Use Volume And Emotion To Tackle Topping Patterns

Traders have been trying to pick tops for generations, knowing the profit potential when selling short at the end of an uptrend, but the majority of predictions fail as the security regains its bullish composure and breaks out to higher highs. It’s unfortunate because tops can be predicted with surprising accuracy, as long as they generate technical attributes that point to considerably lower prices. 

Consider the emotional dynamics in play at these turning points. A downtrend finally ends, yielding higher prices in a series of rallies that attract a lot of market participants. Sentiment shifts steadily throughout this ramping process, with excessive bearishness replaced first by cautious optimism and then by greed that eventually yields excessive bullishness. 

This euphoric state generates risk blindness that encourages weak hands to buy the security at higher and higher prices, often lifting it to all-time highs that present no overhead resistance. Trends can escalate even further at this point, entering a blowoff or climax phase that sets off warning signals, telling observant technicians the rally is probably coming to an end.

The highest volume in a security’s history often prints during this manic phase, with the last supply of sidelined bulls jumping on board and generating overbought technical conditions that signal the evaporation of buying pressure. In turn, the security reverses sharply, dropping into a trading range that signals a period of active selling by strong hands while weak hands hold on tightly, eventually providing highly efficient fuel for a new downtrend. 

Distribution Patterns

The climax phase isn’t required for the forming of a top but provides additional support to the topping process when it occurs. Climactic behavior can unfold in less obvious ways, with vertical price action that doesn’t yield extraordinary volume or high volume prints without vertical price action. In all cases, it’s important to note that the last phase of an uptrend always marks the first phase of the subsequent trading range, with early retracements setting mathematical and emotional parameters for the evolving pattern. 

That’s why smart technicians watch price action relative to the first reversal as a trading range evolves, looking for evidence of aggressive selling behavior consistent with a trend climax. The depth of the retracement may offer additional clues on the pattern’s bearish future direction, with a 100% retracement of the last rally leg signaling a first failure event often seen in significant tops.

Example

Let's look at a historical example. Schlumberger (SLM) rallied to an all-time high in June 2014 when it lifted above the 2007 peak near 114. The uptrend printed the highest volume in a year, but the rally stalled just four points above the prior high, giving way to a 100% retracement of the June trend wave (red triangle). This first failure raises a red flag, telling us the uptrend may be coming to an end. Steady distribution into September, as noted by the falling On Balance Volume (OBV), yielded a bearish double top pattern and breakdown that dropped the security to an 18-month low. 

Trends naturally alternate with range-bound periods. Despite technical divergences, we don’t know if a trading range will generate continuation to a new high, keeping the trend intact, or there will be a reversal that completes a top and starts a new downtrend. These binary mechanics tell us to pay close attention to price and volume development within the range, looking for clues that provide the data we need to choose a direction and take an exposure, ahead of the crowd whenever possible.

Short Entry

A breakdown from a topping pattern should print higher than average volume and drop the security well below obvious support. Small penetrations of support, especially when the trading range is still carving through rapid price swings, are more likely to indicate stop running by predatory algorithmic programs than the emotional behavior of shareholders realizing they’re trapped in a new downtrend.

You can avoid these profit-killers by watching relative strength, and avoiding entry until cycles line up in your favor. In addition, avoid short sales when OBV shows greater buying interest than expected. This indicator prints patterns similar to price, with well-delineated support and resistance, and a price breakdown should yield a similar OBV breakdown. If it doesn’t, the bullish divergence may signal a bear trap and short squeeze.

Finding a low-risk short entry price can be difficult when breakdown levels aren’t clearly delineated. That encourages short sellers to choose from a basket of strategies, depending on the pattern’s quality and the number of support levels in play. In general, this translates into early positions when the pattern looks perfect, chasing lower prices when a catalyst triggers a breakdown and waiting for the security to pull back to resistance when a fast-moving market doesn’t permit a risk-conscious momentum entry.

Example

Considering another actual example, Biotech play Geron (GERN) lifted off a quiet basing pattern at 1.50 in September and rose more than 500% into a November climax that printed nearly 50 million shares, 20 times the average daily volume of 2.5 million. A wide-range reversal bar waved a major red flag, with the price dropping nearly 3 points off the rally high. The security then carved out a bearish descending triangle pattern while OBV revealed active distribution. It broke down in March, dropping all the way to the inception point of the uptrend in a single session.

Short sellers focus their attention on the descending triangle, a common topping pattern identified by two lower highs that form a trendline of selling peaks. An attempted rally from December and January runs into a buzzsaw of selling pressure, carving out those highs in line with the pattern’s bearish requirements. While a breakdown gap confirms the downtrend, there are few ways for investors to profit unless they were positioned prior to the breakdown.

Early trade entries form the basis of aggressive strategies. In this case, a short sale makes sense after the third high because the classic pattern is easily recognizable, it shows a well-defined trigger price at horizontal support near 4.25, and a stop-loss can be placed just above the trendline of the declining highs, limiting risk to less than one point, barring a shock gap to the upside.

The Bottom Line

Selling short in a topping pattern offers an advantageous reward-to-risk profile, but it can be hard to find good entry prices. Improve the odds by paying close attention to volume development and relative strength, looking for emotional selling pressure that can trigger large-scale breakdowns.