Chart Analysis: Continuation Patterns, Part 2

03/27/2008 12:00 am EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

Editor’s Note: This week I am re-releasing part two of my two part series on continuation patterns. These patterns I feel are very important, and by learning to identify these patterns, you should be able to significantly improve both your entries and exits.

In the previous article, we introduced continuation patterns featuring examples from markets that were in an uptrend. An emphasis was placed on how correctly identifying these patterns can provide excellent risk/reward opportunities for both the trader and investor. Continuation patterns fall into two major categories, triangles and rectangles, and all have in common two characteristics: A line that indicates resistance and another that defines support. After a very sharp rally or decline, if the continuation pattern does not retrace much of the previous move, then it can be expected that the next move (in the direction of the major trend) will be dramatic. This is because the shallow nature of the correction indicates that very few are willing to sell (or buy, in the case of a decline).

There are also usually some common volume patterns within a continuation pattern. As the continuation pattern develops, the volume will generally decline, and at the pattern’s resolution, the volume should significantly increase. There is a logical reason for this. When looking at a continuation pattern, consider the nerves of the traders. In an uptrend, those with long positions who are nervous about the trade will sell quickly. This leaves fewer sellers in the market, yielding a lower volume as the pattern progresses. Once the pattern is completed, there is an influx of new buyers, in addition to new buying by those who already have positions.

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Figure 1
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Over the past four years, the overseas markets have been the strongest, with many of the smaller, emerging markets leading the way. However, there have also been some rather sharp corrections along the way. This should not be surprising when ETFs like the iShares MSCI Brazil Index Fund (EWZ) have risen from a low of $5.35 in 2003 to over $47 per share this year. Throughout this dramatic increase, many continuation patterns have developed, and I would like to focus on a few examples. The first occurred after EWZ had rallied from its lows to the $11.30-$11.35 area (line 1). This formed the upper boundary of a rectangular continuation pattern with support (line 2) in the $9.85 area. This formation lasted from May to August 2003, but considering the fund had recently doubled, this was not unusual. EWZ finally moved through resistance on August 20, 2003, and volume did show a nice increase as noted by point a. The volume patterns in EWZ overall were not as “classic” as one would like to see, as during the early years, ETFs were relatively unknown, and the overall volume in the ETFs was just a fraction of what it is now.

The width of the rectangle was $1.50, which, applying the method mentioned in the last article, gave an upside target of $11.35 (resistance) + $1.50 = $12.85, which was easily exceeded in two weeks. As some relatively heavier selling (red bars) was evident in September, EWZ formed a short-term flag formation (lines 3 and 4). This is a fairly normal sequence of events in that EWZ rallied for about six weeks from the August lows, then corrected for a couple of weeks (lines 3 and 4). Once again, there was a slight pick-up in positive volume at point b (blue bars) as this pattern was completed. This rally took EWZ quickly up to the $14.61 area before it ran out of steam. The tightness of the pennant formation that then formed (lines 5 and 6), was a sign of strength, as the tight ranges suggest that there were not many sellers. The breakout on November 24, 2003, did show a slight increase in volume (point c) and the longs were definitely rewarded as the ETF approached the $19 level by early 2004.

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Figure 2
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It is important for traders and investors to realize that in a major up or downtrend, not all the pauses in the trend (continuation patterns) are shallow, as there will generally be one (if not two) severe enough to cause many to liquidate their positions. The first indication that EWZ was ready for such a correction was the heavy volume decline that occurred on January 14, 2004 (line d). The 30- and 50-day moving averages of the volume were under 7,000, so the volume on January 14 over 45,000 was significant. This type of continuation pattern, a long-term triangle formation (lines 7 and 8), is characterized by a number of sharp drops that eventually scare many out of their long positions. After the initial drop, there were a few days of consolidation before another weak close in late January started the next wave of selling, which took EWZ down to the $15.50 level. Over the next few months, a broad trading range developed before a final wave of selling began in the latter part of April, which took EWZ to a low of $12.13 on May 10. You will note that this low just reached the previously drawn support (line 8) from the February lows. In fact, the entire decline retraced exactly 50% of the rally from $5.35 to $18.81. Those who are familiar with Fibonacci analysis will not find this surprising, and I have written a series of articles on this topic that you might find useful. The first indication that the worst of the selling was over came in late May when EWZ closed higher on strong volume of over 26,000. It was over a month later that the major resistance (line 7) was overcome. The close above the downtrend was followed by a short-term continuation pattern, as indicated by the circle labeled e. This allowed for several good entry points on the long side, as after the breakout above the $15.50 level, EWZ would double again in the next year.

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Figure 3
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The chart above shows the hourly trading in the USD/JPY from April 5 through May 12 of that year, and reflects the number of yen that are equal to one dollar. As the chart declines, the dollar is weaker, because one dollar buys fewer yen. Conversely, when the chart is rising, the dollar is stronger. The dollar rebounded after dropping sharply in late 2005 and early 2006, and the hourly chart shows the formation of a rectangular continuation pattern (lines 1 and 2) as the dollar’s downtrend was interrupted. The key support (line 2) was in the 116.70 area with resistance at 118.60-118.90. When the dollar violated support on April 24 at the start of Asian trading, the width of the formation (118.90-116.70 = 2.20) gave a downside target of 116.70-2.20 = 114.50. This was met later that same day. The dollar then consolidated for two days, forming a flag formation (lines 3 and 4). The support at 114.25 yen/USD gave way later in the week, taking the dollar sharply lower as it dropped briefly below the 112.50 level early the following week. After a drop of over six yen, the dollar was due for a period of rest. The dollar did consolidate for most of the week of May 1- May 5 and was able to rebound back to the prior support, now resistance, in the 114.25 yen/USD area.

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Figure 4
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The continuation pattern that formed on the hourly chart (lines 5 and 6) is even more apparent on the ten-minute chart as shown in Fig. 4. The rising level of support (line 6), defined by three higher lows, as well as the resistance at 114-114.25 (line 5) gave the trader some well-defined parameters. The violation of the uptrend (line 6) in the 113.40 indicated the dollar’s decline was ready to resume, and the following week, the dollar dropped down to the 111.00 yen/USD area, fulfilling the targets from the triangle formation.

In this and the previous article, we have focused mainly on continuation patterns that form within uptrends and continuation patterns on the weekly and daily charts. Obviously, this is just part of the story as major declines often have a different structure than major uptrends, though the same type of continuation patterns are often formed within both bullish and bearish markets.

It should be apparent from the dramatic swings evident in the ten-minute chart that trading intraday continuation patterns is not for the faint of heart. Nevertheless, whether you are a trader or investor, the ability to correctly identify continuation patterns should increase your percentage of profitable trades.

As always I welcome your feedback on these articles. I can be contacted at taspray@moneyshow.com. I would also appreciate any suggestions you may have for future articles.

Tom Aspray, professional trader and analyst, serves as senior editor for MoneyShow.com. The views expressed here are his own.

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