive upward movement toward the level of resistance established following the formation of the first price trough.
Once the price rises to the level of resistance established by the highest point of the peak in the middle of the pattern, traders will have confirmation that the pattern has been completed, and can look for a breakout in an upward direction.
Trading A Double Bottom
A common method for trading on a double bottom is to enter a long trade, placing a stop below the previous low as protection against a reversal. Then, one profit target can be set at the level of resistance and a second profit target can be set at twice the distance between resistance and support seen in the double bottom formation. In a mirror image of price movements in a double top, once price has reached the second trough of the formation, it will most likely gain an upward momentum barring any unforeseen market surprises.
As with other reversal patterns, paying attention to changes in trading volume can be an important factor in confirming an advantageous moment to trade. With the double-top pattern, traders are likely to see high volume during the first price peak. It's also likely they'll see a falling off of volume following the second peak, when buyers lose conviction about the continuation of an upward market trend. It will be followed by an increase in volume during the breakout phase. The double-bottom pattern will show similar volume tendencies, with volume diminishing during the second trough and picking up as a breakout upward is confirmed.
Spotting double tops and double bottoms is an easy-to-learn and essential skill for traders who seek a visual guide to forecasting market trends. Traders should be on the lookout for formation of the familiar M and W patterns in the charts, which can signal the end of an upward or downward movement and a reversal of prices that are likely to continue for at least the height of the double-top or double-bottom pattern that has emerged.
Barring any surprise market moves brought on by unforeseen news or data, the patterns are considered by traders to be useful predictors that can help with setting up trading strategies during both upward and downward market trends.
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Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…