Using Options to Trade Double Tops

Thomas Aspray Professional Trader & Analyst,

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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NEXT PAGE: What About the Strike Price and Liquidity?

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For option trading, I feel you have to look at the daily analysis to get your entry signals. As indicated on this daily chart, the potential double top formation, points 1 and 2, was quite clear on this daily chart from 2012 as was the key support at line a.

The RSI3 formed a short-term negative divergence (line b) as KMB closed at $87.68 on October 18 of that year. The candle chart shows that KMB closed lower the following day and the RSI3 turned lower as indicated by vertical line 3.

The daily OBV also formed lower highs in October but did not form a negative divergence as KMB did not move above the August high. The OBV did test its resistance at line c and by October 19 had also turned lower.

In option trading, the strike price and liquidity are key considerations. On October 22, 2012 the November 85 put opened at $0.75 and closed at $0.95. The following day it traded in a range of $0.88 to $1.10.

I favor establishing multiple positions in one strike price so that you are able to scale out of your position. Given the October 19, 2012 shift in momentum, buying four Nov. 85 puts at $0.90 would have been a reasonable trade that year.

Of course, risk control is a key concern with options as second guessing your stop or exit level is often disastrous. This position should have been closed out if KMB closed above $88.25, which was the August high.

The put option started to move on October 24 closing at $1.55, followed by a close at $2.45 on October 25 and then $2.55 Friday, October 26, 2012. I favor closing out half of a position if I am fortunate enough to get a 50-100% profit.

If two of the puts were sold on Thursday, November 1, 2012 at $1.80, it would have covered the cost of the entire position. By comparison, the November $82.50 put opened at $0.30 on October 22 and closed on October 26 at $0.95. Given the oversold reading of the RSI3, a break of the key chart support (line a) could have been followed by a rebound.

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As another historical example, this daily chart of BioMarin Pharmaceutical, Inc. (BMRN) shows that it made a high on July 12, 2012 at $44.18 as it had risen from a low of $23.75 in August 2011. BMRN reversed from the July highs and dropped to a low of $36.20 on August 29, 2012.

BMRN started to turn higher in September of that year and made a high of $43.53 on October 16 before closing the day lower. The next day (line 3) BMRN was down again and the RSI3 dropped below its uptrend, line c, and its WMA. The RSI3 formed lower highs, line b, which was a negative divergence.

The volume on the rally in September and early October 2012 was significantly lower than the volume was leading into the July highs. The daily OBV formed a slight negative divergence in July and then broke support, line e, in July.

The OBV was much weaker than prices in October as it was well below its prior highs, line d, and just rallied back to resistance at line e. With the lower close on October 19, 2012 the OBV closed well below its WMA, and soon after, it violated the September lows.

The next trading day was October 22 and BMRN closed at $41.21. That day, the Nov. $42 put closed at $3.60, while the Nov. $38 put closed at $2.45. By the end of the week (October 26) BMRN closed at $38.85 after making a weekly low at $37.78.

The Nov. $42 put closed at $5.70 Friday, October 26, 2012 while the $38 put settled at $4.20. Therefore, one did have an opportunity to close out half of either put position for a 50-100% profit. For example, if a 50% profit was taken on half the Nov. $42 put position, the cost of each remaining put would have been $1.80. A break of the support at $36.50-$37.13, line a, would have projected a drop to the $28.80 area.

NEXT PAGE: Some of the Best Trades That Could Have Been Made Using this Strategy

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Given the historical approach of this lesson, we will now readdress a weekly chart from 2012 of the apparel company Fifth & Pacific Companies, Inc. (FNP) which appeared to show a double top or formation, points 1 and 2 during that year. (Fifth & Pacific Companies, Inc. is now known as Kate Spade & Company and trades under the symbol (KATE)). However, in 2012, while it still traded as FNP, it had a spike high at the end of March of $15.37 and then continued higher for a few weeks with the highest weekly close on April 28 at $13.75 (point 1).

For the next 11 weeks,  FNP drifted lower finally bottoming in the middle of July at $9.02. Two weeks later,  FNP reversed to the upside with a strong close but the volume was light. The week ending September 8, 2012, FNP closed at $13.68 (point 2) and was unchanged the following week. This was a sign the uptrend was losing momentum.

The next week FNP did turn lower, which was confirmed by the declining RSI3, line 3. The weekly RSI3 had formed lower highs, line b, but since the weekly close was just a bit higher in March, it was not technically a negative divergence.

The weekly OBV had formed lower highs in April (line d) and then violated support, line c, in May. On the September rally the OBV just tested the downtrend, line b, and its flat WMA before turning lower. The volume was much higher during the spring highs than it was during the September rally. This is typical of a double top.

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Under Armour, Inc. (UA) is even a better known apparel company that rallied from an early July low of $44.07 to a closing high on September 14, 2012 of $60.03. The intra-day high was $60.96. The decline found support at the $53.28 level, line a, which was just above the late July low of $53.02.

On October 18, 2012 UA had a high of $60.20 but then closed at $59.27. The following day UA formed a doji and declined for three consecutive days after the high. Though the RSI3 showed divergence at the September highs there were no divergences when UA was peaking in October.

The RSI3 turned lower on October 19, 2012 and on October 23 the RSI3 dropped below its WMA (line 3), which confirmed that the momentum was declining. The uptrend in the RSI3 was then broken.

The OBV did form a slight negative divergence at the September highs (line c) and broke two-month support, line d, later in the month. As UA was making its secondary high the OBV just barely made it above its WMA and then retested the resistance (former support) at line d. Just two days after the highs, the OBV had dropped back below its WMA.

On October 24, 2012, UA opened at $57.92, traded as high as $58.31, but then closed at $56.62. The Nov. $57.50 put opened and closed around $3.40. On Friday, October 26, 2012, this put traded as high as $6 and closed at $5.50. The 50% profit level (excluding commissions) was therefore at $5.10, and if half of a four-lot position were sold at this level, it would have brought the cost on the remaining options to $1.70 each.

The stop on the position should have initially been a close above the high at $60.96, but this stop should have been lowered when the support at line a was broken. The downside target from the formation was next in the $45 area. This seemed like a legitimate break of support as volume was high.

The best trades using this strategy will be when double tops are observed on a weekly chart though they do not occur that often. What appear to be double top formations are more frequently observed on daily charts, but because they are often just part of a continuation pattern, discipline is the key.

I suggest that you use a close only stop based on the stock, not the option. If your entry level is quite close to the high, and prices do reverse, the loss should be no more than 10-25%. But as I cautioned earlier, if the stop is hit, get out, don’t wait.

Secondly, if it is a continuation pattern and not a double top, the stock may just test the key support and then reverse to the upside. That is why I recommend you scale out of the position when it goes in your favor and not get greedy. By taking partial profits, it will protect your trading capital by significantly reducing the dollar risk on your position. If the double top is confirmed, the remaining position should do quite well. I hope this historical example aids you in your current trading strategy, especially in regards to using options to identify and subsequently trade double tops.