Double Top Formation- Stocks peaking out
Double top formation is one of the most common technical analysis patterns. It is an effective pattern which has stood the test of time and is very easy to spot on charts. In this article we will look at what is the Double Top (DT) and few stock examples which have shown DT at the beginning of this correction and lastly, as a bonus, we will discuss other evidences which strengthened the double top formation and made it effective to observe.
Like any bull run, the last bull ended with a state of euphoria being rampant. As a result many new retail participants were pulled in because the stock market looked and felt infallible. Most have been left with stock holdings bought at peak prices. Unfortunately, many of these peak prices will not be seen again until the peak of the next bull run which can be well 10 years into the future (if the company survives the coming recession that is).
After reading this article, you will, hopefully, be better prepared when the next bull run peak comes and at least be able to identify a double top formation.
Double tops are formed when price approaches a previous top but fails to cross above it. The formation had been noted to work across timeframes such as hourly, daily, weekly and monthly. It is mostly used for long term positions where analysts and traders refer to the daily or weekly charts (sometimes even monthly) to identify potential tops.
There are many reasons for this :
- Stock tops are areas of key resistance. They often witness high selling volumes by those unfortunate buyers who were caught at the previous peak price. This time they want nothing more than to recover their capital by selling close to the entry level.
- Previous tops are popular target levels for traders to sell short term long positions in a stock.
Since previous top is a potentially high resistance area, therefore, in order to overcome a previous top, a stock needs to demonstrate high participation interest which is difficult unless there is a genuinely good reason to believe that the company is on a growth trajectory. This is the reason you will find many good traders and analysts using breakout signals in their trading. They are basically playing the old adage- The trend is your friend. It is always better to catch a stock hot in uptrend rather than one in downtrend in hope of it reversing soon.
To validate a double top formation, it is important to take note of the volume activity. Sometimes, due to the above mentioned factors of resistance near the top, a stock may show consolidation / sideways movement with dry volumes before the actual breakout. However, if you happen to notice high volume and a downward pressure in the stock, then know there is distribution undergoing in the stock. This little detail about volume is very important. Volume has to be high on the candle enabling the breakout because that is when BIG money flows into the stock. Breakouts accompanied by low volume often fail.
Many a times, non professionals mistake distribution volume as high volume near tops and buy stocks prematurely anticipating a breakout. Such purchases are often destined for long and painful correction or in better cases big stop loss triggers.
Let's move on to discuss some real life examples of Double Top which have been noted on the weekly time frame. Pay attention to the accompanying evidences to solidify your understanding of this amazing technical pattern frequenting charts as global economy slowly but surely slips into recession.
BHARAT RASAYAN (NSE:BHARATRAS)
Previous Peak : 28th June, 2021
Current Peak: 18th April, 2022
315 days apart
Let's discuss 3 important observations on the weekly chart of Bharat Rasayan-
1- The double top formed in the month of April was in line with the April '22 peak in Nifty 50. While the broad market index started falling off its peak since October '21, this stock managed to keep the steam on until April '22. Its failure to cross above the previous top and show of low volume in the last week of April was a definite sign of weakness. On the same chart you can see when the last time this stock approached a previous peak, it broke above the resistance with very high volumes (orange circle)
2- Breach of twin support- On 19th May this stock broke below the twin support 11550. This meant the breach of the upward trending support line and the weekly 50EMA line.
3- RSI negative divergence- This is perhaps the 2nd most important indicator after volume in identifying a double top formation or false breakouts. You can see the RSI peak on the weekly chart is higher for the first peak but lower for the second peak, even though the price is nearly the same. If you delve deeper into the analysis of this aspect you will see that weakness on this stock had already been hinted- even before the formation of the second peak in April. This hint is what RSI picks up for us and makes obvious via the evident divergence.
As of today, Bharat Rasayan continues to breach important support levels one after another. For more analysis and details on support levels on this stock, raise Stock Query here.
PRISM JOHNSON LIMITED (NSE:PRSMJOHNSN)
Previous Peak : 15th Jan, '18
Current Peak: 10th Jan, '22
4 years apart
3 important observations in the weekly chart of Prism Jhonson above-
1- In the COVID-19 fueled market crash of March '20, this stock had breached the important support trendline, signalling the first sign of trouble in the stock price.
2- When the post covid rally happened, this stock scaled back the correction in a very short span of 504 days rallying nearly 350%. However, it failed to cross above the previous high of 160, and topped out in July '21 while the rest of the market continued to register positive momentum. In January the stock did make another attempt at a new high but could not sustain the momentum and fell 35%.
3- The RSI negative divergence pointed to the potential failure of the reattempt and the above evidences combined played a role in warning against initiating long position in the stock.
JSW STEE LTD. (JSWSTEEL)
Previous Peak: 10th May, '21
Current Peak: 18th April, '22
343 days apart
The steel sector was caught in massive tail wind for larger part of the last year for various reasons. This rally was never going to be forever. Naturally prices of commodities cannot rise exponentially and hence the stock prices of companies dealing in such commodities cannot rally indefinitely. Majority of times such strong rallies in commodity sector do not hold their highs and correct severely when the cause of momentum cools off. The steel sector is in such mood currently. Let's discuss JSWSTEEL observations to understand this better.
1- Failed breakout- On the chart you can observe that the momentum of the current rally did take the stock price briefly above the previous peak but it did not sustain the same leading to what we call a failed or false breakout.
2- Low volumes- As highlighted with an orange circle on the chart, the volume accompanying the rally to the peak was low compared to the previous volume. This means big money did not participate, if at all they were selling to the retail public which bought hoping the rally witnessed in the last year would continue.
3- RSI negative divergence- Here again, momentum indicator gave an early indication of waning interest in the stock by failing to reach the same level it had reached in the previous rally and remaining shy of 65.
I hope these examples have helped you understand the Double Top pattern better. Volume, RSI, support resistance levels, trendlines are few other key evidences you should look out for when buying stocks relatively late in a rally. While I have used only weekly timeframe, the rules also apply to other time frames, both bigger and smaller.
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Thank you for reading!
- Kavita Agrawal CFA CMT