What Are Descending Tops?
The term descending tops refers to a pattern in a price chart in which each peak in price is lower than the previous peak in price. The descending tops pattern indicates a bearish trend in the price of the security. Descending tops and other related patterns are commonly used in technical analysis, a trading methodology traders use by studying charts and graphs to find entry and exit points.
- Descending tops is a pattern found in the price chart of a security in which each peak in price is lower than the previous peak.
- Traders identify descending tops after three successive peaks.
- This pattern indicates a bearish trend in the price of the security.
- The opposite of descending tops is known as ascending tops, which is a pattern in which each price peak is higher than the previous one.
Understanding Descending Tops
Investors have different investment analysis options at their disposal when they want to analyze market and investment performance. One of these techniques is called technical analysis. Traders who use this strategy evaluate and identify patterns in stock prices by studying graphs and charts. By doing so, they are able to determine points of strength and weakness, along with trading patterns that help them identify bullish and bearish patterns that signal viable entry and exit points.
One of the patterns traders may find on a stock price chart is a descending tops pattern. This trend indicates that the market for the security in question is turning bearish. Bear markets are those that experience significant declines in security prices—normally 20% or more from the most recent highs. Descending tops can be recognized when a second peak is less than the first peak—which is called the top—and then confirmed when a third peak is less than the second peak.
A descending tops pattern has to end eventually. If the next peak in price is higher than the current peak in a descending top run, the trend is broken and the market will either go bullish or stagnate. Sometimes a descending tops pattern will have drops that progressively descend, too. This pattern is called descending bottoms. When a descending tops pattern reverses, a descending bottoms pattern is likely to reverse at the same time, or within one more drop and peak.
Since descending tops may last only a matter of minutes, long-term value investors are unlikely to invest specifically during this pattern. Traders who time the market—also called day-traders—can find descending tops convenient to help them make money during a short run. These short-term investors generally short the stock. This means that the longer the descending run lasts and the lower the price, the more money they can make.
Because descending tops generally last only a few minutes, long-term value investors won't them in their trading strategies, though day-traders will in order to make money during a short run.
The key to success when shorting a descending tops market is to set an upper limit above one of the earliest peaks—perhaps the second or third peak—and to get out of that position as soon as the market reverses. To set the upper limit, a trader enters a stop-loss order.
To know when to get out of the position entirely because the market is reversing, short-term traders need to understand that the first peak above the previous peak is their signal to trade out of their position.
Descending Tops vs. Ascending Tops
If descending tops are an indicator of a bearish market, there must be a term that describes when the market turns bullish, right? This term is known as ascending tops—the opposite of descending tops. It is a pattern found on price charts in which each price peak is higher than the previous one.
Traders confirm an ascending tops pattern when the third peak is higher than the second. For example, the first peak in a stock's price may hit $35, then fall to $25. The price may then rise to $40 and drop down to $28. This signals the second peak. The trader may identify an ascending tops pattern if the next peak goes beyond $40, signaling a bullish market.
Example of Descending Tops
The following chart is a good example of how to visualize descending tops and how they work.
You can see that the peaks in the chart all successively decrease from the first peak. As mentioned above, the first peak is called the top while all the subsequent peaks are called the descending tops.
Let's take the chart and apply a hypothetical example to help you understand the concept of descending tops. Say the first peak of Company XYZ's stock jumps to $40. The stock price then drops to $28 and peaks at $37 before dropping back down to $25. When charted, this looks like descending tops. If the next peak is less than $37—and in the case of the chart above, it is—this confirms that this is a descending tops price pattern, and the trader or investor should prepare for a bear market, even if only for the short-term.