Charts Patterns

Reversal Chart Pattern: Double Bottom and Double top

Double

Double Bottom (Reversal Pattern)

Double Bottom formation is in many ways the mirror image of the Double Top. After an extended decline to new lows a

stock puts-in a bottom on massive volume and a moderate rally ensues. After several sessions (sometimes weeks) the stock drifts back to test the first bottom but this time buying accelerates and another rally occurs.

d1

Technical target is derived by adding the difference between bottom #1 and the reaction high to the new breakout level. After the second bottom has been created, the new breakout level is the reaction high. No double bottom formation is complete until the stock rallies through this level.

d2

  • For double bottoms volume must increase as the stock moves toward the first and second bottoms. In many cases, volume will actually be higher at the first bottom because this is where value-oriented investors first take positions.
  • No double bottom pattern is truly valid until the stock moves through the reaction high.
  • Upside breakouts through the reaction high often lead to small 2-3% advances followed by an immediate test of the breakout level. If the stock closes below this level (now support) for any reason the pattern becomes invalid.
  • Technical targets are implied but they are by no means assured. Targets are guideposts only.

Double Tops are all about distribution, Double Bottom is about accumulation. After an extended decline characterized by aggressive short-selling and valuation concerns, value-oriented investors with longer-term time horizons begin to take positions in the stock. They understand that the only way to build a large position in a stock that they like is to do so when selling

predominates. It is their willingness to buy the stock when all of the news is bad that creates a clear support level, the first bottom (bottom #1).

This first part of the pattern will normally be sufficient to force many professional short sellers (bears) to cover positions. This coupled with buying from longer-term value investors may be enough to rejuvenate investors that recently purchased the stock at higher levels — they may even rationalize that the “market” is finally beginning to realize that the current weakness is without merit a few bullish speculators may be enticed to take new long positions. Unfortunately, after several sessions of positive price action buying pressures are exhausted and the stock once again begins to falter. The reaction to the decline that formed bottom #1 is complete. Technical traders call this the reaction high.

Sensing easy profits, short sellers return and bullish speculators decide to take profits, modest selling becomes a route. As the stock approaches bottom #1 volume remains light and in many cases the stock will actually fall through the previous low on very light volume.

It is at this point in time that pessimism is greatest, there seems to be no legitimate reason to continue holding the stock. Novice short sellers add new short positions and beleaguered bulls who purchased the stock at much higher levels begin to surrender in anticipation of a new leg lower. However the expected big decline never materializes, selling pressures have been exhausted and this is when professional short sellers realize the “jig is up”.

It is the new buying by bearish investors to cover short positions to capture profits and the continued accumulation by longerterm investors that helps the stock stabilize. As a second bottom (bottom #2) begins to take shape the pace of short covering accelerates and a new group of bullish speculators take long positions, the rally explodes. On the chart two equal bottoms are created, the double bottom is in place. In many cases double bottoms lead to important rallies because a vital support level has been established.

Double bottom occurs when prices form two distinct lows on a chart. A double bottom is only complete, however, when prices rise above the high end of the point that formed the second low.

The double bottom is a reversal pattern of a downward trend in a stock’s price. The double bottom marks a downtrend in the process of becoming an uptrend.

Double bottoms are often seen and are considered to be among the most common of the patterns. Because they seem to be so easy to identify, the double bottom should be approached with caution by the investor.

The double bottom is a “much misunderstood formation.” Many investors assume that, because the double bottom is such a common pattern, it is consistently reliable. This is not the case. Bulkowski estimates the double bottom has a failure rate of 64%, which he terms surprisingly high. If an investor waits for a valid breakout, however, the failure rate declines to 3%. The double bottom is a pattern, therefore, that requires close study for correct identification.

What are the details that I should pay attention to in the double bottom?

1. Downtrend Preceding Double Bottom

As mentioned previously, the double bottom is a reversal formation. It begins with prices in a downtrend. Bulkowski cautions that on their way down, prices should not drift below the left low of the pattern.

2. Time between Bottoms

Analysts pay close attention to the “size” of the pattern – the duration of the interval between the two lows. Generally, the longer the time between the two lows, the more important the pattern as a good reversal. Analysts suggest that investors should look for patterns where at least one month elapses between the bottoms. It is not unusual for a few months to pass between the dates of the two bottoms.

3. Increase from First Low

Some analysts argue the increase in price that occurs between the two bottoms should be consequential, amounting to approximately 20% of the price. Other analysts are not so definite or demanding concerning the price increase. For some, an increase of at least 10% is adequate.

4. Volume

As mentioned previously, volume tends to be heaviest during the first low, lighter on the second. It is common to see volume pick up again at the time of breakout.

5. Decisive Breakout

It is a challenge for the analyst to determine whether the rise from the bottom is the indication of the development of a valid double bottom or simply a temporary setback in the progression of a continuing downtrend. Analysts, therefore, advise cautious investors to wait for the price to rise back up and break through the confirmation point before relying on the validity of the pattern. Many experts will maintain that an investor should wait for a decisive breakout, confirmed by high volume.

