Forex Trading System-Double tops and bottoms

OVERVIEW

Pattern recognition is essential to profitable point and figure charting. In this chapter,we examine two of the most basic P&F formations.

DOUBLE TOP PATTERN

One of the easiest P&F chart formations to identify is the double top pattern whichconsists of two X columns and one O column. (See Figure 14.1.) The highest Xs in both
the X columns must be in the same row, thus forming a local (and temporary) line ofresistance.

DOUBLE BOTTOM PATTERN

The inverse to the double top pattern is the double bottom, which has two O columnsand one X column. (See Figure 14.2.) The lowest Os in both columns must be in thesame row, thus forming a local line of support.

DOUBLE TOP SIGNALS

In the double top pattern displayed in Figure 14.1, the stage is set for a potential buy orsell market entry signal. If the price can exceed the local line of resistance, then a buysignal is generated. (See Figure 14.3.)

Coversely, if the price can decline below the lowest O in the previous columns ofOs, then a sell market entry signal is triggered. (See Figure 14.4.)

There is a third alternative in which the price does in fact decline but does not golower than the lowest O in the previous O column. (See Figure 14.5.) The pattern
does not generate an immediate signal. In fact, traders will note that with the latestprice movement the original double top formation has now become a double bottompattern.

DOUBLE BOTTOM SIGNALS

If the price can extend below the local line of support in a double bottom pattern, then asell signal is generated. (See Figure 14.6.)

However, if the price can advance above the highest X in the previous columns ofXs, then a buy market entry signal is triggered. (See Figure 14.7.)

Analogous to the double top pattern, there is a third alternative in which the pricedoes in fact advance but does not go higher than the highest X in the previous X col-umn. (See Figure 14.8.) In the diagram, no immediate trading signals have been trig-gered. The latest price movement has transformed the double bottom into a doubletop formation.

FALSE SIGNALS

All traders are familiar with the concept of false signals, perhaps more intimately thanthey wish to admit. This undesirable phenomenon involves the following sequence ofevents: (1) a buy or sell signal is generated by some mechanical means, (2) the traderenters the market at the designated price level, and (3) a breakout in the opposite direc-tion occurs. False signals have also been labeled failures. Regardless of the nomencla-ture, they can be very disheartening and costly.

Although the effect of false signals can never be completely eliminated, their detri-mental impact can be significantly reduced by the use of confirming signals and theproper positioning of stop-loss limit orders.

SIGNAL PERCENTAGES

We will be using the diagrams in Figure 14.9 as the basis for our statistical calculations.
On the left is a double top pattern and on the right is a double bottom pattern.Both employ a three-box reversal amount that will remain constant throughout thisanalysis. We will vary the box size from one pip to five pips. The sample data is our7,000,000+ quotes in our SQL (structured query language) database, which consistsof the streaming tick closes for the calendar year of 2002 in the EURUSD currencypair.

Likelihood of a Reversal

The likelihood of a reversal in price direction after the basic double top or double bot-tom pattern is as shown in Table 14.1.

The results in the table are not particularly impressive since it is a common beliefthat there is a 50:50 chance that the next price will go either up or down anyway. It is in-teresting, though, when we consider that a change in price direction must satisfy theminimum reversal amount of three boxes, while a single box is all that is necessary tocontinue the trend in the most recent column.

Continuation Percentages

In Table 14.2, the leftmost column lists the number of boxes required to continue thetrend in the current column in either of the two patterns in Figure 14.9. The numbers inthe top row indicate the box size for the reversal algorithm.

For example, assume a double bottom pattern with a four-box reversal amount. Thelikelihood that the price movement will decline exactly two boxes is 24.40 percent (the
intersection of the row labeled 2 and the column labeled 4). The probability that it willdecline two or more boxes is 41.69 percent (100 – 58.31).

The continuation percentages may look low since a buy or sell signal has alreadybeen generated with a minimum of one continuation box. However, it is not necessaryfor the price objective to occur in the same column in which the signal is generated.Two, four, or even six columns may occur before the price objective is reached.

OBSERVATIONS

The double top and bottom patterns are two of the simplest price formations to identify.Traders should also calculate existing trend, support, and resistance lines as well asother factors before initiating a new trade based solely on these double pattern signals.