In a recent Trader's Corner (TC) article I wrote about research done by Andrew Lo at MIT regarding 5 chart patterns that he could demonstrate (by his research) had future predictive value in terms of how the trend unfolded. Of the 5 patterns: the Head & Shoulders, Rectangle Tops, Rectangle Bottoms, the Broadening Bottom and (5) Double Tops, the only one I haven't devoted this column to the double top formation.

An OIN Subscriber asked me if there was anything more to double tops than the obvious; i.e., two highs in the same area and the stock or index reverses direction. Well, there's a bit more to this than the obvious although the core idea is pretty simple.

Before getting into the topic de jour, I'd like to follow up on a couple of recent chart developments that relate to or could amplify prior TC articles.

RECTANGLE TOPS

In my 4/13/11 Trader's Corner article I showed the following chart of Intel (INTC) as an example of a likely rectangle top with a downside objective to 19.0; i.e., the point distance between prices at the top and bottom end of the rectangle, subtracted from the lower price equals a 'typical' minimum price objective. In the case of the pattern shown for INTC, this is equal to 1.5 subtracted from 20.5. INTC had already hit an intraday low of 19.36, so INTC had already gotten close to the downside measuring implication after the break below the bottom end of the rectangle. You may recall what happened AFTER this 4/13, the end date of this daily chart.

THE NEXT DEVELOPMENT AFTER THE ABOVE CHART SNAPSHOT:

After Q1 earnings that handily beat Street expectations, Intel gapped higher and opened at 21 and change and kept climbing in the days since. The point I would make here is (1) the stock had further weakness after breaking below the lower end of what looked to be a rectangle top, (2) that 'measuring' objectives implied by chart patterns may come close but not hit the expected mark exactly and (3), INTC formed a possible double bottom before the big upside move occurred which was an alert to cover any shorts and possibly get long this stock. Since double tops AND double bottoms are my topic, I'll use this chart as a pre-example.

RECENT WAVE PATTERN:

In my Trader's Corner articles on Wave patterns, part one , two and three I covered basic wave analysis.

Those of you that follow my Saturday Index Wrap commentaries may recall my comments that I thought the downside correction had run its course after the mid-March low was made.

What followed the mid-March low has been predictable in Elliott Wave pattern terms. The most recent rally looks characteristic of a 'wave 3' upswing, which can be stronger and longer than the first advance (wave 1). The possible unfolding wave pattern we're seeing is highlighted on my next chart:

DOUBLE (& TRIPLE) TOPS and BOTTOMS

I don't know why the aforementioned study done by Professor Lo indicated that ONLY double tops had a statistically significant predictive outcome after such formations. I find that double bottoms are frequently ALSO an excellent indication that a tradable low is in place. The double bottoms studied may not have made his cut off point so to speak, as to predictability.

A recent example seen in the Russell 2000 (RUT) Index:

Of the many technical chart patterns I put a lot of stock in formation of either a double bottom or double top and this Trader's Corner article is about why. The double or triple top or double (or triple) bottom formation is, as the name implies, a situation where a high or low fails to exceed the price area of a prior significant top or bottom, on 2 or 3 occasions. This second or third top or bottom does not have to occur at the same exact level as the previous high or low, as long as this subsequent high or low is in the same general price area as the earlier peak(s) or bottom(s); e.g., within 5%.

Going back to saved charts from prior years, the following chart of the S&P 500(SPX), formed pretty much an exact double bottom low in 2002 as seen in my next chart:

As always, I look for other 'confirming' technical indicators that might suggest that the market had reached an extreme and was reversing its trend at least for a while; e.g., in above-normal selling pressure as measured by the Arms Index (TRIN) being over 1.60 on a 10-day moving average basis as seen above. I don't use this indicator all the much currently but was making more use of when I saved the above chart.

When I refer to a 'significant' prior high or low, this is the high/low that was the extreme point of an advance or decline in the prior most recent market move or trading swing.

