When a trader looks at the price chart of a stock, it can appear to be completely random movements. This is often true and, yet, within those price movements are patterns. Chart patterns are geometric shapes found in the price data that can help a trader understand the price action, as well as make predictions about where the price is likely to go. Continuation patterns, when they occur, indicate that a price trend is likely to continue. This article provides an introduction to continuation patterns, explaining what these patterns are and how to spot them. (See also: Analyzing Chart Patterns.)
Varieties of Continuation Patterns
Continuation patterns occur mid-trend and are a pause in the price action of varying durations. When these patterns occur, it can indicate that the trend is likely to resume after the pattern completes. A pattern is considered complete when the pattern has formed (can be drawn) and then "breaks out" of that pattern, potentially continuing on with the former trend. Continuation patterns can be seen on all time frames, from a tick chart to a daily or weekly chart. Common continuation patterns include triangles, flags, pennants and rectangles.
Triangles are a common pattern and can simply be defined as a converging of the price range, with higher lows and lower highs. The converging price action creates a triangle formation. There are three basic types of triangles: symmetrical, ascending and descending. For trading purposes, the three types of triangles can be traded similarly.
Triangles vary in their duration but will have at least two swing highs in price and two swings lows in price. As price continues to converge, it will eventually reach the apex of the triangle; the closer to the apex price gets, the tighter and tighter price action becomes, thus making a breakout more immanent. (For more, see: Triangles: A Short Study in Continuation Patterns.)
- Symmetrical: A symmetrical triangle can be simply defined as a downward sloping upper bound and an upward sloping lower bound in price.
Fig 1. Symmetrical Triangle
- Ascending: An ascending triangle can be defined as a horizontal upper bound and upward sloping lower bound.
Fig 2. Ascending Triangle
- Descending: A descending triangle can be defined as a downward sloping upper bound and horizontal lower bound.
Fig 3. Descending Triangle
Flags are a pause in the trend, where the price becomes confined in a small price range between parallel lines. This pause in the middle of a trend gives the pattern a flag-like appearance. Flags are generally short in duration, lasting several bars, and do not contain price swings back and forth as a trading range or trend channel would. Flags may be parallel or upward or downward sloping, as shown in Figure 4.
Fig 4. Flag
Pennants are similar to a triangle, yet smaller; pennants are generally created by only several bars. While not a hard and fast rule, if a pennant contains more than 20 price bars, it can be considered a triangle. The pattern is created as prices converge, covering a relatively small price range mid-trend; this gives the pattern a pennant appearance. (See also: Continuation Patterns: Rectangles and Pennants.)
Fig 5. Pennant
Often there will be pauses in a trend in which the price action moves sideways, bound between parallel support and resistance lines. Rectangles, also known as trading ranges, can last for short periods or many years. This pattern is very common and can be seen often intra-day, as well as on longer-term time frames.
Fig 6. Rectangle
Working With Continuation Patterns
Continuation patterns provide some logic to the price action. By knowing the patterns, a trader can create a trading plan to take advantage of common patterns. The patterns present trading opportunities that may not be seen using other methods.
Unfortunately, simply because the pattern is called a "continuation pattern" does not mean it is always reliable. A pattern may appear during a trend, but a trend reversal may still occur. It is also quite possible that, once we have drawn the pattern on our charts, the bounds may be slightly penetrated, but a full breakout does not occur. This is called a false breakout and could occur multiple times before the pattern is actually broken and a continuation or a reversal occurs. Rectangles, due to their popularity and easy visibility, are highly susceptible to false breakouts.
Patterns can also be subjective, as what one trader sees is not what another trader sees, or how another trader would draw or define the pattern in real time. This is not necessarily a bad thing, as it can provide traders with a unique perspective on the market. It will require time and practice for the trader to develop his or her skill in finding patterns, drawing them and formulating a plan on how to use them.
The Bottom Line
Continuation patterns, which include triangles, flags, pennants and rectangles, provide some logic on what the market may potentially do. Often these patterns are seen mid-trend and indicate a continuation of that trend, once the pattern is complete. In order for the trend to continue, the pattern must break out in the correct direction. While continuation patterns can help traders make trading decisions, the patterns are not always reliable. Potential problems include a reversal in a trend instead of a continuation and multiple false breakouts once the pattern is beginning to be established. (For additional reading, check out: Introduction to Technical Analysis Price Patterns.)