With the S&P 500 SPDR (ARCA:SPY) slumping on July 23 and 24 to start out the trading week, the possibility the market could continue to move lower looms. Therefore, stocks that are exhibiting a potential double top chart pattern present a shorting opportunity as well as a warning signal to the bulls in those stocks. A double top is created by a push higher in price followed by a correction, then another move higher into the same area as the prior high. The pattern is complete and signals another move lower when the price moves back below the low of the correction. If the price moves back above the high(s), then the pattern is nullified. The key to the pattern is waiting until the price actually moves below the correction low to take a short position (or exit longs). The danger of entering early, assuming a breakout will occur, is that the stock could begin to range or move higher before the breakout occurs.
SEE: Trading Double Tops and Double Bottoms
Discovery Communications (Nasdaq:DISCA) presents a very interesting opportunity. It rallied earlier in the year to a 52-week high in May at $55.35. It then corrected, putting in a low of $48 in June. The next rally almost made it to the former high, reaching $55.11 on July 3. Through the rest of July though, the stock has slid back towards the $48 support level. If the stock drops below $48, a double top is in place and the price target is $41. The stock is also showing short-term relative weakness compared to the S&P 500. While the S&P 500 has been moving sideways in July, Discovery Communications has moved almost straight down. Weakness in the market index is likely to cause a drop below $48 in the stock. The relative strength index (RSI) has also been showing a bearish divergence since early April, and is currently testing former RSI lows. A RSI reading below 30 and a price drop below $48 indicates a downtrend is likely already underway. A rise back above $55.11 nullifies the double top pattern.
East West Bancorp (Nasdaq:EWBC) rallied in a 52-week high at $24.39 in March. At that point it was already diverging with the S&P 500, which didn't top out until early April. The stock then corrected, putting in a low of $20.71 in June. In subsequent moves the stock has rallied back to a recent high of $24.10, and has fallen back below $22. A drop below $20.71 confirms the double top pattern and gives a price target of $17.50. The RSI has been making lower highs since January - a bearish signal for the stock. If the RSI moves below 30 coupled with a completed double top pattern, then a downtrend is likely underway. On the other hand, if the stock finds support above $20.71 and rallies back to $24.10, the pattern is nullified.
SEE: Momentum And The Relative Strength Index
Highwoods Properties (NYSE:HIW) remains some distance away from the double top breakout point, but is worth keeping an eye on. The main reason is that the support level of the pattern ($31) was tested on two occasions in the past; a breakout is likely to be significant. As the stock rallied earlier in the year, $31 was the pullback point in March before the stock rallied to a 52-week high at $35.78 in May. Throughout May the stock fell, and in early June the stock tested $31 again. A rally followed to a July 17 high at $34.92, but now the price is weakening again creating a potential double top. A drop below $31 completes this large pattern, which arguably is also a head-and-shoulders chart pattern. The downside target for a breakout is $27 to $26.25. If the RSI drops below 30 it indicates the stock is shifting to a downtrend, as it breaks prior RSI lows. There has also been a bearish divergence in the RSI since January, as new price highs were not been able to create new RSI highs. Rallies back toward $35 nullify the double top pattern.
La Salle Hotel Properties (NYSE:LHO) has had a rough July, which means the stock is weak compared to the S&P 500. Since the stock is very close to the double top breakout point, weakness in the S&P 500 is likely to push the stock through support. It is also possible the stock could move lower on its own, even without confirmation from the market index. The first peak in the stock occurred at $30.46, followed by a low of $25.22 and another high of $30.01. A drop below $25.22 signals the double top is in place and the price is likely to slide lower. The target for the completed pattern is $20.50. The RSI on La Salle Hotel Properties has already broken below 30, penetrating the former RSI lows. This is a bearish sign, and indicates a downtrend in price is likely underway. While a rally is unlikely, it could occur. If support is found and the stock moves back towards $30, the double top pattern is nullified.
SEE: Support & Resistance Basics
The Bottom Line
When trading a double top chart pattern, the most important element is waiting for the pattern to complete. A breakout needs to occur in order for a trade to be taken based on the pattern. The breakout means a higher probability that the stock is likely to drop. Until that breakout occurs, the stock could just as easily bounce or begin to range. False breakouts do occur, which is when the low is punctured but the stock then proceeds to rally instead of drop. Therefore, risk should always be managed. If a short position is taken, stop orders can be placed above the highs of the formation or above a recent swing high. The pattern is not just used for shorting though. Those with long positions should also watch for double tops. When the pattern completes, the price could continue to slide and downside risk should be managed.
Charts courtesy of stockcharts.com
At the time of writing, Cory Mitchell did not own shares in any of the companies mentioned in this article.