Double Top Reversal
Explore the Double Top Reversal chart pattern and learn to identify, interpret, and trade this common bearish reversal pattern.
The Double Top Reversal is a bearish reversal pattern typically found on bar charts, line charts, and candlestick charts. As its name implies, the pattern has two consecutive roughly equal peaks, with a moderate trough in between.
Although there can be variations, the classic Double Top Reversal pattern marks at least an intermediate-term bullish to bearish trend change. The chart below is an example of a Double Top Reversal.
Note: A Double Top Reversal on a bar or line chart differs from a Double Top Breakout on a P&F chart. Double Breakouts on P&F charts are bullish patterns that mark an upside-resistance breakout.
Many potential Double Top Reversals can form along the way up, but until key support is broken, a reversal cannot be confirmed.
The following are key points in the Double Top formation:
Prior Trend. With any reversal pattern, there must be an existing trend to reverse. In the case of the Double Top Reversal, a significant uptrend of several months should be in place.
First Peak. The first peak should mark the highest point of the current trend. As such, the first peak is fairly normal, and the uptrend is not in jeopardy (or in question).
Trough. After the first peak, there is generally a 10-20% decline. Volume on the decline is usually inconsequential. The lows are sometimes rounded or drawn out a bit, which can signify tepid demand.
Second Peak. The advance from the trough usually occurs with low volume and rises to the previous high. Resistance from the previous high should be expected. Only after meeting resistance will a Double Top Reversal pattern be possible. It still needs to be confirmed. The time between peaks can vary from a few weeks to many months, with the norm being one to three months. While exact peaks are preferable, there is some leeway. Usually, a peak within 3% of the previous high is adequate.
Decline from Peak. The subsequent decline from the second peak should witness an expansion in volume and/or an accelerated descent, perhaps marked by a gap or two. Such a decline shows that demand forces are weaker than supply, and a support test is imminent.
Support Break. Even after trading down to support, the Double Top Reversal and trend reversal are still incomplete. Breaking support from the lowest point between the peaks completes the Double Top Reversal. This should occur with increased volume and/or an accelerated descent.
Support Turned Resistance. Broken support becomes potential resistance; sometimes, this newfound resistance level is tested with a reaction rally. Such a test can offer a second chance to exit a position or initiate a short.
Price Target. Subtract the distance from support break to peak to obtain a price target. This would infer that the bigger the formation is, the larger the potential decline.
Although the Double Top Reversal formation may seem straightforward, proper steps should be taken to avoid deceptive Double Top Reversals.
The peaks should be separated by about a month. If the peaks are too close, they could represent normal resistance rather than a lasting change in the supply/demand picture.
Ensure that the low between the peaks declines at least 10%. Declines under 10% may not indicate a significant increase in selling pressure. After the decline, analyze the trough for clues on the strength of demand. Demand could be drying if the trough drags on and has trouble moving back up. When the security does advance, look for a contraction in volume as a further indication of weakening demand.
Perhaps the most important aspect of a Double Top Reversal is to avoid jumping the gun. Wait for support to be broken with an expansion of volume.
You can apply a price or time filter to differentiate between valid and false support breaks. A price filter could require a 3% support break before validation. A time filter might require the support break to hold for three days before it is considered valid.
The trend is in force until proven otherwise. This applies to the Double Top Reversal as well. Until support is broken convincingly, the trend remains up.
In the chart below, the double top formation took five months to form. Even after the support break, there was another test of newfound resistance almost four months later.
Let's walk through the above chart.
Ford's stock price advanced from a low near 10 in March 1997 to 36 by December 1998. The trend line extending up from March 1997 is an internal trend line, and Ford held above it until the break in May 1999.
The stock declined around 15% from the first peak to form the trough.
After reaching a low near 30 1/2 in early February, the trough formed over the next two months. There wasn't a rally until early April. This long-drawn-out low suggested tepid demand.
The decline from $36.80 occurred with two gaps down and increased volume. Furthermore, the Chaikin Money Flow moved below -10%. The speed at which money flows deteriorated indicated a significant increase in selling pressure.
In late May and early June, the stock traded for about three weeks at support from the previous low. During this time, money flows declined below -20%. Even though the situation looked ominous, the double formation would not be complete until support was broken.
Support was broken in early June when the stock fell below $28.50. That's more than 3% below support at $30.50. This sharp drop was followed by an equally sharp advance and the stock price was back above the newfound resistance level. A test of broken support can happen, but typically not this early. The advance to $32 in late June may have triggered some short-covering by those who jumped in on the first support break. The stock fell to $25 and then began the retracement advance that would ultimately test support.
The chart below shows that $30.75 marked the support turned resistance level, and $31 marked a 50% retracement of the decline from $36.80 to $25. Combined with the price action in early June and early July, a resistance zone could probably be established between $31 and $32. The stock subsequently formed a lower high at $30 in Jan 2000 and declined to around $22 by mid-March.
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