Potential double top formations can provide profit opportunities for option traders and technician Tom Aspray explains how two key technical tools can be used to take advantage of this important pattern.

Double tops and double bottoms can often alert the investor to major turning points, especially when they are observed in the weekly charts of a major market average or a key commodity like crude oil.

In November 2011 I discussed double bottom formations on crude oil (see chart), and at the time, many stocks were showing potential double bottom formations.

There are many articles on the classic characteristics of double top formations and the 1948 technical analysis classic Technical Analysis of Stock Trends from Robert D. Edwardsand John Magee is still a wonderful source on the topic.

The traditional interpretation dictates that the formation must be completed before action is taken. In the crude oil example it took a close above $90.52, which was almost 20% above the double bottom lows, to confirm the bottom and project a move to $105.33.

To confirm a double top formation prices often need to decline significantly from their highs and stops above the previous peak can make the risk uncomfortably high. Often times what appears to be a double top or bottom on the daily chart turns out to just be part of a continuation pattern. Traders who wait for the formation to be confirmed often have trouble managing their risk and therefore do not take the trade.

In this article, I will show you how combining the chart formation with two technical tools can allow you to take advantage of these situations using options. With this approach you can find a low risk entry point if a true double top is being formed, but also can profit if it is just part of a continuation pattern.

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In this historical example, this weekly chart of Kimberly-Clark Corp. (KMB) shows what appears to be the formation of a double top. The initial high in August 2012 at $88.25 (point 1) was followed by a drop to $81.25 the following week. Prices stabilized for five weeks as support was found in the $82 area, line a.

KMB rallied back to $87.80 in October of that year (point 2) before dropping sharply at the end of the month. Of course, the key support at $81.29-$82 needed to be broken next in order to complete the double top.

In order to determine the downside target in this example, you take the difference between the high and support ($88.25-$81.29 or $6.96) and subtract it from $81.29 to get a downside target of $74.33.

I have found two technical tools to be quite useful in identifying double tops. The first is what I call the RSI3, which I learned about from cycle expert Walt Bressert. It is calculated by taking a three period simple moving average of a five period RSI. As discussed in a past trading lesson, I use the RSI3 along with its 13 period WMA not only to identify divergences but also to identify changes in momentum.

For KMB, the weekly RSI3 peaked in May 2012 and formed a lower high, line b, as KMB was making its high in August (point 1). The RSI made even a lower high in October and was already declining at point 2. The RSI3 subsequently dropped below its WMA.

I find the on-balance-volume or OBV to be quite good in identifying changes in the volume patterns that are essential in identifying double top or bottom formations.

Volume in KMB was heavy on the decline from the August high and while there were no weekly divergences, the OBV did break its uptrend, line c. This weakness was confirmed when the OBV failed to move back above its flattening WMA on the October rally. The increase in volume at the end of October 2012 was consistent with a double top.

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Tickers Mentioned: Tickers: KMB, BMRN, UA, KATE