Chart patterns can help you understand the condition of the market. The double top pattern can warn you about a market peak, but do you know what it is and how to identify it?
The double top chart pattern is a price action formation that consists of two swing highs that end around the same level. It is a reversal chart pattern seen at the end of an uptrend or a prolonged pullback in a downtrend. When completed, the pattern indicates that the price is likely to turn and head downwards.
In this post, we take a look at the double top pattern and at the end of the article, we give you a backtest of the double top chart pattern strategy.
What is a double top chart pattern?
The double top pattern is a price action formation that consists of two swing highs that end around the same level, and a swing low between them. It is a bearish reversal chart pattern seen at the end of an uptrend or a prolonged pullback in a downtrend. When completed, the pattern indicates that the price is likely to turn and head downwards.
With the two swing highs ending at roughly the same level, that level becomes a resistance level. A line joining the swing low to the preceding swing low constitutes a neckline, which serves as a support level. When the price breaks below the neckline, it shows that the uptrend might be over and the price is about to decline.
Being a bearish reversal chart pattern, traders see it as a warning sign that the uptrend might be over and as such, close their long positions. Short sellers might open short positions when the price breaks below the neckline.
Example of a double top chart pattern
Below is an example of a double top in Tradingview:
From the chart above, you can see that the price was in an uptrend, as indicated by the blue arrow trendline. The price reached a peak and pulled back to the neckline (yellow line), and then started to rally again. It got to the level of the first peak and was rejected twice before it eventually declined to the neckline and broke below it.
Is the double top pattern bullish or bearish?
The double top pattern is bearish. It is formed at the end of an uptrend and indicates a potential downward reversal, which is why it is considered a bearish reversal pattern.
How do you trade a double top pattern?
You can use the double top pattern as a warning to close a long position if you are a long-term investor. If you want to sell short, wait for the price to break below the neckline, and if you miss that opportunity, you can wait for a retest of the neckline, as you can see in the chart below:
You estimate the profit target by measuring the height of the pattern and projecting it downwards from the neckline. The stop loss can be in the middle of the pattern, which offers a better reward/risk ratio, or above the pattern, which offers a poor reward/risk ratio but appears safer.
Double top pattern trading rules (settings)
To summarize, here are the suggested trading rules for the double top pattern:
- There must be an existing uptrend before the pattern appears
- Both swing highs should be within 3% of each other
- The price must break below the neckline on a huge volume
Amibroker code for the double top pattern
To code a double top is hard. We have made the code to show the formations in the chart, and it can additionally be backtested with a few modifications. You can purchase the code together with lots of other code from our free and profitable trading strategies.
An example of how the code looks can be found here:
Double top chart pattern strategy (backtest and example)
To code properly to make a backtest of a double top pattern strategy is hard, difficult, and time consuming. But we are lucky and have a book by Thomas Bulkowski called The Encyclopedia of Chart Patterns. It’s a bit old, published in 2000, but we assume chart patterns never go out of style.
Bulkowski is an engineer and wanted to build his trading on some kind of scientific research and not on unquantified predictions. That’s why he wanted to go through all the major chart formations and quantify them over many years. He picked 500 stocks, not adjusted for survivorship bias, and looked manually at patterns over a period of 5 years. One of the patterns was the double top chart pattern.
We summarized his findings about the double top pattern in this table:
|#Formations among 500 stocks from 1991 to 1996||454|
|Reversal or consolidation||113 consolidations, 341 reversals|
|#False signals||75 (17%)|
|Average decline of successful formations||20%|
|Most likely decline||10 to 15%|
|#Formations that reached the target||177 (39%)|
|The average length of the formation||57 days|
|Average price difference between tops||1%|
A double top is a short strategy and shorting is very difficult – we have explained why shorting stocks is difficult in a previous article. Only 39% of the formations reach their target, a number that is much lower than the 68% for the opposite double bottom chart pattern strategy. The reason for the difference is simple: the stock market has a tailwind in the form of inflation and increased productivity. Please read our article about night trading strategies.
Bulkowski’s research gives us an indication of the double top pattern strategy, but it still involves a lot of human judgment. For example, all the chart patterns are manually detected and not scanned by precise buy and sell rules. Short-term trading is all about statistics and probabilities and thus you are a little blind if you rely too much on Bulkowski’s statistics (in our opinion).
Double top chart pattern strategy – ending remarks
Generally, we believe shorting the stock market is a futile idea (most of the time) because of the tailwind from rising stock prices. It’s only during brief periods of time that shorting is profitable (when the market falls hard and fast). These occasions are far between. Thus, we believe the double top chart pattern strategy is a pretty tough formation to trade.
– How do you identify a double top pattern?
The double top pattern is identified by two swing highs at approximately the same level, forming a resistance level. A neckline, formed by connecting the swing low to the preceding swing low, serves as support. A break below the neckline suggests a potential downward reversal.
– Is the double top pattern bullish or bearish?
The double top pattern is bearish. It occurs at the end of an uptrend, indicating a potential reversal and a likely downward movement in prices.
– What are the trading rules for the double top pattern?
Trading rules include identifying an existing uptrend, ensuring both swing highs are within 3% of each other, and waiting for a significant volume break below the neckline for a valid trade signal.