My response in blue text.
Has anyone noticed that a Double Top (imagine a Figure M) "/\/\" looks very similar to a Bull Flag on the first section of the pull back?
Yes, and it is also similar to a "V" top, falling wedge, box range or simply a normal pullback in an up trend. The "first section of the pullback", as you put it, can become any form of reversal, congestion or consolidation. Probably the best indication of possible, future, price action during this "first section", will be volume. If volume decreases during this "section" we are likely looking at a continuation pattern, such as a bull flag. If volume is not lower on this first descending section, we could be looking at a possible trend reversal. We never know what pattern is forming until that pattern is complete. In the meantime we can only make conjectures and rule out other possibilities.
So the question is how do you spot before the full double top has formed that it is not a bull flag? Is there some other indicator that should be used (MACD, Volume, etc)?
First, let's put some labels on your "Figure M" ("/\/\"). / = Wave A or WA, the existing up trend. \ = Wave B or WB, the first pullback or reaction. / = Wave C, or WC, the rally after WB. And finally, \ = Wave D, or WD, the next reaction. P1 will represent the pivot high formed by WA and WB. P2 is the pivot low between WB and WC. P3 is the next pivot high.
Now, in your question, we have WA (existing up trend). Assuming WB has not given us a lower low (indicating a possible trend reversal), we look to WC for clues of what may happen next. If WC is part of a bullish continuation pattern, we would expect to see an increase in volume. We can guess that we have a possible bull flag at this time, but can not rule out a double top forming. Flat or decreasing volume would lead us to suspect a possible reversal pattern, or at least, additional consolidation. If we break above the previous high (P1), we have a trend continuation signal and the WA - WB formation becomes a confirmed bull flag. As the P1 level is approached we can look at various technical indicators for clues. You mentioned the ever popular MACD and this indicator can easily be used for our example. Whether you use the two line MACD, the histogram or both, a bearish divergence is the clue we are looking for. As the P1 level is reached, a higher high should be appearing on the MACD. If P2 is higher than P1, we have a confirmed bull flag and can rule out a double top. If the MACD has made a higher high at this time, we can anticipate the continuation of the bullish trend. A bearish divergence on the MACD at this point could indicate a possible break out failure in the works. If We have a bearish divergence and P2 is equal to, or close to, P1 in height, then a possible double top could be forming. At this point we can not rule out further consolidation, perhaps in the form of an ascending triangle or box range. A double top can not be confirmed until a close below P2.
If I was trading credit spreads and saw the Bull Flag, I would then put a Bull Put spread on. Depending on where it was placed, I could lose on that.
I hold to the school of thought, that believes a credit spread should not be held until expiration. You hold an increasing amount of risk, for an ever decreasing additional reward. As the stock forms P2, I would consider taking my profits off the table, or at the very least, morphing the trade into some reduced risk, or risk free strategy.
Hope this answered your question.
Dave
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