The theory of technical analysis predominantly takes human psychology into account where it is believed that the price patterns are result of how market responds to similar situations that arise time after time. In other words it is believed that the crowd reacts similarly in given circumstances that lead to predictable price pattern formation, which form the base of a chartist or a technical analyst. Let us discuss and understand one such price pattern that despite remaining one of the favorites in the financial markets is ironically interpreted incorrectly more often than not.
What is double top & bottom formations, how it works in online trading?
How double top and double bottoms are formed
For ease of understanding let’s take double top pattern first. In online share trading there is a setup where the share market has been rallying and suddenly comes down from a level which way assume to be “A”, the decline takes price lower to a level named “B”, after which it starts moving higher again but fails to make way above the previous high marked at “A” and eventually turn lower from “C” towards the low marked at “B” , this time however the prices find it difficult to turn higher and breaks below the support placed at “B”, completing a so called “Double top formation”. Before we understand the psychology behind the pattern, crucial parameters that must support the setup and how to benefit from it, first have a look of a typical double top formation looks like. Another name for a double top pattern which is popular amidst the traders is an “M” formation because of its shape that resembles the alphabet “M”.
Also Read : Straddle and Strangle
Understanding the psychology- The confident bulls who were successfully taking control of the trend so far witnesses a pause in the rally at level “A” which can be due to profit booking or price completing a target or any other reason but is not a cause of concern for bulls yet and they are comfortable watching prices ease believing that they will reenter with more strength at the support levels again near “B”. When the prices reach the level “B” bulls make fresh attempt to take the prices higher assuming the trend is still up, however by this time the bears have made a leak as have marked the level “A” where they aim to counter the bulls, interestingly the weaker looking bears take out the bulls at “C”, take control of the prices at “C” and not only manage to push them lower but call for a trend reversal. The final battle of online share trading is conquered only after the bears succeed in taking the prices below “B”.
The exact opposite holds true in case of a double bottom where the prices form a bottom twice near a level and reverse the down trend by breaking above the immediate recent peak’s high. Like a double top pattern, the double bottom pattern is also a reversal pattern where the down trend is reversed. The chart suggesting a double bottom is placed below. It is also known as a “W” formation given its shape matches the shape of “W” alphabet.
Factors to keep in mind:
- The most important thing to keep in mind is that before jumping into trade based on either of these pattern formation one must wait for the prices to break the volley line ( the line that crosses through B and D) , as it is only a breach above/below that line when these patterns are confirmed. Any hasty trade incurred before it can lead to wrong trade as it is a well known phenomenon of the share market to take a little halt near previous high or low.
- Since Double top /bottom patterns are trend reversal patterns therefore there must be a trend before these patterns are spotted. The formation of any such pattern in a sideways or consolidation phase should be ignored.
- The formation of tops between “A” and “C” do not necessarily have to be at exact price, rather whenever these patterns are usually spotted the prices usually break the previous high or low by just a small margin before reversing.
- Both these patterns are spotted on all the time frames ranging from intraday to weekly and monthly charts. However, the significance of the pattern is a direct function of the time frame on which they are spotted i.e. the longer the time frame on which it is spotted the more significant it carries.