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Friday September 03, 2010 |
Double
Top
A double top formation is a distinct chart
pattern characterized by a rally to a new high followed by a moderate pullback
and a second rally to test the new high. As the stock rallies to make the
second peak (top) sellers overwhelm buyers and the stock price collapses. Several weeks later
the stock moves to test prior support levels.
Why Does It Happen?
Getting caught in a stock at the high is never
much fun but it happens. The double top pattern occurs because most
investors that buy a stock "wrong" will refuse to exit until they can
do so without suffering a loss. Double tops occur after extended rallies leading
to new highs. As the "story" of
the stock becomes more widely accepted investors are willing to pay increasingly
exorbitant prices but one day investors find the price is simply too high, the
stock puts-in a top and prices begin to fall (top#1).
This first top will normally be sufficient to force many of the more speculative
investors from the stock. As they sell the price of the stock falls
further but many investors will not sell regardless of how far the price falls
because they refuse to take a loss.
After several sessions (sometimes weeks) of poor price performance
the stock will begin to stabilize (reaction low) then gradually
move higher. In most cases this advance will occur because of some
fundamental factor like an upcoming analysts meeting, earnings report or stock
split. As the stock rises volume slows and investors who bought at the
first top get ready to exit positions into further strength. As the stock
approaches the prior high volume surges and new buyers begin to talk about bright
fundamental prospects. It is at that moment that all of the investors who
purchased positions at the prior high begin selling. Volume surges and the
stock soon retreats (top #2). On the chart two equal
peaks are created, the double top is in place. In many cases double top formations lead to
important declines because two separate sets of investors have been disappointed
at a particular level.
How are Technical Targets Derived?
The technical target for double tops is derived
by subtracting the point difference between the top#1 and the reaction low from
the breakout level. After the second top has been created, the breakout
level is the reaction low. No double top formation is
complete until the stock falls through this level.
The Emulex Double Top
In the era of momentum stocks Emulex (EMLX) was
one of the favorites. In February of 2000 the stock had an upside breakout
from a consolidation at $70 and promptly exploded to more than $112. This
rally pushed the stock to one of the richest valuations anywhere but
investors seemed undaunted until the middle of March when the wheels fell
off. The stock skidded from $112.18 to $70.63 amid rumors that growth
rates were slowing. In the following days several Wall Street analysts
made bullish comments and once again momentum traders pilled into the stock.
Within days the stock was very near the first top and on March 27 Emulex
actually traded at $112.75 before closing at $109.03. The very next day the
company warned that growth rates were slowing and the Emulex lost $28.57 to
close at $80.46. The next day Emulex shares fell through the reaction low at
$70.63 and just four days later the stock traded to $27.00!
Vital Signs
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For a valid double top formation it is important that volume
decline significantly as the stock moves toward a test of the first top and
accelerate as price begins to decline.
-
No double top is truly complete until a
breakout below the reaction low occurs.
-
Downside breakouts often lead to small 2-3%
declines followed by an immediate test of the breakout level. If the
stock closes above this level (now resistance) for any reason the
pattern becomes invalid.
Now let's take a look at the next reversal
pattern, the double bottom.
island
reversal 
double
bottom
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