Trends can persist for longer than most people anticipate, which is why attempting to spot and trade based on where a trend will end—tops and bottoms—is often met with this skepticism. Being able to isolate potential tops and bottoms has its advantages though. Trading tops and bottoms doesn’t mean “catching a falling knife.” On the contrary, top and bottom traders rely on evidence that suggests a top or bottom has already formed; this is different than assuming a top or bottom has formed.
Like any strategy, trading tops and bottoms has risks. Trades are in the opposite direction of the former trend, a trend that could re-emerge at any time. As long as risk is controlled, this downside is outweighed—with a proper strategy—by the profit potential of getting into a new trend early.
Be sure to read Trend Reversals: How to Spot and How to Trade.
Top and Bottom Chart Patterns
Certain chart patterns provide evidence a trend reversal is potentially underway. These patterns include double/triple tops and bottoms, head and shoulders, inverse head and shoulders and the cup and handle (like a rounded top/bottom yet more tradable).
Double and triple tops are formed when the price halts, and reverses, at the same price area two or three times during an uptrend. It shows momentum has stalled, as the price is no longer able to make “higher highs,” and could only muster a similar high to the last rally.
A double and triple bottom occurs during a downtrend, when the price falls to the same area two or three times, but fails to advance below that area. It shows the downtrend is losing steam.
The traditional way to trade this pattern is to sell short when the price falls below the retracement lows between the double/triple tops, or buy when the price rallies above the retracement highs between the double/triple bottoms.
The head and shoulders and inverse head and shoulders also show a slowing of the trend. The head and shoulders is formed during an uptrend, when the price makes a higher high followed by a lower high.
An inverse head and shoulders is formed during a downtrend when the price makes a lower low followed by a higher low. This creates three points simulating the appearance of a shoulder, a head and another shoulder.
The traditional way to trade this pattern is to sell short when the price falls below the retracement lows within the pattern, or buy when the price rallies above the retracement highs in an inverse head and shoulders pattern. Often the lows and highs within the pattern can be connected, forming a trendline called the neckline. An entry can also be taken when the price moves through the neckline.
The cup and handle is another reversal pattern. In the stock market, the bottoming pattern is much more common than a cup and handle topping pattern.
The pattern is formed by a decline that slowly tapers off, forming a rounded bottom. The price then rallies to where a section of the decline started, pauses or pulls back (forming a handle) and then proceeds to advance higher again.
A long trade is taken after the price breaks above the handle of the formation.
Chart patterns provide evidence there’s potential for a reversal. Since chart patterns have their own trade signals, by the time the signal occurs it’s quite likely the reversal is underway and a top or bottom is in place.
Candlesticks are also used to provide evidence that a reversal may be occurring. Candlestick patterns occur over one or two time periods (days, on a daily chart), which means they get a trader into a reversal quicker than a chart pattern. Candlesticks are more prone to false signals though, since one or two days of reversal evidence isn’t as powerful as a chart pattern that shows a reversal forming over multiple days/weeks.
There are two major candlestick reversal patterns: the kicker and the engulfing pattern.
Kicker patterns are rare, showing a very strong shift in momentum from one day to the next.
A bullish kicker occurs during a downtrend. The first candle in the pattern is a strong down bar (close below open), but the next day opens at above the prior day’s open, and continues to advance strongly. The close of the kicker candle is near the high of the day.
A bearish kicker occurs during an uptrend. The first candle in the pattern is a strong up bar (close above open), but the next day opens at below the prior day’s open, and continues to sell-off throughout the day. The close of the kicker candle is near the low of the day.
Trades are taken near the close of the kicker pattern, or near the following open, since the momentum often continues.
Engulfing patterns also show a strong shift in momentum, but are more common and aren’t as powerful as the kicker pattern.
A bullish engulfing candle occurs during a downtrend. The prior candle is strong down (close lower than open) but the following day the price opens at below the prior close and rallies to close above the prior open.
A bearish engulfing candle occurs during an uptrend. The prior candle is strong up (close higher than open) but the following day the price opens at above the prior close and falls to close below the prior open.
An entry is taken at the close of the engulfing candle (or as soon as it is visible in real-time on a chart) or near the next open.
Indicators at Tops and Bottoms
Indicators are also used to isolate top and bottoms. The MACD and RSI are two indicators commonly used. An indicator will almost always signal a reversal; the downside is that indicators often signal reversals that don’t actually occur.
The MACD is composed of two lines. When both lines are below zero (downtrend) and the MACD line (black) moves above the signal line (red) it indicates a bottom may be in place, and is a buy signal. The MACD line moving above zero (0) from below is also bullish.
When both lines of the MACD indicator are above zero (uptrend) and the MACD line moves below the signal line it indicates a top may be in place, and is a sell signal. The MACD line dropping below zero (0) from above is also bearish.
The RSI is a single line indicator also used to isolate potential tops and bottoms. When the RSI moves below 30 the associated stock is considered oversold, and when the RSI moves above 70 the associated stock is overbought. During strong trends (down or up) these levels are reached frequently, and while this method may pick many market tops and bottoms, it’s prone to signaling reversals that don’t occur.
A buy signal, and potential bottom, occurs when the RSI moves below 30 and then rallies back above it.
A sell signal, and potential top, occurs when the RSI moves above 70 and then drops back below it.
Use either the MACD or the RSI (or another indicator) based on preference. Using both isn’t required and provides little additional insight.
Putting It Together
While each method—chart patterns, candlestick patterns and indicators—could be used in isolation, they are also used together.
Until all three methods indicate a reversal higher, after a downtrend, avoid going long. Only when all align is the buy initiated. Same for an uptrend. Wait for all the methods to align before entering short. The last signal to occur is the one that initiates the trade.
Be sure to see our list of the Best Investments of All Time.
Figure 12 shows a downtrend, followed by a move higher in which all three reversal signals are present.
The same concept applies to isolating and trading a top.
The Bottom Line
Isolating a top or bottom isn’t arbitrary or random. Traders who trade them compile evidence to suggest a reversal may occur. The price has already started to reverse course before a trade initiated. Using multiple signals help confirm a reversal, although even with all the signals aligning the former trend could still re-emerge, resulting in a loss. No matter what method is traded, control risk with a stop loss order, and consider at what point profits are taken if the trade works out.