Double tops and double bottoms are some of the most common price reversal patterns in the currency market. The familiar M- or W-shaped patterns appear regularly on anything from 15-minute charts to weekly studies. Here we look at how you can identify these patterns and use them to make reasoned, profitable trades in forex.

Tutorial: Popular Forex Currencies

Identifying Double Tops
In the interest of clarity, we'll focus on double tops, but be aware that the rules are simply reversed for double bottoms. The basic double top price pattern has three stages: 1) the price makes a short-term swing high, 2) this is then followed by a slight retracement, and finally, 3) the price makes another assault on the swing highs, only to be rejected once more as the reversal pattern completes itself.

Why do these patterns recur? The underlying assumption is that price has a memory. As the price of an asset approaches a prior point of resistance or support, traders will begin to aggressively buy or sell ahead of these levels based on the belief that since these prices recently held, they will hold once again. This method is often quite profitable, but as we will see later on, even if this setup fails, it may still offer promise to traders willing to view this pattern in an unconventional way.

To properly trade a double top, a trader first needs to determine what constitutes a proper retrace in the formation. Otherwise, the price pattern may look like a simple consolidation range, which would greatly lower the probability of success in the trade. A simple and effective way to calculate a retrace in a double top is to use Fibonacci retracement levels. (To learn more, see What is Fibonacci retracement, and where do the ratios that are used come from?) The retrace segment should be at least 38.2% of the prior move in order to be considered valid. Figure 1 shows this dynamic in action.



fibonacci level double top forex
Figure 1: The 38.2% Fibonacci level is the minimum amount of retracement needed to establish the beginning of a valid double top formation.
Source: FXtrek Intellicharts

Don't Anticipate - Wait for Confirmation
Once the retrace segment is established, the next step is to properly position yourself for the double top. Novice traders will simply try to anticipate a double top by laying out limit orders at or near the prior swing high. This approach is often a mistake that creates unnecessary losses. If you look at Figure 2, you will see that a runaway trend would have bulldozed right through a trader's short in the GBP/USD, as price relentlessly rallied against the position.




Figure 2: This chart is an example of the loss that can occur when a trader anticipates the second top by placing a short sale order before he/she confirms the strength of the earlier resistance.
Source: FXtrek Intellicharts

Instead of anticipating resistance at a double top, traders should let the market confirm their assumption that such resistance actually exists. In order to have a minimum of confidence that a double top is indeed in place, traders need to wait for a red candle to form at the resistance levels, as shown in Figure 3.



a double top in the making
Figure 3: A bearish looking candle near the earlier resistance can be used as a signal that the previous resistance is strong and that a second top may be forming.
Source: FXtrek Intellicharts

Make a Good Entry
Finally, in order to achieve a good entry, you shouldn't simply jump in with a market order to sell on the next candle. Instead, you should place a limit sell order somewhere in the middle of the prior day's range. This tactic has two substantial benefits. If the double top does indeed form, you would be optimally positioned with a superb price entry. On the other hand, if price decides to make one final thrust upward, you would be likely to survive as your excellent entry would allow you to set a stop wide enough to escape any last-minute thrusts.



Figure 4: Placing a limit order at a resistance level that has shown its strength is key to drastically increasing your odds of a successful trade.
Source: FXtrek Intellicharts

The Traditional Setup and What To Do If It Fails
To summarize, here are the rules to properly trade classic double top formations:


  1. Determine that a true retrace segment has been put in place by using Fibonacci retracement levels to measure minimum levels of correction.
  2. Wait until the price actually shows weakness on the charts by printing a red candle at the expected resistance level.
  3. Using the red candle as a reference point, enter a limit sell order somewhere in the middle of that candle's range.
  4. Set a stop at least 50 points above the most recent swing high to avoid being taken out on a fake spike.
  5. Target at least the length of the prior segment for good risk to reward potential.
This traditional double top/double bottom trading setup is an "oldie but a goodie". It can be an extremely profitable trading strategy, but it is not the only way to extract gains from such price action. What happens when these setups fail? What happens when price barrels through resistance, as shown in Figure 5?



Figure 5: Once the price of an asset breaks through a support or resistance level, it can become difficult to determine where it is headed.
Source: FXtrek Intellicharts

Most traders would simply abandon these trades and move on to the next setup, but not unlike a valuable antique hidden in a country barn, these busted trades hold enormous promise for those traders willing to look beyond the surface. Contrary to popular opinion, former resistance and support levels still exert a gravitational pull on price, creating a very strong possibility that it may reverse in the near future.

Let's look at the same EUR/USD trade from Figure 5 a few days later. What happened? Price did indeed set a short-term swing top a few hundred points higher than the original resistance point.



Figure 6: This chart is an example of how the price of an asset often retraces back toward a broken support or resistance level.
Source: FXtrek Intellicharts

How can a currency trader take advantage of such price dynamics? More importantly, how can you protect yourself from the possibility of a runaway market should you be wrong in your assumption that a reversal is just around the corner? One possible way to find an intelligent stop point that will provide ample room for price to bounce, without exposing you to an excessive amount of risk, is to use the preceding price action as a guide.

Here is how a fakeout double top setup might work:


  1. Once the price has exceeded the prior swing high, do nothing until price shows a sign of weakness with a red candle - which indicates a drop in price for that day.
  2. Measure the amplitude of the preceding retrace segment from the segment's swing high to its lowest low.
  3. Add the value of the length of this segment to the most immediate swing high and make that your stop.
  4. Initiate one-half of your position at a sell limit at about the midpoint of the red candle's range.
  5. If price moves counter to your direction, initiate the other half of your position midway to your stop point.
  6. If price turns in your favor, target the original resistance point of the "fake out" double top.
Let's apply this setup to the specific example of the EUR/USD trade. First, you would measure the amplitude of the retrace segment, which is approximately 300 points. Then you would add that amount to the swing high to establish a proper stop point. In this case, the stop provided plenty of room to remain in position until it turned in the traders' favor.



Figure 7: This chart illustrates that a stop loss is generally set to equal the swing high plus the height of the earlier retracement, which in this case is nearly 300 points.
Source: FXtrek Intellicharts

Why would you want to use the prior retrace segment as a guide for setting stops? If price does indeed have a memory, then - under normal conditions - there should be some symmetry in price movement. Therefore, price swings should not exceed in thrust what they produced in a retrace. If they do, then it's clear that a powerful new trend is in place and traders needs to cover their shorts and retreat, protecting their capital.

Most importantly, using the prior retrace segment as a guide for setting stops provides a logical reference point for you as a trader to gauge the status of your trade. In his book "The Logical Trader" (2002), Mark Fisher notes that a logical reference point is one of the key ingredients for success for the technically-oriented trader. Since a trader can never predict the accuracy of any particular trade, having a logical method to ascertain when a trade is wrong is the single most important skill that a currency trader can develop.

Conclusion
Although many academics argue that price movements are completely random and unpredictable, technically-oriented traders heartily dispute this thesis. They believe that price graphs represent the cumulative opinions of millions of traders and, like many products of human activity, possess an institutional memory that can be analyzed and traded. The fakeout double top/double bottom setup is one such example of this premise that you may employ profitably in forex trading.

For further reading, see Trading Double Tops And Double Bottoms.

comments powered by Disqus
Trading Center