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What is the meaning of a blow off top in the markets?

A blow off top is a reference in the financial markets. A blow off top is typically associated with a chart pattern which shows a sharp and a rapid increase in a security's price as well as trading volumes. A blow off top is usually driven by speculation or it can also be driven by actual fundamentals.

A blow off top can occur in any market, and chances are that you have seen one of these below. However, they are more commonly occurring in the stocks or equity markets. It is called a blow off top, because just as quickly as price moves higher, it also makes a correction at the same pace. The correction or the pullback doesn't have to be a full correction.

The blow off top is usually seen as an exhaustion move. In terms of technical analysis, blow off top is usually associated with the fifth wave of the Elliott wave form of analysis. An important point to note is that a blow off top can only be determined in hindsight. Therefore, just because you see the price of a security making a sharp parabolic move does not necessarily mean that it is a blow off top in the making.

But there are many examples of such moves looking at past price history. For example, the chart below shows the price action in gold between July and August 2011. As you can see, price advanced over $400 in just 52 days.

01 Gold Blowoff Top

Example of a blow off top in gold

Similar to this rapid increase, price then begins to correct itself lower. Despite the fact that a blow off top looks easy to spot, it can be quite tricky to trade in real time. This is similar to attempting to catch a top or a bottom when momentum is strong in the markets.

In the stock markets, blow off tops are fueled by speculation and this drives prices higher. In some ways, blow off top can be similar to the buy the rumor, sell the news. One can see this commonly occurring in the forex markets.

You will generally witness prices rising steady in the run up to an important news announcement only to see price making a correction instantly after the news item is released.

How to identify a blow off top?

As mentioned earlier, it is indeed difficult to spot accurately a blow off top. It is also equally difficult to predict where this blow off top pattern will end. But there are some methods to validate whether the price action is a blow off top or not.

  • Parabolic rise: This is the most easiest to spot. A parabolic rise in price action occurs, which is not that typical in the markets. Usually prices tend to make corrections as they head into a trend. But with a blow off top, you will often see that there is little to no pullback at all. This is one of the early signs that a blow off top is in the making.
  • General market conditions: Another way to further substantiate whether a blow off top is valid or not is to look at the general markets. Typically, securities or instruments tend to follow similar patterns. In some cases, conditions in one market can simply set off a blow of top in another market (especially if there is some form of correlation between the two)
  • Consolidation: Prior to a blow of top, you will see prices in a long period of consolidation. These consolidations or sideways movement can occur over weeks, months or in some securities even years. But following this, the blow off top is very rapid and can catch traders off guard.

Why does a blow off top occur?

Fundamentally, a blow off top is driven by speculation. In some cases, this speculation can be warranted, meaning that traders are simply discounting the news that is likely to come. From a technical perspective, a blow off gets more fuel due to weak positions.

When price is consolidating, one might become complacent. This can lead to a number of positions on either side of the trade. But when price makes a short but rapid move, it tends to capture all the weak positions in the opposite direction.

As a result, these weak positions must be closed out, thus leading to additional momentum that feeds the blow off top pattern.

02 XOMA Blowoff Top

Blow off top example, XOMA

The above chart shows another example of a blow of top in one of the securities. As you can see there has been little to no pullback during this rally. We also see how price first makes a sharp reversal after a prolonged downtrend and then prices snap back higher.

What is the best way to trade a blow off top?

No matter what other articles or websites say, there is on guaranteed method to profit from trading a blow off top. This is a very risky chart pattern and if you are not careful with your position and risk management, there is indeed a great chance that you will lose all you capital.

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