Trading using Double Top pattern and Double bottom pattern
Chart patterns form an integral part of technical analysis. New traders and experienced traders use the patterns to analyze price movements, to study the strength of underlying trends, and to predict the future price. Patterns repeatedly occur in the markets but have varying forms of success rates. One of the most significant occurring reversal patterns is the double top pattern and double bottom pattern, and the triple top and triple bottom pattern.
Double Top And Double Bottom Pattern Full Video
Contents
- Double top candlestick pattern
- How to identify double top pattern
- Double top pattern forex trading
- Double top pattern intraday trading
- Double Bottom Candlestick Pattern
- Double Bottom Pattern forex trading
- How to trade double bottom pattern
- Double bottom pattern meaning
- Using additional confirmations
- Different ways to trade the pattern
- Pros and cons of the double top/bottom strategy
- Triple Bottom Pattern
- Triple Top Pattern
- Limitations
- Conclusion
- Infographic
Double top candlestick pattern:
The double top pattern is a chart pattern that occurs when the price moves in a similar pattern to the letter “M”. Double top analysis is used in technical analysis to explain how prices move in a security or other investment, and can be used as part of a trading strategy to exploit recurring patterns. The basis of the pattern consists of a neckline and two highs. However, the height of the second high formed must not be higher than that of the first. If not, the pattern would be deemed invalid. This is due to economical reasons that we will then explain in the later part of the article.
How to identify double top pattern:
Picture B illustrates the components of the double top pattern to identify the pattern properly. The price rallied and formed a top at point A, this is the first top of the pattern. The prices then retraced to the lowest retracement point C and then made a second top at B, slightly lower than the first top A. The second top B may not be equal to the first top A, it can be slightly higher or lower than the first top A. The prices then moved to E which is the halfway or the midpoint between the first top A and lowest retracement point C. The pattern is confirmed only when the price makes a clear break by closing below point F, point F is formed by drawing a horizontal line from point C.
Double top pattern forex trading
Picture C illustrates the trading method of the double top pattern. The trader may not be able to identify the double top pattern until points A, C, and B are formed. At point B there may not be any indication that the prices had formed the pattern, since from point B price may continue to move higher in the direction of the existing trend. But the inability of the prices to make a new high, higher than point A and the subsequent drop in the prices may provide a hint of the formation of a pattern.
Once the trader finds the prices going lower than point E, the trader gets ready for price reversal and prepares a trading plan in advance, if the pattern is confirmed later. The prices should make a clear break of the neckline, with prices closing below the neckline and effectively confirming the completion of the reversal pattern. Entry will be possible once prices closed below the neckline, giving an optimal risk to reward ratio, with the risk to be taken at point D and the Reward to be expected at point H, in accordance to the profit target at point I. The profit target is based on the magnitude between the neckline, F and the first high, A at a 1:1 ratio.
However, conservative traders will wait for the price to retest the neckline at point G and avoid any false breakouts. As the market moves in waves, the price starts to lose its bearish momentum and starts to rest, forming a retest at point G. Typically when this occurs, prices will head in the direction of the neckline, providing a potential second point of entry. The stop loss is placed at point E, which is also the halfway point of the pattern, and the take profit can be calculated as the same length of the distance between the neckline, F, and the first high, A. This ultimately achieves an approximate risk to reward ratio of 1:2.
Double top pattern intraday trading
Intraday traders can also benefit from double pattern trading as the pattern is formed in all time frames and can be traded successfully. However, the pattern may take a longer time for completion in the higher time frame charts making intraday traders focus on patterns found in the lower time frame charts only.
Double Bottom Candlestick Pattern
Conversely, the double bottom pattern is a chart pattern that occurs when the price moves in a similar pattern to the letter “W”. Double bottom analysis is used in technical analysis to explain how prices move in a security or other investment, and can be used as part of a trading strategy to exploit recurring patterns as well. The basis of the pattern consists of a neckline and two lows. However, the height of the second low formed must not be lower than that of the first. If not, the pattern would be deemed invalid. This is due to economical reasons that we will then later on.
Double Bottom Pattern forex trading
The double bottom pattern is a reversal pattern similar to the double top pattern. In the above picture, prices were in a downtrend until the price reached a low at point A and bounced back to C. At point C prices then stalled and went again lower to reach point B, which was equal to the previous low A. Prices failed to move lower beyond A and reversed direction reaching midpoint E. Midpoint E is measured as half the distance between A and C . As prices continued to move higher it broke the neckline at point F. The pattern is completed once prices closed above point F.