In the 2000-2002 Bear Market, examples of a double top were not hard to find such as is shown with the S&P 100 (OEX):

What about the case of a high or low being made in the same area repeatedly and more than 2-3 times? A stock that makes a top or bottom in the same approximate area on MORE than 3 occasions is considered to be in a trading range between repeated highs and lows established in the same price area again and again. This is the case in the highs and lows made repeatedly where a 'rectangle top' or rectangle bottom can be traced out as seen in my first chart above. A subsequent breakout above or below this price range can also establish an upside or downside reversal of the trend but this is a different pattern than the Double/Triple Top or Bottom.

What is happening in a double top or bottom (generally more common than the triple top or bottom in stocks)from a technical perspective? Support is a price area where there are more willing buyers than sellers and this buying will drive prices back up. Resistance is a price area where selling interest is strong and sellers will overwhelm buyers and drive the price down.

Double bottoms form in a price area where in the initial bottom there was an abundance of willing buyers; e.g., a group of savvy investors and traders view the market as especially cheap. If the potential buyers were strongly interested once in a particular area and there is no great change in the market outlook, they will then tend to be interested again in further buying in the same price area, perhaps even more strongly on a second decline to the same area. This buying will cause a rebound.

Double or triple tops form in a price area where the would be sellers are in control because of their numbers and willingness to sell most or all of what they own of a stock or the overall index or sector. This may also be a price area where there is willingness to take substantial short positions such as by hedge funds. My last three chart examples are drawn from my (Essential Technical Analysis) book:

A technical 'confirmation' can be used to determine whether a SIGNIFICANT double or triple top or bottom is in place and the dominant trend has reversed. The definition of an uptrend is a series of higher highs and higher reaction lows. It is not the failure of prices to exceed a prior peak (this could always happen later), but a decline that exceeds a prior reaction low that initially confirms that a trend reversal has taken place.

A double bottom is confirmed when a prior significant rally peak (in a decline just ended) is also exceeded, after an apparent double bottom. Another related confirming indicator, while secondary to exceeding a prior swing low or high, is having volume action in synch with price action. If there's a reversal of trend implied by a double bottom or top, the volume will typically jump from average daily volume in the recent past.

Generally the MORE time that separates twin (or triple) tops or bottoms the more significant is a subsequent trend reversal.

Volume offers (frequently, not always) a good secondary confirmation for double/triple tops and bottoms in stocks and can be looked at in addition to price action. If there is no volume confirmation to price action and there is only a slight closing break of a prior low or high, it's usually a good idea to wait for a second consecutive close above or below the low or high in question.

It's useful to remember the psychology involved in double/triple tops and bottoms that form: they are repeat patterns. Market participants become convinced that a price floor or ceiling has been established. There is then more belief in the staying power of the trend after the double top or bottom has formed and more people get into the index options or into the stock, which then helps keep the trend going.

The pattern of double or triple, tops is a very useful one as a guide to getting into or out of the market for traders and investors. I myself like entry at such points as I can then take a relatively small risk as liquidating stops can be set just above or below the second or third top or bottom. Because of this, I will not necessarily WAIT for confirmation of the double top or bottom reversal pattern, which is achieved only when prices also go on to exceed a prior upswing high or low as described above.

This preemptive strategy assumes the risk of a pattern failure in exchange for a more favorable risk to reward ratio, which is especially relevant to traders. Investors looking to take a long-term position may wish to wait for the confirming price action. It is always important to pull together all aspects of trend analysis.

If long at a possible double top, your risk of giving back a substantial portion of any unrealized gain is generally higher than the reward potential of a further up leg. At such a juncture, it is not necessary to exit your position, as the old top may certainly be exceeded, but raising any exiting stop to just under the last prior significant downswing low is warranted.

You can exit calls at a probable double top, especially if the prior peak was a major one, while also being prepared to assume new long positions/long calls if prices push through the most recent high by a significant amount (e.g., more than 5%) and on strong volume. Conversely, be prepared to exit puts on the first signs of a strong upside reversal, especially on a volume jump, after prices have moved into the area of a prior significant low.


GOOD TRADING SUCCESS!