How to Trade Tops and Bottoms
Forex Bits

How to Trade Tops and Bottoms

Double tops and double bottoms are the most frequently encountered chart patterns in forex trading. These patterns occur when the price hits a support or resistance level twice in a row and fails to break through.

For instance, a double top occurs when the price rises to a resistance level, falls back, rises to the resistance level again, and then falls away. When this happens, traders gain confidence that the resistance level is well defended, and then make investments that reinforce the subsequent downward trend (or upward trend following a double bottom).

While this may seem fairly straightforward, the truth is that it is often difficult to identify double tops and double bottoms accurately. Some more aggressive traders use a variety of indicators to try to anticipate these patterns, whereas more reactive traders look for a confirmation of the pattern before entering the market.

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As with any trading strategy, both of these have advantages and disadvantages. Traders who try to anticipate these patterns will typically enter at a more advantageous price, but run a higher risk of the pattern failing. On the other hand, reactive traders don’t get as much of a price advantage and run the risk of high losses if the pattern does fail.

One of the most important ways of managing this risk is to place stops correctly. However, many traders make the mistake of placing their stops too close to the top of a double top or bottom of a double bottom. They do this because they believe that if the pattern does fail, they need to get out immediately to manage risk. While this might seem obvious, what they fail to take into account is normal volatility in the market. This can lead to them getting stopped out too early, producing a series of frustrating losses as they try repeatedly to jump on the trend. In fact, major institutional traders know that inexperienced retail traders do this and exploit this to generate profits. Remember that the right way to control risk is to take appropriate position sizes and limit leverage, not to place stops too close.

A better way of placing stops on double-top or double bottom-trades is to use Bollinger Bands. These bands already incorporate expected volatility in the market by using standard deviations. Because of this, they provide a more accurate measure of where traders should exit their positions. To use Bollinger bands to do this, find the first top or bottom, and set up Bollinger bands around it with four standard deviations. Then, plot a line from the top or bottom to the Bollinger Band and use the intersection point as your stop. While four standard deviations may seem like overkill, it is in fact a good choice because of the extreme price action that can occur around these chart patterns.

Further reading:  5 Most Predictable Currency Pairs – Q3 2014