A Beginners’ Guide to Trading with Double Tops and Double Bottoms
If you are planning to try your luck in Forex trading, like any other trader, you will need to look into the concept of ‘double top’ and ‘double bottom’ trading. While they come across as jargon associated with Forex trading, they certainly are not.
When you study the graphs that represent the price trends of a currency, you will encounter various patterns that are potential predictors of future trends. Two such trends are double tops and double bottoms. Essentially, the double top is visible when you can see an ‘M’ in the chart, and the double bottom is when a ‘W’ is visible in the same way.
Here, we are going to discuss what the two terms represent and how traders use these patterns to make a living.
1. Double Top
Over a long period, you will be able to detect two consecutive rounded tops, not necessarily peaked at the same level, on the line graph of your currency of interest. The first of the two rounded tops, will definitely create an inverse U. As you should already know, rounded tops can predict bearish reversal because they are visible after a stretched bullish rally.
Similarly, two rounded tops indicate a bearish reversal. In the case of a double top, the second rounded top will indicate resistance and exhaustion and will always be, sometimes slightly, below the first one.
Since you are just beginning to study market trends, you may not know double tops are rare occurrences that tell you that investors are looking to obtain final profits by selling off their investments. The bearish reversal is anticipated to follow, compelling traders to sell off their stock.
Why the Bearish Reversal Trend?
The reason behind traders assuming a bearish reversal after a double top is because – if you notice the pattern – the first top is the highest point the currency has ever reached. After the price went down a little, it bounced back within a short time, which should be good. However, the new top was unable to break the record-high price of the first one. This indicates that the buying pattern is about to finish.
Decreased buying pressure after a double top can be so severe that the price falls past the neckline and doesn’t seem to stop. An uptrend as attractive as a double top is not something you should be attracted by; because the buyers are exhausted, you are better off taking out the final profits. If you do not sell at this time, you will have to take a more emotional exit.
In its essence, the double bottom is the opposite of the double top. When you study the currency of your interest over time, you will come across a pattern that forms a ‘W’. Since W is the inverse of M, it is only fair that the inferences from the double bottom are the reverse of inferences from the double top.
Two rounded bottoms create a double bottom. It is often the end of an extended bearish pattern that brings these rounded bottoms into the light. However, the pattern begins appearing with a single rounded bottom, which is a sign of reversal. However, when a consecutive rounded bottom joins it, this indicates that investors are following a more secure pattern to capitalise on the last lower push.
The two bottoms show how investors are taking advantage of the falling prices of the currency. It is a bullish reversal trend that should not be ignored, as many investors have gained immensely by identifying it. Traders leave no stone unturned to make profits from this bullish rally. It is often observed that trading pricing after a double bottom will rise tremendously.
Why the Bullish Reversal?
When studying the market in patterns, it is crucial to notice the extreme lows and highs of a currency. The reason that double bottoms lead to a rise in the price is that the first rounded bottom is the lowest the currency has been over the year. Even though it rises for a short time, it doesn’t take long to fall. However, the fall could not drop further than the first bottom. This indicates that the sellers have exhausted their stocks. Now that the seller pressure has almost finished, the prices will definitely rise.
Also, the price rise in the currency is similar to the fall. So, when a market is showing a strong downtrend, there is a possibility that a double bottom will occur to revive the market.
Limitations of Double Tops and Double Bottoms
Beginners should try not to jump to conclusions. So, even if you spot patterns in the market that are similar to a double top or double bottom, make a close observation. If they are interpreted correctly, they can prove extremely beneficial for your trade. However, if your interpretation is incorrect, you will lose a significant amount of time and money.
Double tops are represented by sharp jumps followed by sharper declines. Therefore, you should only look for an extremely bearish pattern in the market. If you read two consecutive peaks incorrectly, you could lose out on the position that you already hold in the currency market.
Where to Find Double Tops and Double Bottoms
Often, traders cannot figure out the patterns because they are looking at the wrong part of the graph. So, if you want to be accurate with your predictions, look for double tops at price highs and double bottoms at price lows. Also, since they are reversal patterns, why not focus on the M forming near bearish trends and the W forming near bullish trends?
How to Manage Risks During Double Tops and Double Bottoms
Placing stop loss is one way that traders can prevent their investments in Forex causing losses. This is the level of price fall at which they order their brokers to sell off their assets.
Regarding pattern trading, traders prefer to stop trading when the asset is above the lower top. However, this leaves your win or loss ratio below 1:1. This is because the chances that this pattern will appear are only 60–70% so you will lose out on potential profits and market position much sooner.
Therefore, the trade will be more favourable if you allow the stop loss to remain close to the entry price. This will increase your chances of winning by 70%.
In the case of a double bottom, you should make sure that you don’t end up exiting the market just because of the bullish trend. So, place your stop loss strategically. Moreover, if you are keeping a close eye on the market trends anyway and want to make a living out of it, you should not opt for setting stop losses.
In the end, whether it is in the Forex market or regular investment market, double tops and double bottoms can prove to be of great help for traders. However, as a trader, you need to be careful when studying these trends. To begin with, keep the main characteristics and results in mind. Once you have identified the trend, you can deal in any currency that you are interested in.