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This post talks about double-tops (DT), and double-bottoms (DB), two well-known and widely traded patterns. The simplest way to trade these patterns, is to take a position at the break of the neckline, with your stop above/below the support/resistance level and aim for an initial 1:1 as your target.
However, most of the time, after the break of the neckline, we will reach the 0.618 Fibonacci extension before witnessing a pullback to either the neckline (which will coincide with the 38.2 Fibonacci retracement), or the 61.8 or 78.6 Fibonacci retracements. Using the same example as above;
After mentoring hundreds of students, what I’ve noticed time and time again is that they see the double-top or double-bottom pattern and immediately jump into the trade.
As traders, we need to take the bigger picture into account. All our traders look at the wider timeframes before taking any trade.
What we’re looking for on the wider timeframe is an accumulation/distribution phase in the price action. If we get a steep trend, as we’ve seen on the DAX recently, then a small DT form, it’s never going to retrace as far as we think it will. For example;
DAX – 5min chart
Typically, we will have a trend that will often complete the 5th leg of an Elliott wave, before an ABC retracement. The ABC retracement will typically pull back to around the 38.2 Fibonacci retracement of the entire trend. The B-leg will proceed to re-test the previous swing high (or low), thus forming a double-top (or double-bottom). For example;
It’s important to note that the resistance (or support) area will typically align with a long-term support/resistance trend lines or a fundamental number.
Double-tops and double-bottoms are not always perfect. Sometimes there can be a deviation in the two points, or “shoulders”. This is what’s referred to as a ‘liquidity grab’, where the B-leg of the ABC corrective move will make a higher high (or lower low). This is also still considered valid "B point" in Elliot Wave theory.
When this happens, the larger players will jump into the trade as it provides them with the cheapest price and thus, the better risk:reward ratio on the trade.
For me personally, I don’t consider this to be a double-top, but rather divergence. To identify divergence, I use the Relative Strength Index (RSI) oscillator. Throughout my years in the markets I’ve tried other oscillators, but I’ve found the RSI to be the most visually accurate. in addition, this is really the only oscillator we use. I'm not a fan of lagging indicators, only leading tools.
Additionally, to determine whether it is a double-top/double-bottom, or a liquidity grab, I’ve found the best method being to measure from the shoulders to the neckline using the Fibonacci retracement tool, and if the B-point comes within the 0.886 and 1.112, it’s a valid double-top (or double-bottom).
However, if it precedes the 1.112, it’s then a valid liquidity grab, i.e; divergence.
In terms of accumulation and distribution, we need to think of it as a circle. We’re at the end of a trend and we’re now rolling over. As mentioned previously, a small double-top, or double-bottom is not going to revert and retrace the ground made by the previous trend. There needs to be some form of accumulation/distribution to validate the reversal pattern. For example, a hypothetical distribution stage at the end of a bull trend might look something like this;
Now, generally speaking, the larger the previous trend is, the larger the stage of accumulation/distribution is likely to be. This is why, as I mentioned earlier, we look at the wider timeframes. We will typically see an accumulation/distribution phase on a small timeframe, happening within an accumulation/distribution phase on a larger timeframe. Using the previous example, a distribution phase on the 4-hour chart might reveal a smaller distribution phase on the 30-minute or 1-hour chart;
Hence why it is invaluable to look at the wider timeframes. By analysing what’s happening on the larger scale, we’re able to determine the importance, or impact, of the pattern on the smaller timeframe.
Now that I’ve explained the theory behind this concept, let’s piece it all together using a real-life example.
Below is a 4-hour chart of the AUDUSD. As you can see, identified by the black circle, we have a rounding of distribution at the end of the trend;
If we zoom in to the 1-hour chart, we can see a smaller ‘roll-over’ within the one previously identified on the 4-hour chart;
And finally, if we piece all of this together, we can see the exact analysis of the double-top pattern;
By doing a top-down analysis and identifying these ‘rolling-over’ areas on a larger timeframe, we’re able to identify where the smart money is taking profits and/or increasing positions against the previous trend. Or in other words, accumulation and distribution.
Have this knowledge allows us to then identify the trading opportunities on the lower timeframes with added certainty in our analysis. Simply taking a double-top or double-bottom trade because it broke the neckline is not good enough. You need to have the longer-term view to validate your trade on the lower timeframe.