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What is Double Top and Double Bottom?
No chart pattern is more familiar in stock trading than the double top or double bottom. It appears so often that it alone may prove that price action is not as highly random as many academic tutors claim. A price chart simply expresses the sentiment of a trader. Besides, the double top and the double bottom represent a re-testing of temporary extremes. Have you ever thought that if the prices were truly random, why would they pause at those points so frequently? It is as simple as participants’ making their stand at those clearly determined levels.
Double top and double bottom patterns occur when the underlying investment moves in a similar design to the English letter “M” (Double Top) and “W” (Double Bottom). These two chart patterns are used in technical analysis to explain the movements in a security or other investment. In addition, these can be used as part of a trading strategy to influence recurring patterns.
Understanding the Double Top and Bottom Patterns
The double top and bottom patterns generally develop over a long time period. Plus, these do not always present an ideal pattern because the shift in prices doesn’t necessarily match the letters “M or W”. Most importantly, the investors have to understand that the peaks and troughs do not need to reach the same points to appear the “M or W” pattern.
The double top and bottom patterns are formed with the help of straight rounding tops and bottoms. Further, these two chart patterns are often used with other indicators since rounding patterns can easily lead to incorrect or mistaking reversal trends.
Double Top Pattern
A double top is a bearish reversal trading pattern that is formed after an uptrend. It is made up of two peaks above a support level, known as the neckline. The first crest (top of a specific time frame) is formed after a bullish trend, and it will backtrack to the neckline. Once the price of a particular stock hits the support level, the momentum will shift to a bullish trend once again to form the second peak. The formation of this pattern is completed when the prices of a stock move back to the same neckline after creating the second top of the design.
These patterns are pretty trustworthy for trading as these often give you the profit. In case these patterns fail, then more tops will be formed that will be stronger than the double top pattern. Typically, a double top pattern signifies the end of a bullish market, depending upon the width of the peak formation. Simply, when the prices break the support level or the neckline, the bearish reversal trend is confirmed.
Double Bottom Pattern
A double bottom is a bullish reversal chart pattern formed after a downtrend. It is constructed with two lows below its resistance level, also known as the neckline. The first low is created after a strong downtrend (a bearish trend) and goes back towards the neckline in a bullish trend. After getting hit by the neckline or the support level, the prices again started to decline (bearish trend) unless the momentum shifted to bullish, making the second low once it touched the neckline again.
The formation of this pattern is completed when the prices of a stock move back to the support level or neckline after forming the second low. These patterns offer reasonable risk to reward ratios. At the same time, if the double top pattern fails, traders find triple or more bottom patterns that are much stronger than the double bottom pattern. Nevertheless, when the prices break through the neckline or the resistance level, these (prices of that particular stock) generally move upwards, confirming a bullish trend reversal. As a result, traders can enter a long position.
Significance of Double Tops and Double Bottoms
A double top or double bottom helps traders understand a possible trend reversal. Yet, the reversal is not confirmed in both cases until the current trend has formed the second peak or second low before getting reversed in the opposite direction to the trend before the first peak or first low.
Like other technical indicators and chart patterns in stock trading, the double top and double bottom patterns are by no means specific trend indicators. Due to this reason, traders should always use this chart pattern alongside others to confirm the trend before opening a position.
Trading with Double Top – First of all, a trader should check the market whether it is in an uptrend or downtrend. As the double top is formed at the end of an uptrend, the previous trend must be an uptrend. Traders should observe well if two rounding tops are forming and record the tops’ size. Concurrently, they should only enter the short position when the price breaks out from the support level or the neckline.
Trading with Double Bottom – In the case of a double bottom pattern, one should see the market phase, whether it is up or down. Remember, a double bottom pattern is formed after the end of a downward trend. So necessarily, the preceding trend should be the downtrend. Further, the traders should spot if two rounding bottoms are forming and note the bottoms’ size. Besides, the best way to enter the market for a long position is when the price breaks out from the neckline or resistance level.
Both the double top and bottom patterns are trend reversal patterns. These are generally used to define whether a bearish trend turns bullish or a bullish trend turns bearish. Moreover, traders will open a short position at the height of the second peak of a double top and a long position at the formation of the second low of the double bottom. The most important thing you should keep in mind is that the pattern is only confirmed after the trendline breaks the neckline, and if it does not break through the support level, then the pattern is nullified.
Overall, double top and double bottom formations are hugely helpful when identified correctly. But if you make a mistake while interpreting these patterns, then you will be in an immense problem. Hence, be careful as well as have patience before jumping to conclusions.