One of the most common chart patterns in trading is the double bottom and double top. In fact this pattern appears so frequently that it alone could serve as evidence that price action is not as wildly random as many academics claim. One way to think of price charts is simply that they express the sum of trader sentiment, and double tops and double bottoms in particular represent a re-testing of temporary highs and lows.
Double tops are commonly found during an uptrend in prices where a new high is formed followed by a slight pullback and a retest of the new high, but ultimately failing to surpass the price level established at the first peak. This results in a movement of prices to a lower level and completes the pattern of the double top. The second peak does not have to stop exactly at the price reached from the first peak but should be relatively close. This pattern is usually indicative of a trend that is weakening where buying interest is decreasing.
A double bottom is simply the opposite of a double top. This pattern occurs during a downtrend and is a signal of a reversal of the downtrend into an uptrend. This pattern is easily recognizable after the fact by its resemblance to the letter "W". The initial downward move will find a support at the first bottom and then the price action will rally off the support to a temporary new high (the middle of the "W"). Another selloff will take place that will reach the same support level of the first bottom, and consequently cause another rally upwards. Lastly, the trend is confirmed when the price breaks through the upper resistance to complete the pattern and reversal.
Identifying The Pattern
Here we'll look at the task of spotting the important double bottoms and double tops. Take a look at the first chart of the EUR/USD for an example of a double top, and the second chart for an example of a double bottom.
React Or Anticipate?
One criticism of technical analysis based on chart patterns is that setups always look obvious in hindsight but anticipating them as they're occurring in real time is particularly difficult. Double tops and double bottoms are no exception. Though these patterns appear frequently, successfully identifying and trading a majority of them is no simple feat.
There are two approaches to this problem and both have their pros and cons. In short, traders can either try to anticipate these formations, or wait for confirmation of the pattern and then react to them. The approach you choose is more an indication of your personality or trading style than relative merit. Those who have a fader mentality - who love to fight the tape, sell into strength and buy weakness - might try to anticipate the pattern by stepping in front of the price move. See the next few charts for an example of an anticipatory trade.
On the other hand, reactive traders, who want to see evidence or confirmation of the pattern before entering, have the advantage of knowing that the pattern exists but there's a tradeoff: their entry point is later than an anticipatory trader which results in worse prices and greater losses should the pattern fail.
Double tops and double bottoms are common reversal patterns every trader should keep an eye out for, as they can signal a reverse in the trend. In the next section, we're going to take a look at one of the more popular technical indicators - Bollinger Bands® - and see how they can be used to gauge trends and help traders enter and exit trades.
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