DOUBLE TOP

The point articulated throughout this book is to try to buy weak-ness in up-trending markets and sell strength in down-trending ones. Double tops, if confirmed by our One Shot – One Kill indi-cators, show a transformation underway from a market that is buying the dips to one that is beginning to sell the rallies.

For example, imagine that you want to buy a stock that has gone on a tremendous run. You tell yourself that if it ever gets cheap again, you will jump in and buy. This yearning to jump in and buy is what forms the first leg of the double top. After the stock falls, it soon begins to rise again, because of all of the traders who bid into the pullback. The shorts have also used the

Chart 3.1 for the Network Appliance Corporation (NTAP) puts forth a telling story of a nearly perfect double top in Octo-ber 2000.

The rise was preceded by a tremendous amount of exertion from the previous six months. Those who were not able to be part of the first run got in when the stock traced back to a Fibonacci support level (which will be explained in Chapter 4 in more detail). The market then got its second life and the stock rallied back up to 154 three weeks later.

Unfortunately for investors at that time, the stock turned and took a precipitous drop down, allowing traders who cor-rectly used chart patterns in their trading style to profit hand-somely from others’ misfortunes as a result of their lack of trading skills. While shorting near the highs may be tempting, what separates a double top from an ascending triangle, explained below, is the how the stock handles the pullback from that second high.

A pullback from that second high that only generates a modest bounce before falling again should offer a much cleaner entry to the short side. Once you begin to actualize some of the profits that exist in detecting and attacking double tops, you will see very good evidence as to why I am so excited about trading.

In order to not get stampeded by a freight train when attempting to enter a double top, you need to understand the five components to every double top that determine whether or not it is worth shorting.

The first thing to measure is the exertion behind the stock’s movement before it makes its first high. The longer the time period the stock runs, the more greed that is accompanying its rise, and hence, the greater potential for fear to emerge on a short position. Look at Chart 3.2, concerning the Vitesse Semi-conductor Corporation (VTSS), to get an understanding of the exertion that preceded the rise up in February 2000.

The initial rise was accompanied by three straight weeks of upward movement before the stock made its first top.

The second component to a powerful double-top formation is its compression, or the space that exists between the first and second top. Using a time frame of 10 time periods or fewer is ideal. Chart 3.2 shows there is excellent compression being

54 Phase I: Basic Trading Tactics

CHART 3.1 Opportunities like the one seen here occur following a huge runup. A double top forms and the market shifts from buying dips to selling rallies. The first solid entry to the short side occurs near point 2, when the market bounces back up to what is now a declining 15-period MA.

CHART 3.2 The Vitesse Semiconductor Corporation (VTSS) rallied strongly, pulled back nicely, then broke up again to retest highs before finally changing course and retracing all of the gains from the strong rally.

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ment before it retests old highs. In other words, if a stock only has a shallow pullback before challenging new highs, then attempting to short it is like a salmon swimming upstream.

However, if a stock pulls back at least 50 percent of the move and attacks old highs on weakening volume, nice compression, a negative TRI, and breaking down below the 15-point MA, then the probability of a trend reversal increases significantly.

The fourth part of a highly probably double top is the subse-quent failure following the pullback from highs the stock or mar-ket will experience on its second run. If the stock goes to make new highs on the second run higher and pulls back, you should be alert for a possible short entry. However, if this pullback is met by more buyers, then the stock may not be ready to fall yet and could very well have another higher move in it. However, if this pullback from highs fails to mount another charge and instead fails at a declining 15-period MA, you now have a very lower risk entry to the downside in a stock that has gone from being bought on weakness to now being sold on strength.

The fifth part of making a successful double top is having the stock take out the previous day’s low following the scenario in the fourth part. That is, once the subsequent rally after the curve has made a double top fails, making a lower high and suc-cumbing to selling pressure at what is now a declining 15-period MA, you need to enter the position when the stock takes out the previous day’s low. This is the spot where most professionals are looking to take aggressive short positions, as the risk-to-reward ratio is excellent.

In summary, you are looking for strongly trending stocks,

boat the first time the stock breaks down through the previous day’s low (PDL) from highs, since, usually, the most profitable short entry from a double top will occur after the second lower high is made. Thereby it provides a more tangible means of entering the position on the short side, using pullbacks to a declining 15-period MA to add to positions to the short side. This loss of momentum usually does a good job of shaking out a lot of buyers. This development offers a tremendous opportunity to playing the downside or at least closing out your long position and watching from the sidelines.

Understandably, many traders don’t have the stomach to short stocks. But recognizing this scenario and other formations is helpful in protecting yourself if any of the stocks in your portfolio resemble these characteristics. Understanding the dynamics of this formation alone can save or earn you a tremendous amount of money over the course of your trading and investing career.