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Trading the Doubles

Trading the Doubles

2014-08-21 19:00:00
James Stanley, Currency Strategist

Talking Points:

  • The Double-Top and Double-Bottom formation show multiple tests of support (or resistance) at a particular price level.
  • Traders can look to trade subsequent tests of these price levels.

Price action is the study of past price movements in an effort to trade the future. While this definition could be applied to the entirety of technical analysis, it has a special meaning with the topic of price action because price action investigates price, and price alone.

One of the most important elements of price action analysis is support and resistance, because if we can notice a specific price at which buyers or sellers have entered a market in the past, we might be able to use that in our favor in the future.

In this article, we’re going to examine a formation that can develop around these areas of support or resistance.

The Double-Top/Double-Bottom

The Double-Top or Double-Bottom formation will occur when two separate ‘moves’ bounce from a support or resistance level. This highlights that level as being especially strong, so that the next time price encounters this, traders may be able to look for a significant reaction.

In the below chart, we take a look at a recent double bottom formation in the AUDUSD pair.

Trading the Doubles

Created with Marketscope/Trading Station II; prepared by James Stanley

Notice how price action has reacted to this level of support two different occasions. So the next time that we approach this level of established support, it could be reasonable to assume that some type of reaction may take place.

Imagine this support level as a theoretical ‘line in the sand’ that can have the potential to pull additional buyers into the mix. But this isn’t necessarily a completely bullish prospect… because after this support level was defended, prices ended up coming right back down.

The exact opposite is true of resistance in the Double-Top formation…

Trading the Doubles

Created with Marketscope/Trading Station II; prepared by James Stanley

Notice how this level of resistance on the chart has been validated twice by price action, as sellers have come in to push prices lower once this level was hit.

Up to this point, we’ve covered everything that is known about the formation. Support (or resistance) has come into the market on separate occasions, and it may come in again: That’s all that we really know.

And this is just like any other congestion formation in the fact that all that we really know is that a reaction of some type may happen. But that’s ok – because with risk management, even that simple expectation can be enough to formulate a strategy.

How to Trade the Double Top/Bottom Formation

The default mannerism of trading the double bottom is to look for a bullish price reaction after the second test of support.

So, using the same AUDUSD example we had looked at previously, we look at how a trader could’ve approached this formation.

After support was hit for a second time, the trader knows that there could potentially be a bullish bias coming into the market. After all, if buyers jumped in to protect the ‘line-in-the-sand,’ they may do so again.

So after the double bottom was formed – the trader waits: The trader waits for a ‘higher-low’ to come into the market so that they can look to ‘buy low,’ with a stop placed below the level of support at the double-bottom. This way, if the formation doesn’t come to fruition, the loss can be mitigated; but if the formation does come through, then the trader can look to reap more upside than they had to put in to risk.

We taught traders how to look for ‘higher highs’ and ‘higher lows’ in the introduction to price action, and we showed the power of trading candlestick wicks in the article, The Power of Wicks in the FX Market.

Trading the Double Bottom

Trading the Doubles

Created with Marketscope/Trading Station II; prepared by James Stanley

As you can see in the above setup, the real allure of trading the double top or double bottom is the potential to have a really strong support or resistance level to use for the basis of a position’s risk management.

The exact opposite is true for the double top formation; in which the trader can look to sell ‘lower highs,’ with a stop above resistance so that if that level holds, the trader can look to manage a profitable position… but if the high point of resistance doesn’t hold, the trader can look to exit the position while mitigating the loss.

--- Written by James Stanley

Before employing any of the mentioned methods, traders should first test on a demo account. The demo account is free; features live prices, and can be a phenomenal testing ground for new strategies and methods. Click here to sign up for a free demo account through FXCM.

James is available on Twitter @JStanleyFX

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