Don Dawson A View From The Top And The Bottom Don Dawson shows how to use the double top and double bottom chart pattern in trading. He also describes how to include Bollinger Band analysis to enhance the trading opportunity. The patterns I am 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. 8
Figure 1 When I started trading futures, the luxury of desktop computers was still a dream. Traders either subscribed to a service that snail mailed printed charts to you or used scotch tape to put sheets of graph paper together for an extended chart view. Then, we would tape them to our office walls creating a huge mural of bar or point and figure charts. Either method you elected, at the end of the day, you used a pencil and ruler to manually draw the open, high, low and close for each market that 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 still relied heavily on fundamental analysis to trade. By using only a pencil and ruler, we had a limited number of chart patterns we could locate and base our trading decisions on. This is unlike today where software programs like TradeStation have literally hundreds of different technical indicators that generate buy and sell signals for traders. Chart patterns like double-tops/bottoms, head & shoulders, flags, pen- 10 APRIL 2009 / VOL. 5 ISSUE 4
Figure 2 nants, etc. had such a following that some people felt that the popularity caused the patterns not to be as profitable. Today, I believe some of these classic patterns are returning to favor. With so many different ways to trade, we do not 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. His work on the double-top formation is very surprising. The overall performance of this pattern ranks a 2 out of 21 ( 1 is best). It shows that after the neckline is broken, 59% of the time the market will pull back to the neckline. Here is the astonishing point price meets its profit objective 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 12 APRIL 2009 / VOL. 5 ISSUE 4
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 the 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 is 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 using the 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, which will give your profit objective at point D. Below is a chart of a double bottom pattern. Both patterns work the same way using the Bollinger Bands. The trade would be inverted for a buy setup instead of a sell setup. 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 them, 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, Online Trading Academy Commodity Futures Instructor APRIL 2009 / VOL. 5 ISSUE 4 13