It seems like every time the market approaches a previous level of resistance the “double top” callers come out in force. There is nothing wrong with correctly identifying this reversal pattern, the problem is that a double top has not formed in the $SPY. Look below at the chart of RedHat ($RHT) this stock formed a true double top earlier this year and the points on the chart are explained below so you can corrrectly recognize what a double top is.
A– The stock rallies up to find resistance near 60 and then sells off to
B– The low of this pullback near 54 is the low end of the emerging pattern, the stock then rallies to
C– The second peak occurs in the same general area, it can be a little higher or lower, it is not exact.. With the higher high at this point there is no reason to think it has reached a high, but as always, risk management is job #1 and you should have a stop based on your timeframe.
D– RHT breaks the uptrend line which had been in place for approximatetly 5 months. This is the first sign of potential trouble. A trendline break doesn’t always mean a reversal is coming but it does imply that the rate of ascent has slowed and your guard should be up!
E– When the pullback low (point B at 54) has been violated the double top is officially recognized and a price objective can be determined. To find the price objective of the pattern, the height of the pattern (the distance between point A at 60 is subtracted from the level at point B, 60-54 = 6 points) is subtracted from the breakdown point of 54. So here our targe is 54 – 6 = 48.
F– Becomes our target of 48 and you can see that RHT attained that target in a few short weeks.
A few things to remember about double tops (and technical analysis in general)
– Not all breaks of the point B low will lead to their objective, risk management is much more important than waiting for your target to be obtained. Cut your losses if the stock recovers from the break down.
– As you can see, a double top doesn’t mean it is THE TOP, they can just be a setback in a longer term uptrend.
See the current SPY chart below and observe the two double tops which were identified this year. The first one went well beyond the measured move target, while the 2nd one fell short of its target and reversed higher. Currently there is ZERO EVIDENCE that a double top has formed. The trend is higher, it is extended and probably due for a pause but dont fight the trend, have your stops in place for YOUR TIMEFRAME.