6. Pullback after Breakout

A pullback after the breakout is usual for a double bottom. Bulkowski estimates that in 68% of double bottom patterns, price will throwback to the breakout price.

Are there variations in the pattern that I should know about?

1. Two Lows at Different Levels

Sometimes the two lows comprising a double bottom are not at exactly the same price level. This does not necessarily render the pattern invalid. Analysts advise that if the second low varies in price from the first low by more than 3% or 4%, the pattern may not be a double bottom.

Double Top (Reversal Pattern)

Double Top formation is a distinct chart pattern characterized by a rally to a new high followed by a moderate pullback and a second rally to test the new high. As the stock rallies to make the second peak (top) sellers overwhelm buyers and the stock price collapses. Several weeks later the stock moves to test prior support levels.

d3

The technical target for double tops is derived by subtracting the point difference between the top#1 and the reaction low from the breakout level. After the second top has been created, the breakout level is the reaction low. No double top formation is complete until the stock falls through this level.

d4

  • For a valid double top formation it is important that volume decline significantly as the stock moves toward a test of the first top and accelerate as price begins to decline.
  • No double top is truly complete until a breakout below the reaction low occurs.
  • Downside breakouts often lead to small 2-3% declines followed by an immediate test of the breakout level. If the stock closes above this level (now resistance) for any reason the pattern becomes invalid.

Getting caught in a stock at the high is never much fun but it happens. The double top pattern occurs because most investors that buy a stock “wrong” will refuse to exit until they can do so without suffering a loss. Double tops occur after extended rallies leading to new highs.

As the “story” of the stock becomes more widely accepted investors are willing to pay increasingly exorbitant prices but one day investors find the price is simply too high, the stock puts-in a top and prices begin to fall (top #1). This first top will normally be sufficient to force many of the more speculative investors from the stock. As they sell the price of the stock falls further but many investors will not sell regardless of how far the price falls because they refuse to take a loss.

After several sessions (sometimes weeks) of poor price performance the stock will begin to stabilize (reaction low) then gradually move higher. In most cases this advance will occur because of some fundamental factor like an upcoming analysts meeting, earnings report or stock split. As the stock rises volume slows and investors who bought at the first top get ready to exit positions into further strength.

As the stock approaches the prior high volume surges and new buyers begin to talk about bright fundamental prospects. It is at that moment that all of the investors who purchased positions at the prior high begin selling. Volume surges and the stock soon retreats (top #2). On the chart two equal peaks are created, the double top is in place. In many cases double top formations lead to important declines because two separate sets of investors have been disappointed at a particular level.

A double top occurs when prices form two distinct peaks on a chart. A double top is only complete, however, when prices decline below the lowest low – the “valley floor” – of the pattern.

The double top is a reversal pattern of an upward trend in a stock’s price. The double top marks an uptrend in the process of becoming a downtrend.

Sometimes called an “M” formation because of the pattern it creates on the chart, the double top is one of the most frequently seen and common of the patterns. Because they seem to be so easy to identify, the double top should be approached with caution by the investor.

Bulkowski estimates the double top has a failure rate of 65%.3 If an investor waits for the breakout, however, the failure rate declines to 17%.

What are the details that I should pay attention to in the double top?

1. Uptrend Preceding Double Top

As mentioned previously, the double top is a reversal formation. It begins with prices in an uptrend. Analysts focus on specific characteristics of that uptrend when searching for a valid double top. The trend upwards should be fairly long and healthy. If the uptrend is short, the double top may not hold and the uptrend will continue.

2. Time between Tops

Analysts pay close attention to the “size” of the pattern – the duration of the interval between the two tops. Generally, the longer the time between the two tops, the more important the pattern as a good reversal. Analysts suggest that investors should look for patterns where at least one month elapses between the peaks. It is not unusual for a few months to pass between the dates of the two tops.

3. Decline from First Top

This element is even more significant to the validity of a double top than volume. He argues the decline in price that occurs between the two peaks should be consequential, amounting to approximately 20% of the price. The deeper the trough between the two tops, the better the performance of the pattern.

4. Volume

Volume tends to be heaviest during the first peak, lighter on the second. It is common to see volume pick up again at the time of breakout.

5. Decisive Breakout

The technical odds usually favor the continuation of the present trend. This means that it is perfectly normal market action for prices on an uptrend to peak at a resistance level a couple of times, retreat, and then resume that uptrend. It is a challenge for the analyst to determine whether the decline from a peak is the indication of the development of a valid double top or simply a temporary setback in the progression of a continuing uptrend.

Many experts maintain that an investor should wait for a decisive breakout, confirmed by high volume.

6. Pullback after Breakout

A pullback after the breakout is usual for a double top. Bulkowski argues that the higher the volume on the breakout, the higher the likelihood of a pullback. “When everyone sells their shares soon after a breakout, what is left is an unbalance of buying demand (since the sellers have all sold), so the price rises and pulls back to the confirmation point.”

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