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Trading: How to trade using the Dow Pattern (Part 2)
How do you place your trade by looking at the Double Top Formation
Refreshing our understanding of the Dow Theory
Under the Dow Theory, a few basic rules may indicate if the Dow Pattern is forming, i.e., it tells you if it’s a good time to buy, sell, or hold — much like trying to see if it’s going to rain, the sky gets dark, the air feels humid, and clouds are forming! So, here are the 6 basic tenets of Dow Theory:
- Market moves in 3 broad trends.
- There are 3 phases under each trend.
- Everything is discounted into the stock market.
- Averages must confirm each other
- Volumes must confirm trends
- Trends will continue until there is a reversal
The ones that we will cater to the most during the pattern identification process are the first and second tenet. How? Let’s find out together as we go.
Double Top Pattern
A double top formation is considered a bearish reversal pattern, signaling a potential trend reversal from an uptrend to a downtrend. The pattern is formed after an extended price move upwards and consists of two peaks that reach a similar price level.
There’s a simpler way of explaining it tho — where I’d say it’s when they tried to push the price on a bull run — twice, and they failed both times, at which they decided it’s time to give up.
What happens during a double top formation?
Here’s a breakdown of the key features of a double top formation:
Initial Uptrend: The price of the asset is in an uptrend, indicating bullish sentiment among traders.
First Peak (Left Shoulder): The price reaches a high point, forming the first peak. After this peak, there is a temporary pullback as some traders take profits.
Valley (Trough): Following the first peak, the price experiences a retracement or pullback, creating a trough. This phase is often referred to as the “neckline.”
Second Peak (Right Shoulder): The price again rises to a level close to the first peak, forming the second peak. However, the second peak is typically lower than the first one, creating a horizontal line that defines the neckline.
Breakdown: The key signal of a double top formation occurs when the price breaks below the neckline. This breach indicates a shift in market sentiment from bullish to bearish.
Confirmation: Traders often wait for the price to close below the neckline to confirm the double top pattern. Increased trading volume during the breakdown adds to the validity of the pattern.
Price Target: The projected price target for the bearish reversal is often calculated by measuring the distance from the neckline to the highest point of the double top and subtracting it from the breakdown point.
How to trade?
Traders typically enter a short (sell) position when the price breaks below the neckline, confirming the completion of the double top formation and signaling a potential trend reversal. This is when you place your short sell.
Just in case things doesn’t work out, where do you place your stop loss? You’d usually want to put your stop loss just a bit above the second peak.
Where can you start taking profit? The key is to draw a line vertically to measure the distance between the neckline and the height of the two peaks.
In this example, we can see that the distance is around 35%. So, what you can do is drag the line to go around 35% below the neckline. That is how much it is likely for the price to drop.
So, for this example, 35% below the neckline is around a decrease from $8.32 to $5.36. Of course, the stock dropped deeper in this example, but you can never be too sure, right?
Profit-Taking (for long position):
If you already own positions in the stock or asset, you might want to let go of that position (depending on your strategy) and start taking profit from your position, if you bought it at a lower price prior to the trend taking place.
P/s: Assess the risk-reward ratio before entering the trade. Ensure that the potential reward justifies the risk taken.
- The Double Top pattern is a sign that a current trend may be going for a reversal.
- It indicates a possible reversal from bullish market to bearish.
- In trading, always set a limit where you are going to take profit from the stock, set a stop loss limit, and consider resistance level.
- Your profit taking (for short sellers) can be measured by comparing the height of the neckline and the peaks to the depth that the stock will fall.
- Your stop loss can be put slightly above the peaks.
- Assess the risk-reward ratio before entering the trade. Ensure that the potential reward justifies the risk taken.
- It’s important to note that no trading strategy is foolproof, and risk management is crucial.
- Traders should adapt their strategies based on market conditions, use proper position sizing, and consider additional technical or fundamental analysis to support their decisions.
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