Tuesday, March 2, 2010

Reversal Chart Patterns - Double Top and Triple Top

Some of the most important resources in a technical analyst's arsenal are indicators that can help identify reversal in chart patterns. Double-top and the rarer triple-top are two such indicators.

These are pattern formations that typically lead to severe price corrections during bull markets. In bear markets, double-bottoms and triple-bottoms reverse downtrends and are followed by a price surge.

The BusinessLine newspaper is something I like to read regularly. They provide fairly unbiased and balanced opinions. In a recent issue, there was a 'buy' call given for Elgi Equipments.

This company wasn't on my 'watch' list so I decided to take a quick look at the price chart pattern. This is what I saw on the longer-term price chart:-


In April 2006, the stock made a high of 97. Shortly thereafter, it collapsed to 52 in July 2006 and then, after a brief sideways consolidation, dropped to 48 in Mar 2007.

Another sideways consolidation was followed by a sharp rise, this time to 95 in Jan 2008. That was a 'test' of the previous top that failed. Once again, the stock collapsed down to 44 in March 2008, going below the previous low of 48.

A quick upward bounce to 70 in April 2008, then a drop to 43 before the bear market took the stock all the way down to multiple bottoms at 27. A classic example of a double-top chart pattern formation.

First, the second top was almost the same as the first. Second, the volumes preceding and during the first top of 97 were higher than the volumes preceding and during the second top. Third, the low between the first and second tops could not support the fall from the second top as the stock dropped much lower.

Unfortunately, the double top can't be confirmed till the low between the two tops gets broken after the second top gets formed. On occasion, the stock price may continue to move upwards after falling briefly from the second top. Now you know why I keep mentioning that technical analysis is more an art than a science!

Next, have a look at another interesting chart pattern formation during the current bull rally. The stock had a sharp up move to 98 in Jan 2010 - almost the exact same level it hit in 2006 and 2008. The correction started immediately, and we may be witness to the much less frequent triple-top chart pattern formation.

Can we conclude that the stock is going to drop steeply once more? There are a couple of indications that suggest so. Except for a single, very large spike in Oct '09, volumes have been just as meager as it was during the formation of the second top.

Also, have a look at the 50 day EMA. Each time that the stock price moved 25-30 points above the medium-term moving average, the stock came crashing down. It could happen again.

If I was a gambling man, I would lay a wager that this is a triple-top reversal chart pattern. But I have lost enough money trying to predict what a chart pattern is going to do next.

A triple-top can't be confirmed till the 48 level is broken on the down side. But for existing holders, this can be as good a time as any to book some profits.

I'm afraid I can't agree with the BusinessLine 'buy' call from a technical perspective, even though the company may be doing fine fundamentally.

This is a good example to support my argument that investors should learn both fundamental and technical analysis. Only when the technicals and fundamentals are in synch should a stock be bought.

(A question: Why do you think the double-top or triple-top patterns get formed? Are there some logic behind them, or are these random patterns that defy logic?)


Unknown said...

Just for confirmation double top and cup and handle are two different patterns.

We have to wait to form the handle formation to confirm the cup and handle classic pattern.

Please convey is it correct.

Subhankar said...

Both statements are correct.

Cup and handle is usually an interim bottom formation, after which prices rise. It can also be a major bottom. Double-top is formed at major tops, and some times at intermediate tops, and prices fall subsequently.

One of the problems of technical analysis is that if you wait for the confirmation, whether for a double-top or a cup and handle or for an EMA crossover, it may be already too late to decide whether to buy or sell!

The trick is to identify a pattern while it is still forming, and then buy/sell a small amount. Once the pattern is confirmed then buy/sell in larger quantity.

Sumanta said...

One logic of why double top patterns form could be because of the typical bias of investors not to square of their loss and holding on to their buys hoping for the stock to get back its high levels. Non traders would typically not likely to sell off their holdings as they bought them during the first top.

Once the stock falls and consolidates and the next upward surge happens, these investors would try to exit during the second top formation. Not sure if this could be an explanation but booking loss is something humans are not trained for naturally.

The triple top formation could happen because of the same set of buyers who entered the stock during the second top and trying to exit during the 3rd top.
Similar logic could hold true for double bottom formations.

BTW another great analysis, shows why we should not blindly believe respected article recommendations without doing due diligence on our own.


Subhankar said...

Appreciate your comments, Sumanta.

Your logic is spot on. Learning to set stop losses and booking losses are skills that can be learned.

Our 'loss aversion' stems from the notion that 'I am too smart to make such a foolish investment decision'! By hanging on, we hope to break even. In the process, we make real losses - loss of interest and opportunity losses.

rk77 said...

Head and Shoulder formation indicates an impending fall and this pattern is clearly seen in the chart of IDBI Bank. Yet this share has been recommended by several people and I did make the investment based on the last 3 yrs chart. The H&S pattern is seen only on 5 year chart! Guess I discovered it too late. Any comments from the master?

Subhankar said...

Don't follow IDBI Bank but did take a quick look at the 5 years chart. It does look like a h-s pattern is being formed, but the volumes tell a different story. The formation of the left shoulder was on lower volumes. It should be the other way around.

rk77 said...

I stayed invested in IDBI and it has reached 195. My interpretation of the H&S pattern was not correct it seems.

Subhankar said...

Good for you, Dr K.

Like many technical patterns, the head-and-shoulders fails more often than not. The volume action during the formation of the head and the two shoulders provides clues.