Fly Fishing the Stock Market: How to Search for, Catch, and Net the Market's Best Trades

TOPS

Paradoxically, top patterns can be traded in two completely opposite ways. A novice sees a double top or a head-and-shoulders top and shorts the stock with reckless abandon, thinking that this is a sure sign of lower prices ahead. Much of the time, however, what looks like a top does not end an uptrend but rather serves as a continuation pattern—a mere pause within a powerful upmove. Experienced traders are well aware of this and trade accordingly.

Double Tops

A double top forms an “M” pattern on a chart. An uptrend surges to form the first high on high volume, then pulls back, and then rises again to challenge the previous high. In valid double tops, the second peak tends to show less vigor, with lower highs on most indicators. A double top is confirmed when the low point between the two peaks—called a trough—is violated on above-average volume (see Figure 2.8).

FIGURE 2.8 Bulls fumble at a double top.

AMSC, daily, indicator set #2. The chart shows how I traded a double top of AMSC. Despite the clues foreshadowing weakness, I was too slow setting the hook on this trade. Shorting the second top (area C) would have been the ideal time to short, with a target near the 50-day EMA or the trough (marked B). My mistake was shorting a stock as it approached its key support near the trough. Notice price behavior at the second top (C). Bulls had difficulty breaking through, creating a failed retest of the first top (A). Another sign of weaker momentum was the lower volume at the second ...