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Chart Patterns - Reversal - 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 in 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

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.

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