A discussion in Chat the other day prompted me to pull out some charts to demonstrate visually the points being covered. On this topic Ryan and I agree. Specifically, that seeing a double high in price just isn't enough in our book to call something a double top with any form of confidence when risking my money. Rather I would prefer to see some form of negative divergence in indicators to lead me to believe that the trend is weakening and ready for a reversal.
Now the learned gentlemen @ FreeStockCharts.com lay out some great guidelines in their Chart School on double tops:
- You have to have a prior trend to reverse.
- Volume increase on the breakdown [as they clear out stops] is helpful to confirm.
- Time. I'm also in agreement with them that I prefer to see one to three months elapse in the building of the two peaks. Remember, big money is placing their buy/sell orders based on weekly and daily timeframes. That's not to say that these conditions cannot exist intraday [5/15/60min], but the longer timeframe [daily/weekly] rules the trend of the stock so don't fight the trend.
The thing they don't address and I definitely like to see is negative divergence in MACD, Stoch or some other indicator when the 2nd peak is achieved as a confirmation of weakness in a stock
As an example, MSCC challenged it's high but you'll notice that MACD failed to achieve a new high. That's a negative divergence and it's that divergence that leads me to believe that buying interest in the stock has waned. Warning Will Robinson.......stay away!
Once it breaks support, conventional wisdom will call that prior support area, new resistance however some stocks will once again challenge their high [as MSCC did] and when the stock challenged once again, it would've given one the perfect opportunity to get short with a cover stop above the prior swing high.
Others don't give you that opportunity. The breakdown area serves as solid resistance and buyers simple cannot believe a breakdown is taking place as what happened in PCLN.
The same divergences can also signal head-and-shoulder tops and triangles. Take this example of FDO where there was a divergence as the head was formed.
Observant traders seeing the divergence would've begun to short the stock as it attempted to head higher; thus forming a right shoulders. Eventually the bulls give as the sellers overwhelm. Once support is broken, stops are triggered and the stock corrects.
One of my idols, Thomas Bulkowski, defines double tops as one of the most reliable chart pattern in terms of performance and breaks them down even further in his Encyclopedia of Chart Patterns with a 71-73% success rate. NOTE: Checkout the free PDF version of this fantastic book in our Book forum.
Clearly if properly identified and if accompanied with divergences, these patterns [applicable in the reverse fashion for head-and-shoulder bottoms] are profitable setups for traders..........and flash warning signals for longs as to when to cut the cord and bail out of a position.
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