How to trade double bottom pattern:
The above picture shows the trade setup of a double bottom pattern. The initial pattern is setup once bottom A, neckline C, and bottom B are formed. However, the pattern becomes identifiable by the trader once the prices pull back from the bottom B and reach point D. At point D the trader prepares a trading plan to be executed if the pattern completes and becomes tradeable.
Once prices move higher than point E the pattern is confirmed. The entry point can be taken once prices closed above the neckline, at point E. The risk can be set to be half of the magnitude between the neckline at point E and the first low at point A as illustrated by point G. The reward to be expected can then be taken based on a 1:1 ratio between the magnitude of the neckline E and the first low A as shown by point H. This gives a risk to reward ratio of approximately 1:2. At point F prices came back to test the support (support and resistance forex hyperlink) and bounces back. This provides an alternative entry or even a second entry for traders who are more aggressive.
Double bottom pattern meaning:
The price movements during double bottom mean that the prices reached the lowest prices twice and failed, this implies the weakness of the sellers or the strength of the buyers eventually resulting in the reversal of the current trend.
This is due to the economic theory of supply and demand. Prices are unable to form lower lows due to a shortage formed in the market whereby the quantity demanded increased at the price level P2, from Q1 to Q2. The market will then have to correct itself to the equilibrium. This is a result of a strong support in the market, or a demand zone.
Chart patterns reveal the underlying market sentiment of the buyers and sellers. The trader intends to identify the direction of the price movement and also the best entry point by these charts.
The above picture illustrates the change in the market sentiment and the underlying shift during the stages of the pattern. The prices were in a downtrend initially with sellers in control of the market, once price reached the bottom the selling pressure was waning and the buyers started to gain control and pushed the prices higher. The sellers however gained control and dragged the price lower. The failure of the sellers to make lower prices made the buyers come back, buyers brought the price higher and confirmed their strength by breaking the neckline with the closing of prices above the neckline. The sellers made one more attempt to bring back the prices lower and were unable as the neckline provided support for the buyers. After that final failed attempt by the seller, the buyers took control and brought the prices higher.
Using additional confirmations
It is always in the best interest of the trader to look for additional confirmation before placing the trade. Successful traders make decisions when there is a confluence of multiple methods. In the above picture of the double bottom pattern, the pin bar reversal candle signaled the price reversal during the seller’s attempt to push the prices lower. The longer wick of the candle of the pin bar shows the weakness of the sellers and the ability of the buyers to push the prices higher and also close the prices on a higher note.
The pin bar candlestick pattern would have alerted the trader of an impending reversal of direction well advance of the completion of the double bottom pattern, the confirmation from the candlestick pattern further strengthens the decision of the trader.
Successful traders always use the confluence of indicators, they check multiple indicators to identify and confirm the outcome of one indicator with the other. The above picture shows a double top in the price chart window and RSI in the indicator chart window.
The price chart shows prices making a new high at point A, the RSI in the chart window correspondingly makes a high at point C. The prices make the second high at point B but the RSI makes a high at D which is lower than the previous high of C, the RSI shows a waning momentum in the price action trading and subsequently moves lower. The RSI confirms the presence of weakness in buying pressure at the second high.
A variety of technical indicators can be used to measure different parameters of technical analysis in conjunction with price action to provide much better entry signals and an overall trade plan with a higher degree of success.
Further read: RSI Forex Indicator
Different ways to trade the pattern
Picture I shows different entry points and methods to trade the double bottom pattern, however, many traders use them at their discretion depending upon their risk appetite and also their risk reward ratio.
The earliest trading opportunity is entry at the midpoint A, at this point, the pattern would not have been completed itself, but the trader anticipates it upon seeing the double bottom and the reversal candle from the second low. The trade has a high risk as the pattern has not been completed yet, however, the reward is higher if the reversal completes. However, the disadvantage of this entry is that the trader enters while anticipating the formation of the pattern, had the pattern not form, or trend in the current direction, that trade entered will be stopped out.
The next entry opportunity is at the break of the neckline at point B, at this point, the pattern has completed itself, traders use the completion of the pattern as confirmation. However, the trade may fail as the neckline break may be a false breakout. Hence, it is crucial to wait for prices to close after the neckline, to avoid being trapped in a false breakout.
