The double top pattern is widely recognized as a prominent bearish reversal pattern in technical analysis, frequently appearing and easily identifiable even to novice traders. In this article, we will provide a comprehensive explanation of how to trade the double top pattern with examples from forex trading.
Double Top Pattern Meaning
The double top in trading means a distinctive candlestick pattern that resembles the letter “M” on a chart; therefore, it is also referred to as the double top M pattern. It typically appears following an extended uptrend and signals a potential reversal in trend.
Compared to another bearish reversal pattern, the head and shoulders, the double top formation is simpler. This means it can be found more frequently but also comes with more false signals.
Double top formation:
- Left top
- Neckline
- Right top
In substance, the double bottom is a classic application of the support and resistance. After a prolonged uptrend, a notable pullback occurs, finding support at a key lower level before attempting to resume the uptrend. However, the market falls again upon reaching the previous high, breaking below the earlier low, and resulting in a substantial downward movement.
Double Top Pattern Entry
Since the formation is quite straightforward, spotting the double top pattern is not difficult. The key question lies in how to identify the entry. There are typically two entries, both related to the neckline.
1). Double Top Breakout - First Entry
As mentioned ealier, the double top often appears, but many of them turn out to be fake pattern. It is highly recommended that traders only consider it valid after the double top breakout occurs — when the price is confirmed to break below the neckline.
In additional to confirming the validity of the pattern, the neckline breakout also serves as the first double top entry. This entry is applicable to every double top and can filter out approximately 50% of false patterns.
2). Neckline Retest - Second Entry
Shortly after the double top breakout, the price often rebounds to retest the neckline before the actual decline begins. This scenario is known as a neckline retest, which provides the second entry opportunity for the double top pattern.
This is nothing new but a simple transition from support to resistance, which occurs frequently in the market. Please note this double top entry doesn’t apply to every pattern.
Double Top Pattern Target
After entering a short position upon the breakout, the next question is how to set the double top traget price. This is particularly beneficial for new traders, as the target price can be easily calculated using the formula below:
Double Top Pattern Target = Neckline Price – (High Price of the Pattern – Neckline Price)
Assuming there is a double top on the spot gold daily chart, with the following key prices:
- High price: 2,400
- Neckline price: 2,200
After the neckline breakout, the double top target can be calculated as follows:
2,200 − (2,400 − 2,200) = 2,000
In most cases, the market will decline beyond the double top target after the breakout, sometimes even starting a completely new, prolonged downtrend. On the other hand, there are instances where the market doesn’t hit the target. Instead of solely relying on the target calculated from the formula, experienced traders will set their targets based on key support levels.
Double Top Stop Loss
Although the neckline breakout can help filter out 50% of false double top patterns, it’s important to note that even after the breakout, a double top can still fail. Therefore, a stop-loss is always necessary to limit potential losses. Typical stop-loss strategies when trading this pattern include:
Above the Neckline
If price breaks above the neckline, it may signal a potential pattern failure. Placing the stop-loss here minimizes losses but risks being stopped out due to short-term volatility.
Above the Pattern High Price
We can often identify a false double top before this point. However, there are still instances where it can evolve into triple or multiple tops, variations of the double top.
Choosing between these two stop-losses largely depends on the trader’s risk tolerance and market conditions. The high price appoach offers greater flexibility and can accommodate larger price swings, whereas the neckline stop-loss is more conservative, minimizing potential losses.
Traders may also consider the risk-reward ratio when setting the stop-loss, calculated based on the potential price target. For instance, an ideal risk-reward ratio might be 1:2.
Double Top Forex Example
Now that we’ve covered the theories behind the double top pattern, let’s demonstrate how to trade it with a Forex trading example. The chart below is a 4-hour chart of AUDNZD for the year 2023. A typical double top pattern is highlighted between June 6 and June 23, with key prices listed as follows:
High price: 1.10500 | Neckline: 1.9250 | Target price: 1.08000
The AUDNZD traded in a narrow range at the right top and faced resistance multiple times. Some traders might have entered short positions after the price broke below the range, even the double top had not yet been formed.
Following the double top breakout with a short position, the entry price was around 1.09000, and the target price was reached in a week. The neckline retest here is intriguing, occurring after the target was hit, emphasizing that the double top pattern fundamentally revolves around the application of support and resistance.
Failed Double Top Pattern
Regardless of whether the neckline breakout happens, the double top pattern can fail at any stage. Below are two typical examples of failed double top patterns. The first one fails without a neckline breakout, while the second one includes all necessary elements but still fails even after the neckline breakout occurs.
Therefore, to limit potential losses from fake patterns, it is important for traders to follow the double top rules:
- Always wait for neckline breakout with a closed bearish candlestick to confirm the pattern.
- Set the target at the level equals to the height of the entire pattern.
- Implement strict stop-losses all the times.
Types of Double Top Pattern
In some cases, after the initial formation of a double top with two distinct tops and a neckline, the price may not break below the neckline but instead continues to consolidate between the top and the neckline.
In such scenarios, this does not necessarily indicate a failure of the double top formation; rather, it could evolve into another two types of duble pattern – triple top or even multiple top.
Irrespective of whether it’s a classic double top pattern or its variations, including triple and multiple top, the trading principles remain the same. Once the neckline is broken, you can apply the double top rules to trade these patterns.
