The basic double top (or bottom) has four stages:
1. The price makes a swing high (or low)
2. This is followed by a partial retracement
3. The price hits the swing high (or low) again
4. The price then reverses
So a double top makes an M formation, while a double bottom makes a W formation. These patterns often recur because, when a price hits resistance or support, traders will begin to close their existing trades and this will cause the price direction to reverse.
The most successful double top or bottom trades occur when the pattern is confirmed using Fibonacci retracement levels. This means the retracement should be at least 38.3% of the prior move.
If we look at the price of gold from the beginning of July to late August 2011, we can see what might be the start of a double top pattern. The price of gold reached a high of USD 1,912.45 an ounce on August 22, and fell back to the 38.2% level on August 24. On August 25 the price continued to fall, almost hitting USD 1,700 an ounce.
Many traders would open a long position now, anticipating the double top with limit orders around the previous high. However, this can often lead to unnecessary losses. In the gold example, if a trader had opened a position at the 38.2% retracement, near USD 1,747 an ounce, his stop probably would have been triggered before the price started to climb again.
The signal to look for is a red candle forming at the resistance levels. In the gold price, this happened on September 6, when gold hit USD 1,920.
Entering the trade
Rather than automatically selling on the next candle, a safer strategy is placing an order somewhere in the middle of the previous day’s range. That way, if the price continues to rise you won’t be caught out. And if it falls, you still have a strong entry price.
In this case, because the next candle was so much lower than the previous one, you could have ordered your trade to open at USD 1,900 and placed a stop at the resistance level of USD 1,920.
Exiting the trade
Two simple ways to exit this trade are either having a profit target, where you would automatically exit the trade when the gold price hit a certain level, such as USD 1,700 (securing you USD 200 in profit), or using a trailing stop (depending on the options offered by your trading provider).
A trailing stop is a stop that will follow a price as it moves in your favour. So, if you had set your trailing stop at USD 20, it would follow the gold price down, always remaining USD 20 behind the most favourable price, closing your trade once the price travels back up through your stop.
The price of gold hit a new low of USD 1,532.70 on September 26, which would have brought your trailing stop down to USD 1,552.70. Later that day, when the price of gold started to rise, you trade would have been closed automatically at USD 1,552.70, securing you USD 347.30 an ounce in profit (excluding any charges such as the dealing spread, commissions, interest and other fees).
The fact that double tops and bottoms are such common patterns means that there is a strong awareness of them among traders, and this results in these patterns being strengthened as traders buy and sell to conform to existing support and resistance. Combining double tops and bottoms with Fibonacci retracement levels, along with waiting for confirmation, increases the potential of this strategy’s success.
This article was written by Jacqueline Pretty at IG Markets.