STRATEGIES

Though many traders and investors are fixated on picking a market bottom or a market top, understanding and identifying a specific type of chart pattern can provide many excellent profit opportunities.

Continuation patterns are probably best seen as interruptions or pauses in either an uptrend or downtrend. Of course, the first step is to identify a change in trend, and if it is a major trend change, you could expect to see a series of continuation patterns that form over months, if not years.

While many look for the major bottom or top before initiating a trade or investment, I have found that often times, the best trading opportunities in terms of both risk and reward are found by identifying continuation patterns. Many of these formations occur in the shape of triangles, while others have a rectangular shape.

Figure 1

chart
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One of the most exciting markets to trade over the past few years has been gold, and during this time, the SPDR Gold Trust (GLD) has become one of the largest and most popular ETFs. During GLD’s rise from near $40 in 2005 to over $185 in 2011, there have been many good entry points for willing buyers.

In examining both the weekly and daily patterns, these interruptions in the major trend have all had shapes that are typical of continuation patterns. A good example of this occurred in late 2009 and early 2010.

GLD had risen from a low of $88.82 in July 2009 to a high in early December of $119.54, where the fund reversed to the downside. On the weekly chart, the entire continuation pattern took the shape of a flag, lines 1 and 2. Flag formations can take many shapes, but the most simple can be broken into three components, as illustrated on the daily chart.

The first is a decline from the high (wave a) that was followed by a rally (wave b) that typically will stop below the 61.8% retracement resistance of wave a. This is followed by another decline (wave c) that will generally drop well below the low of wave a, stopping out anyone who bought too soon.
In our GLD example above, you can see that this final wave of selling took GLD below its 50% retracement support of the rally from the July lows but stopped before reaching the 61.8% support level at $100.65.

GLD gapped through the downtrend, line 3, on February 16, completing the flag formation. The rally quickly stalled when GLD pulled back to $106.60 before moving up to test the stronger resistance in the $112 area. The ensuing decline dropped GLD to $106.24, which was above the 50% retracement support of the rally from the correction lows.

As discussed previously (see “Using Fibonacci to Trade Flag Patterns”), you can determine targets by calculating the 127.2% retracement target of the flag formation. This gives you a target of $124.50, which was met in September 2010.

These examples of continuation patterns should help you become better able to recognize them as they are forming.

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Tickers Mentioned: Tickers: GLD, QQQ, IYE