What Is a Continuation Pattern?
A continuation pattern suggests that the price will continue to move in the same direction after a continuation pattern completes as it did prior. There are several continuation patterns that technical analysts use to signal that the price may continue to trend. Examples of continuation patterns include triangles, flags, pennants, and rectangles.
- A continuation pattern is one which shows a slight tendency for the trend to continue in the same direction after a continuation pattern as it did before.
- Not all continuation patterns will result in a continuation of the trend. Many will result in reversals. By waiting for the breakout, traders can see which it will be.
- Continuation patterns are typically traded by taking a trade in the breakout direction, which should ideally also be the trend direction.
Understanding the Continuation Pattern
A continuation pattern is labeled as such because there is a slight tendency for the trend to continue after the pattern completes, assuming the right context of price action. Not all continuation patterns will result in a continuation of the trend, though. For example, the price may reverse the trend after forming a triangle or pennant.
Continuation patterns tend to be most reliable when the trend moving into the pattern is strong, and the continuation pattern is relatively small compared to the trending waves. For example, the price rises strongly, forms a small triangle pattern, breaks above the triangle pattern, and then keeps moving higher.
If the continuation pattern is almost as big as the trending waves that preceded it, that is more indicative of increased volatility, a lack of conviction in the trending direction, and larger moves against the trend, all of which are warning signs as opposed to green lights for the trend.
Another thing to be aware of is small trending waves that are followed by a continuation pattern. If the price inches higher, then forms a continuation pattern, then inches higher then forms a continuation pattern, that is less compelling and is less reliable than a strong move higher that then forms a continuation pattern. The latter shows strong buying strength. The former shows buyers are hesitant to push prices higher aggressively.
The most common continuation pattern trading technique is to wait for the pattern to form, draw trendlines around the pattern, and then enter a trade when the price breaks out of the pattern in the direction of the prevailing trend.
Types of Continuation Patterns
Some common continuation patterns include triangles, pennants, flags, and rectangles. Below are descriptions of these continuation patterns.
A triangle occurs when the price action in a security becomes more and more compressed. There are three types of triangles: ascending, descending, and symmetrical.
An ascending triangle is formed by rising swing lows creating an ascending line when they are connected. The swing highs all reach a similar level, creating a horizontal trendline when they are connected.
In a descending triangle, the swing highs are declining, forming a downward sloping trendline when they are connected. The swing lows reach similar levels, forming a horizontal trendline when connected.
A symmetrical triangle has descending swing highs and ascending swing lows. This creates a descending and rising trendline which converge toward each other.
It takes at least two swing highs and two swing lows to create the trendlines necessary to draw a triangle. A third, and sometimes even a fourth, swing high and/or swing low is common before a breakout occurs.
Pennants are a form of a triangle, but much smaller. While triangles have swing highs and lows as the price oscillates back and forth, a pennant will often appear as a small price range or consolidation that gets even smaller over time. Pennants are preceded by sharp price increases or decreases and show the market is taking a breather before breaking out again.
Flags are very similar to pennants. They form a narrow trading range after a strong price increase or decrease. The difference is that flags move between parallel lines, either ascending, descending, or sideways, while a pennant takes on a triangle shape.
Rectangles are a common continuation pattern that show a pause in the price trend with price action moving sideways. The price action is bound between horizontal support and resistance levels.
Trading a Continuation Pattern
There are several steps involved in trading a continuation pattern.
The first step is to identify the prior trend direction. For example, was the price increasing or decreasing before it formed a triangle pattern?
The next step is to identify the continuation pattern and find the breakout point. Some traders will only take trades if the breakout occurs in the same direction as the prevailing trend. For example, if the prevailing trend is up, they will buy if the price breaks out of the pattern to the upside. Other traders will take a trade in the breakout direction even if it goes against the prevailing trend. These are lower odds trades, but pay off if the trend is reversing direction.
Once a breakout occurs, a trade is taken in the breakout direction. For example, if the price breaks above a pennant, a stop loss is placed just below the pennant low.
A stop loss order is placed just outside the pattern on the opposite side from the breakout.
A profit target can be established based on the height of the continuation pattern. For example, if a rectangle is $2 in height (resistance price minus support price), and the price breaks to the downside, the estimated price target is the support price minus $2. If the price breaks higher, add $2 to the resistance price. The same concept applies to triangles. Add the height of the triangle from the breakout point if the price breaks higher. Subtract the height of the triangle from the breakout point if the price breaks lower.
For pennants and flags, measure the price wave leading into the pattern. If the price breaks higher, add that measurement to the bottom of the flag/pennant to get an upside profit target. If the price breaks lower, subtract the measurement from the top of the flag/pennant.
The major drawback to trading continuation patterns, and chart patterns in general, is false breakouts. A false breakout occurs when the price moves outside of the pattern but then moves right back inside it or out the other side. This is why stop losses are used to control risk.
When trading a continuation, consider the strength of the price move prior to the pattern forming. Strong moves tend to be more reliable than if the pattern occurs after a weak move or amidst choppy trading. The continuation pattern should also be a relatively small part of the prior trending wave. The bigger the pattern relative to the wave that preceded it, the less reliable it is. It may still act as a continuation pattern, but the increased volatility and increased movement in the opposite direction of the trend is a warning sign.
Many traders look for increasing volume when the price breaks out of a continuation pattern. If there is little volume on a breakout, there is a greater likelihood the breakout will fail.
Example of a Continuation Pattern in the Stock Market
The chart of Amazon Inc. (AMZN) shows three pennant/flag patterns. The first is a pennant, and the next two are flags.
The first two patterns show the measurement technique for coming up with an estimated profit target. The profit target is just an estimate. It does not mean the price will reach that level, or that it will stall out at that level and not proceed further.
The third example shows the breakout point, which in this situation signals to buy. The buy signal direction also aligns with the recent uptrend.
A stop loss is placed below the low of the pattern since the breakout was on the upside.
The height of the wave into the pattern is measured and then added to the bottom of the pattern to provide a profit target. This is an estimated profit target, and can be useful for quantifying the potential risk/reward of a trade. Trading may also wish to utilize a trailing stop once a breakout occurs.