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With the market moving up in a straight line of late, this is probably a good time to review the Test of Top formation. Let's look at a simple bar chart with no indicators and concentrate solely on price action.
Figure One:
We must be able to draw an uptrend line that connects a series of higher lows. No exceptions.
Figure Two:
When a pullback to the uptrend line takes place, we draw a horizontal line above the swing high. This identifies and reminds us of an area of potential resistance overhead.
Figure Three:
As price starts to bounce back up, we draw a horizontal line across the last swing low to mark potential support. We now have three lines on the chart. The uptrend line is self-explanatory. The area between the two horizontal lines marking the last swing high (resistance) and swing low (support) becomes a small trading range. Traders looking to buy would use whatever method they have at their disposal to enter on the pullback in the uptrend. Those without a method use the age-old entry of last resort; that is, they buy a "breakout" when a new high is made.
Figure Four:
The goal of the buyers who bought the pullback is to see if it can go up beyond the first swing high (i.e., go above the upper horizontal line that marks resistance). We know that there are potential sellers there because that is where they showed up before the pullback began. If the move gets stuck there, some of the buyers will sell and get out of their positions. This is called a Test of Top. There are only three possible outcomes. It makes a lower swing high on test and fails to move up. It makes a slightly higher high above the upper pink line and fails to move up. It breaks to the upside to new highs and continues upward.
Figure Five:
A new price high is made. The "breakout" buyers, using the entry of last resort, go in as price moves above the first swing high, the one marked by the upper horizontal line. Those buying on the pullback have arrived at their first upside profit target and are in a wait-and-see mode. If the move fails to continue upward, they can take profits.
Here is the crux of the setup: How and when do the traders know if the breakout to the upside has succeeded? At what point will they believe that it's failed?
Figure Six:
The answer to the question lies in the ability of price to blast upwards. If price stalls and comes back under the upper horizontal line, back under the first swing high, many traders will begin to sell on their long position in case the sellers are back. In and of itself, the profit-taking produces more resistance as sell orders pile up. Here, we find a tiny bar the day after the breakout, a pause that can also be interpreted as stalling. Aggressive swing traders set up short sales.
Figure Seven:
The next day gaps down under the first swing high as price fails to go higher immediately. The bell goes off. Aggressive short sellers are now short, and most will have their stop loss placed above the new swing, the high made on the "breakout".
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Figure Eight:
Quite often, the initial failure is interpreted as another pullback by traders and is bought once again. While it might be a real pullback that leads to higher prices, we are extremely hesitant and will not buy it so long as trading takes place inside the area between the two horizontal lines.
Figure Nine:
The bounce fails and a big down day takes place. This is where the breakout buyers know that they might be in trouble. The downside target is the lower horizontal line.
Figure Ten:
Another day to the downside as support is tested. The downside target is hit.
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