The double top and bottom pattern is one of the most commonly applied tools in technical analysis when trading stocks and cryptocurrencies.
Technical analysis is important as it allows you to time your market entries and exits for maximized profitability in a trade. Understanding technical analysis patterns can give you an advantage over other traders and protect you from falling prey to market traps and fakeouts.
What is a Double Top Pattern?
A double top candlestick pattern is characterized by two consecutive rounding tops. This may resemble the shape of a “M”, but does not have to follow an exact M shape. It is usually seen after a long bullish uptrend and indicates a bearish reversal pattern.
What is a Rounding Top?
A rounding top is usually an indication that the market has exhausted buying pressure and is unable to go any higher. It hints of a bearish trend reversal.
Is a double top bearish?
A double top pattern gives a similar indication. In this case, the market has tested the limit twice, and proven that it is unable to extend beyond a certain price. Thus, this confirms the bearish reversal pattern more strongly than a single rounding top.
The reason for the bearish reversal double top pattern is usually because buying demand has been exhausted and traders have stepped in to take profits. As the market confirms that the asset’s price will not extend beyond a certain threshold, more and more traders sell their shares or cryptocurrency, leading to the expected downtrend.
Example of Double Top Pattern. Source: Diary of a Trader
Example of Double Top Pattern. Source: Diary of a Trader
These examples illustrate clear double top candlestick patterns at different points in the GBPUSD chart.
The peaks in a double top pattern tend to be near equal in price, as shown in the examples above. Alternatively, the second peak might be lower than the first. This would indicate that buying pressure has declined after the first rounding top.
The volume is also likely to be lower for the second rounding top due to declining market demand.
The neckline of a double top pattern is indicated by the base of the middle trough. Once the asset’s price falls below the neckline, a breakout has occurred and the double top pattern is confirmed.
However, traders typically pre-empt the pattern before this happens, and place their buy or stop loss orders accordingly.
What is a Double Bottom Pattern?
A double bottom pattern is the opposite of a double top pattern. Visually, a double bottom pattern may resemble the shape of a “W”. It consists of two troughs, which can also be called rounding bottoms.
What is a Rounding Bottom?
A rounding bottom pattern can usually be considered a sign of potential bullish reversal. This is typically seen at the end of a bearish period. It suggests that sellers have tried to push prices lower but were unable to do so past a certain resistance level.
A double bottom pattern confirms that sellers tried more than once to drive down price but were unable to do so.
Double Bottom Pattern Example. Source: The Trading Channel
Is Double Bottom Pattern Bullish?
The above example is taken from the GBPAUD chart. It demonstrates how trading based on technical analysis patterns is not easy because reality does not always follow theory. The first double bottom showed only a slight breakout before it reversed once more into a bearish trend. Then price entered a second, wider double bottom pattern before finally breaking out into more significant profits for long position traders.
These scenarios demonstrate the importance of setting a good stop loss. If the stop loss were set too tightly based on the hypothetical pattern, it may trigger a premature exit and deprive the trader of greater profits later on.
Understanding how to trade the double top and double bottom patterns is crucial when dealing with cryptocurrency markets.
How to Trade Double Top and Double Bottom Patterns?
Double top and bottom patterns can be traded in different ways.
For a double top which indicates a bearish reversal trend, a trader can short the asset and profit from the downtrend. If the trader has an open position in the market, they may take this as a signal to close the position quickly before the prolonged downtrend.
Conversely, in the case of a double bottom which signals a bullish reversal trend, a trader may either choose to enter a long position to profit from the expected uptrend, or to quickly cover their shorts.
When to enter the trade?
Apart from the type of trades, it is also essential to consider market entry timing.
There are two main approaches that traders take when timing double top or bottom pattern trades.
1 Anticipate potential double top or bottom patterns
The first is to be pre-emptive and anticipate potential double top or bottom patterns. This poses a higher risk because the trader cannot be certain that the pattern will indeed appear or, even if it does appear, that the expected bearish or bullish trend reversal will subsequently occur.
Illustrative Example of Double Bottom. Source: Daily FX
For example, in the case of a double bottom, the trader may choose to set their buy order just above the neckline of the second rounding bottom.
Buying at this level is risky because the asset might just be experiencing a temporary price bump before continuing a bearish downtrend.
However, by taking that risk and setting an earlier buy order, the trader is able to purchase the asset at lower prices and achieve profits more quickly. They can then profitably exit the trade earlier as well if the breakout does not turn out to be as significant as they had hoped. Traders who are confident in their technical analysis or have larger risk appetites may choose this approach.
2 Wait for the Double top or bottom before entering
An alternative approach is to be reactive. This means that the trader will wait for the double top or bottom pattern to be confirmed before entering the trade.
For example, a reactive trader might set a buy order around the middle or top of the bullish trend reversal after the second rounding bottom.
In such cases, the trader is more confident of a bullish trend reversal because a double bottom pattern is occurring. However, they may not enter at an ideal price and subsequently reap less profits after exiting the trade than the anticipatory trader would.
In the event where no strong breakout occurs from the neckline after the double bottom pattern, the reactive trader’s buying price would likely be too close to the peak to secure any meaningful profit.
When to Exit the Trade?
Similar to market entry, your exit timing depends on your trading strategy and risk appetite. Traders with lower risk appetite may choose to set their stop losses or profit taking closer to the necklines of double top or bottom patterns. Traders with higher risk appetites might set their targets further along and will wait out several fluctuations in hopes of increased gains.
One way you can set your stop losses is by using Bollinger Bands. The Bollinger Bands technique can be applied when deciding the best time to exit a double top or bottom trade. This can be done as follows:
- Isolate the peak or trough of the first top or bottom respectively.
- Overlay Bollinger Bands with two standard-deviation parameters. For high volatile assets like cryptocurrency, you can choose to use four standard-deviation parameters instead. For inherently volatile assets, a two standard-deviation parameter might cause you to exit trades too early due to fluctuations.
- Draw a line from the first peak or trough to the Bollinger Band. The point of intersection is the recommended stop loss.
The benefit of Bollinger Bands over traditional stop losses is that they are set in terms of standard deviations. Therefore, they can respond to market volatility and incorporate it into decision-making.
However, as with all technical analysis tools, Bollinger Bands are not foolproof. It is recommended that this method be used in combination with other indicators, such as the moving average divergence/ convergence (MACD), on-balance volume, and relative strength index (RSI). How you choose to use these techniques depends on your trading preferences and market assessment.
Conclusion
Double top and bottom candlestick patterns can be a useful tool for technical analysis. Understanding these patterns can enable you to identify potential market reversals ahead of time. Apply it with other techniques to potentially gain a more holistic assessment of the market and increase the likelihood of successful trades.
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