to Edwards and Magee, double patterns are extremely rare. That certainly appears to be the case for double tops, but not for double bottoms. In doing research for this book, I ran through countless charts covering well over 10 years of data and was unable to find many examples of true double tops.
Edwards and Magee also point out that many patterns that appear to be double tops eventually transmute into other patterns that turn out to be con- tinuation formations rather than reversals. They suggest that an important differentiating characteristic is the time separating the two peaks. If they develop on the daily charts, say at one-week intervals, this is more likely to result in a consolidation formation, such as a rectangle. Although they con- fess that there are no ironclad rules, their guideline for a double top is a separation greater than a month with a “valley decline” of 15 to 20 percent separating the two peaks. They admit that these rules are somewhat arbi- trary, but they go on to point out that the time element is more important than the magnitude of the valley decline. Thus a two- or three-month sep- aration between the two peaks requires less of a decline than, say, a one- month interval. These guidelines are for daily charts. To apply them to monthly or hourly charts would not, of course, make much sense because it is the relative comparison of the time frame that is important. A possi- bility in this case is to take the number of trading periods involved in the
“one month or greater” rule and apply it to the relevant bars. Thus one week of daily trading is approximately 20 bars. Applying this to the weekly charts would imply a separation of 20-plus weeks, and applying it to an hourly chart would imply 20-plus hours. The key in all these time frames is to reflect the
Figure 8-1 Double top.
idea that enough time has elapsed during the valley phase that by the time the price has begun to approach the second peak, the rally is very believ- able, and most people are expecting a significant extension of the previous uptrend so the price will exceed the first peak by a wide margin.
Underlying Psychology
The underlying psychology might work something like this: The first top develops at the end of a substantial rally; volume is heavy, and sentiment is very positive. Then prices “unexpectedly” decline on contracting volume and disappointment sets in. This is then followed by a rally. Rising prices attract more bulls as the rally progresses, and the bullish arguments that were associated with the first peak become more believable. However, this second peak is accompanied by far lighter volume than the first. To the tech- nician, this is a bearish factor because it indicates less enthusiasm by the buy- ers and suggests that prices are rallying more because of a lack of sellers than anything else. Prices subsequently decline again and break below the lower level of the valley separating the two peaks. At that time the pattern is com- pleted, and everyone who bought during its formation is losing money and is therefore a potential seller.
Other Considerations
I mentioned earlier that the two peaks should be of roughly the same height.
Edwards and Magee use a 3 percent rule for this. This is again based on daily charts. The key, though, as they rightly point out, is that buying should not push the second peak above the first by a decisive margin. This is because the second peak really signifies failure—in this case, the failure of buyers to mount a strong second rally that takes the price convincingly above the resistance indicated by the first peak. In other words, if the second top is deci- sively above the first, this indicates that the series of rising peaks and troughs is still intact. Also, when the price breaks below the valley low, a second peak that is close to the first will not cloud the interpretation that a break below the val- ley low is a signal that a new series of declining peaks and troughs is underway. What is decisive is really a matter of experience and common sense. Sometimes valuable clues can be given by other indicators. For example, you may find that there is a serious negative divergence between an oscillator and a price at the second peak. Alternatively, a smoothed oscillator may be overbought and reversing to the downside as the second peak is forming.
According to Edwards and Magee, the normal measuring objective can- not be applied to the double patterns. However, I have not found anything
wrong with the normal approach. After all, if we assume that prices are deter- mined by psychology, and if psychology often moves in proportion, why should the distance between the highest top and the valley bottom not be projected down from the breakout point? Thus, in my view, the minimum downside measuring implications for double tops should be calculated by projecting the maximum distance between the higher of the two highs and the valley low at the point of breakdown, as shown in Fig. 8-1. This suggested approach is the same as that used with rectangles and head-and-shoulders tops.
Marketplace Examples
Chart 8-1, for Jefferson Pilot, shows a double top in 1998. It’s not a classic pattern in the sense that volume dries up on the second top, but it definitely has the price characteristics. There are two rallies separated by an approx- imately 15 percent decline and three months in time. Interestingly the decline took the price down by a little more than triple the measuring objec- tive. If you look very carefully you can see that both tops contained small head-and-shoulders distribution patterns.
Chart 8-2 shows another double top, this time for the DJIA in the 1930s.
Notice that the July–August 1937 top was associated with considerably less volume than the first peak. Prices declined substantially after the breakdown
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Chart 8-1 Jefferson Pilot, 1997–1998, daily.
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Chart 8-2DJIA, 1936–1937, double top. Following a substantial advance from 1932, the first post-Depression bull market ended in 1937. The chart shows a classic double top. Note that the volume during the July-to-August rally was substantially below that of the January- to-March peak. (Source: pring.com.)
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took place. Indeed, this seems to be a characteristic of “double” formations:
They are either preceded or followed, or sometimes both, by a very sharp and persistent price move.