The final and the best entry opportunity of the pattern is at point C, at this point, the price would have completed the pattern, to further avoid a false break out the trader waits for the price to break the neckline and clear the line. The reversal is further confirmed once the price failed to reverse the trendline during the pullback. However, passively waiting for the pullback entry may cause the trade to not happen at all in certain scenarios whereby the breakout has such a strong momentum that it doesn’t pullback.
Pros and cons of the double top/bottom strategy
The pros of using the double top/ bottom chart pattern is that it is a powerful indication of a market reversal. This allows reversal plays to be identified when the prices are in a consolidation. Next, the rewards and risks are clearly identified from the pattern, which makes this strategy easy to grasp and is effective for all levels of trading. On top of that the concepts of this strategy is not really hard to understand and can be digested and applied easily.
However, the identification of this pattern is rather subjective and in certain cases traders tend to mistake a pattern forming or to skip it out accidentally. Lastly, this chart pattern tends to occur more in the lower timeframes rather than the larger ones as prices are reflected clearer with the quicker closing of the candles in the smaller timeframes.
Double Top and Bottom Analysis
To find out the profitability of the double top/ bottom chart pattern strategy, we decided to do a back test based on the past 10 trades from 29 Mar. 21 on the H4 timeframe. The rules for entry will be the same as what was mentioned above. We will be back testing this throughout 3 types of trading vehicles, namely, EURUSD for forex, AAPL for stocks and BTCUSD for cryptocurrency. For simplicity, we will assume that all trades taken have a risk of 1% of the account.
Definitions: Avg Risk reward ratio= ( Total risk reward ratio of winning trades/ total no. of wins) Profitability (% gain)= (no. of wins* reward)- (no of losses* 1) [ Risk is 1%]
An example of the application of the strategy is as shown:
For the Backtest results, trades with blue and yellow zones indicate an overall win with the blue zone as reward and the yellow zone as the risk taken.
As shown in our backtest, the win rate of this strategy for EURUSD (Forex) is 40%, AAPL (Stocks) is 60% and BTC (Crypto) is 80%
The average risk reward ratio of this strategy for EURUSD (Forex) is 1.12, AAPL (Stocks) is 1.26 and BTC (Crypto) is 1.40.
The profitability of this strategy for EURUSD (Forex) is -1.53, AAPL (Stocks) is 3.56 and BTC (Crypto) is 9.23.
Triple Bottom Pattern
The double bottom pattern can sometimes give rise to forming other consolidation chart patterns such as the triple bottom pattern. This is because the market hasn’t accumulated enough momentum to break the resistance or key level that is keeping it in that consolidation. The Triple bottom is similar to the double bottom except that it forms one more low that is approximately equivalent in magnitude. The sellers bring the price down the third time and fail, this itself provides a clear understanding of the underlying weakness of the sellers and the strength of the buyers. Many traders start trading the pattern at the neckline breakout and others wait for the pullback to get a better entry price. It is important to note that during such consolidations, the prices tend to move side ways in a channel or a box with little to numerous false breakouts. Hence, it is important to be patient and wait for the candle to close after it has crossed the neckline, resistance or key level.
Triple Top Pattern
Picture K shows a triple top pattern, which is similar to the triple bottom pattern. The triple top pattern completes itself on the neckline is broken. It has similar entry conditions to the double top.
Limitations
Double top and double bottom patterns are also prone to failures like any other chart patterns. The most important of them is the false break out of the neckline. Price tends to break the neckline only to retrace back and continue moving in the direction of the previous trend. Many traders jump into the trade in a neckline break, instead of waiting for the prices to pull back and retest the neckline.
The tops and bottoms in the patterns are not uniform and do not present themselves in pre-defined shapes. They come in slight variations depending on the market volatility, price momentum, and the time of the occurrence of the pattern. Many traders may not identify properly or even fail to identify.
In an attempt to capture more profits many traders enter the pattern at the midpoint, the halfway point between the neckline and the highest top point, even before the pattern has been completed.
The patterns do not provide a take profit point, they are calculated using other technical tools or risk management tools.
Conclusion:
In hindsight, the double top/bottom is a rather subjective chart pattern with a high profitability potential with an above average win rate and relatively consistent risk reward ratio. It is capable of allowing traders to time the reversal and capture the most out of a trend, giving rise to huge trails. However, as of any other chart patterns, it is prone to fake breakouts. Hence, it is important to learn how to be patient with this strategy as false breakouts tend to do quite a huge damage to one’s trading account.
Infographic
