Toppy

What Is Toppy?

Toppy is a financial slang term used to describe markets that are reaching unsustainable highs. The term toppy may be used to describe a stock, sector, or broad market index, such as the Standard and Poor’s 500 Index (S&P 500), that has had extended gains, but there is analyst sentiment or a general market consensus that a potential reversal is imminent. A reversal is anytime the trend direction of a stock or other type of asset changes. 

How Toppy Works

A toppy stock market climbs to new highs and then retraces. Retracements are temporary price reversals that take place within a larger trend. Investors refer to a retracement as a pullback, a dip, or a correction, in the case of a 10% decline. 

Just because a market is toppy doesn't mean it will stay there for any particular length of time.

Identifying a Toppy Market

Chart Patterns

Technical traders can use chart patterns, such as a double top or a head and shoulders top, to identify toppy price action.

For example, in the chart below, TD Ameritrade Holding Corp. formed a swing high in early March 2018 and another swing high in early June 2018, giving the stock a double top before prices entered a correction phase.

Topping chart patterns that form over several months are typically more reliable than toppy price action patterns over shorter periods.

Example of a Double Top

Image by Sabrina Jiang © Investopedia 2021

Reversal Candlestick Patterns

Traders have been using Japanese candlestick patterns to spot toppy price action dating back to the 16th century. Popular candlestick reversals include the bearish engulfing pattern, the piercing line pattern, and the hanging man pattern. All of these candlestick patterns occur near the concluding stages of an uptrend and show a physiological change in investor sentiment.

Bearish Divergences

Toppy price action often accompanies a bearish divergence between the price of a security and a commonly used technical indicator, such as the relative strength index (RSI) or the stochastic oscillator.

For instance, a bearish divergence occurs when the price of a security makes a higher high, but the indicator makes a lower high. Many traders use a combination of chart patterns, Japanese reversal candlesticks, and bearish divergences to help locate a toppy stock or market index.

Fundamentals

Investors also analyze a stock’s fundamentals to determine if the issue is toppy compared to its peers or sector.

The working capital ratio, quick ratio, price-earnings ratio (P/E ratio), and debt-to-equity ratio are just a few of the many metrics available to analysts and investors to assess the financial health and performance of a security.

Strategies for a Toppy Market

Turn to Cash

While returns for cash (including money market funds) are very low, if the market is in danger you may want to sit on your cash for a bit. What you save now can be invested later at a lower price.

Avoid Buying on the Dip

Buying on the dip means purchasing an asset after it has dropped in price. The reason for doing this is an assumption that the new, lower price is a bargain deal because the drop in price is temporary; given a certain amount of time, the asset will increase in value again.

While buying on the dip can be a good strategy in a bull market, buying overvalued technology stocks on their way down can be incredibly risky. There is a reason that their price is dipping and it remains to be seen what happens next.

Consult With Your Broker

Your broker can help you review your portfolio and help you determine how protected your portfolio is in the event of a toppy market. If you own a significant number of overvalued stocks, it could be an appropriate time to take some gains.

Use Stop Losses

To ensure that you are locking in profits, set up stop losses (even if they are mental). You could also write down a buy price, the potential sell price, and a price to get out (if you are wrong).