By Don Dawson, Online Trading Academy Commodity Futures Instructor
The patterns I was referring to are the classic Double-Top and Double-Bottom chart patterns. I use the word "classic" to give you an introduction as to how these patterns started.
When I started trading Futures, the luxury of desktop computers was still a dream. Traders either subscribed to a service that "snail" mailed your charts to you or some would use scotch tape to put sheets of graph paper together. Then we would tape them to our office walls creating this huge mural of bar or point and figure charts. Either way you elected, at the end of the day, you had to use your pencil and ruler to manually draw your Open, High, Low and Close for each market you followed. Fortunately, we just updated the daily price bars and not intra-day bars. Most people would just get their data from the newspaper the next day. At this time, chart users were still considered a little "out there" because technical analysis was not very popular. Most people were still using fundamental analysis to trade.
By having only a pencil and ruler we only had a limited number of chart patterns we could locate and base our trading decisions on, unlike today where software programs like TradeStation have literally hundreds of different technical indicators that help generate buy and sell signals for traders. Patterns like Double-Tops/Bottoms, Head & Shoulders, Flags, Pennants, etc., had such a following that some people felt like that caused the patterns not to be as profitable. Today, though, I believe some of these classic patterns are returning to favor. With so many different ways to trade now, we don't seem to have the herd instinct when these patterns develop.
While teaching the E-mini Futures class, I bring up these patterns. The usual response is, "That's nice, what else do you have?" Then I show them a website by Thomas Bulkowski, author of several books including "Encyclopedia of Chart Patterns". He has back-tested all of the classic and new patterns that have been submitted. When you read some of the names of these patterns you will get a chuckle. For example, Scallops, Pipe Tops, Long Island, Bump & Run etc. His work on the Double-Tops was very surprising to me. The overall performance of this pattern ranks a 2 out of 21 (1 is best). Shows that after the neckline is broken, 59% of the time the market will pull back to the neckline. But here is the astonishing point - the percentage of time the price meets its profit objective is 73% of the time. How many trading systems can boast that statistic?
Before I show you a method to possibly enhance the already high percentage of success, I would like to add a couple of added features to look for:
- When you find a Double-Top/Bottom pattern, look to the left of your chart and try to find some Support/Resistance levels that help confirm this pattern.
- Remember, these are "Reversal" patterns. Meaning, you have to have an extended trend in place to reverse before they can be reliable. If market is in a trading range, then a reversal pattern will probably have little impact on price direction.
- If the trend has been going up and each previous swing low was higher, then the first swing low break will be the Double-Top pattern neckline. Adding fuel to the downside as people who were long will also be taking profits under these lows.
In the charts below, I have added the Bollinger Band indicator (standard settings 20,2). Many times a price trend will hug or trade just outside one side of the Bollinger Bands until the market finds some Support or Resistance creating point A (left side) on the chart. Once this level is approached, you can look for a pullback of the current trend. Then another attempt will be made in the direction of the trend causing point B (right side) to be made. This is where a divergence can appear. On this attempt, the market may stop at the previous Support or Resistance level causing a Double-Top or Bottom pattern. To confirm the pattern, look for the price to stay "inside" the Bollinger Bands on the retest at point B (right side) on the chart. If the price stays inside the Bollinger Bands while creating the Double Top, you can enter the trade in one of two ways:
- Conservative: Wait for a bar to close under the neckline.
- Aggressive: Once price touches or comes close to the old high, look for your first "red" candle close and go short.
Profit objectives for these patterns are as follows:
Take the peak at point A or B and subtract the neckline, point C. This gives you the height of the pattern. Then take that number and subtract it from the neckline. You will then have your profit objective at point D.
Figure 1
Below is a chart of a Double Bottom Pattern. Both patterns work the same way using the Bollinger Bands. Just inverted for a buy setup instead of a sell setup.
Figure 2
These two reversal patterns are very powerful. By adding the Bollinger Bands, you can add even more success to your trading. These setups can take a while to form but they are worth the wait. Before trading these, make sure you fully understand the setups. Then add the strategy to your written trading plan. For those of you that do not trade them, you should at least be aware of them while you are trading.
Keep the trend on your side,
- Don Dawson
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