Learn to Profit from Continuation Patterns
12/30/2010 10:45 am EST
As we prepare and formulate our trading strategies for 2011, be sure to review this past series of articles devoted to identifying continuation patterns. Trading Lessons will return on January 14 with an all-new issue. Here's wishing all of you a prosperous 2011!
In this series of articles, we will look at the various types of continuation patterns. It is probably easiest to think of these formations, or patterns, as interruptions or pauses in either an up 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 they initiate 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 are in the shape of triangles, while others have a rectangular shape.
As we are all aware, the Nasdaq 100 topped in the spring of 2000 and underwent a severe decline that lasted for over two years. The charts above show the Nasdaq 100 ETF from both a weekly and daily perspective. The weekly chart shows a falling wedge formation (lines A and B) that was completed in November of 2002, as the downtrend (line A) was broken. On the daily chart, more details are revealed, which would help the trader confirm that this was indeed a falling wedge formation. As the fund made lower lows (line D), volume decreased, as evident by comparing the levels at points 2 and 3. This is consistent with a market or stock that is becoming sold out, meaning there are few or no sellers left. The pattern is also visible on the weekly chart, as indicated by line 1. The breakthrough of the daily downtrend (line C) occurred in the $23.50 area, while the weekly downtrend was broken later and higher at about $25.25 per share. The Nasdaq 100 ETF reached its first objective in the $29 area quickly as late buyers hurried to jump on board. This is a common trend because many times, traders will miss a breakout and wait for the pullback. While waiting, many become fearful of being left without a position (or are just plain impatient) and establish a position, only to have it go immediately against them.
In this instance, which is not unusual, the market gave back almost all of its gains from the breakout, making a series of lower highs and lower lows. After the first rebound from the initial peak, the chartist would be able to establish the downtrend, line E. By the middle of January 2003, the lower support line could also be drawn (line E), which creates a flag formation (highlighted in red). A flag formation is created by two lines, one of which is a downtrend or uptrend line, while the other is a support line. These lines can be either parallel or converging; however, both are defined by their marked difference in slope from the previous trend, which creates a flagpole of sorts. Flag formations within an uptrend are called "bull flags," while flag formations in a downtrend are called "bear flags." These are just two types of triangle formations that are considered to be continuation patterns. It is important to note that as the market continued to move lower, volume decreased, indicating that even at lower prices, there were fewer sellers. On the breakout through resistance at line E, which completed the flag formation, volume was heavy (see point 4). As is often the case, the market pulled back and retested the former downtrend (line E) before turning higher once more. This provided an excellent buying opportunity.
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Many of the energy stocks bottomed between mid-2002 and mid-2003, and this was also true of the iShares Dow Jones Energy Sector ETF (IYE). It had formed a two-year falling wedge formation on the weekly chart, lines A and B, which was completed in June 2003 as the downtrend was overcome. The former downtrend (resistance) was tested in September 2003 as part of the symmetrical triangle formation (box 1). In fact, on the weekly chart, three distinct continuation patterns are identified (boxes 1-3) and will be discussed in more detail using the daily charts. I have shown this chart primarily to illustrate how, in a very strong market, you will be able to identify many pauses in the uptrend that can be identified as continuation patterns. These pauses can provide many excellent trading opportunities regardless of whether you are a short- or intermediate-term trader.
On the daily chart (Fig. 3), the falling wedge formation was completed in May 2003 with the close above $42.43. IYE quickly ran up to the $46 level before undergoing a classic correction. I call it that because on two instances, once in July and the other in early August, the former downtrend (blue line) was retested. The second test is identified by the green circle labeled E, and the low was used to draw the support line (line D). It is also important to note that this correction held above the support in the $40 area (dashed line) that was formed during February and March of 2003. During September and October 2003, IYE made several attempts to overcome the resistance in the $44.50-$44.80 area, but was unsuccessful each time. This formed the second point for the resistance (line C), which completed the pennant formation (lines C and D), another type of triangular continuation pattern. A pennant formation consists of resistance and support lines that will intersect at a point in the near future. This formation interrupts a previous trend and reaches completion once the resistance (in a bull market) or the support (in a bear market) is overcome. The uptrend was tested twice more in November (circle F) before IYE was able to rally impressively through resistance at line C on strong volume (line G). To determine the price target from this formation, measure the height of the flagpole, which is defined as the distance from the breakout above resistance to the first high, which is labeled line 1. This is calculated to be $46.10 - $40.40 = $5.70. This amount is then added to the break above resistance (line C), which gives a target of $44.42 + $5.70 = $50.12.
This target was hit in early 2004, Fig. 4, before another continuation pattern developed, lines H and I. On the weekly chart (Fig.2), this rectangular type of continuation pattern is identified as box 2. Although major tops can sometimes take on a similar formation, they are only formed after a long-term uptrend, and as the weekly chart of IYE shows, this was not the case. Also, this rectangle clearly is sloping upwards, which is consistent with a positive or bullish interpretation. The rectangle formations clearly illustrate the battle between the buyers and the sellers. The buyers come in at support (line I), while the sellers take over as resistance was reached (line H). It is interesting to note that the heaviest volume during the period examined came on the downside in May (see blue circle on Fig. 4), but IYE still held well above the previous lows and support at line I. As the chart indicates, the buyers began to win as IYE pushed through resistance three times between June and August 2004 (see arrows), but in each instance, the volume was low and there was little follow through on the upside. In early September, this changed as the extended resistance (line H) was again overcome with the highest volume (red circle) of the past three months. To obtain the price target from a rectangle, you just calculate the width of the formation (line a), in this instance $4.30, and add it to the breakout point, so the target would be $58.04 + $4.40 = $62.44.
After rallying from $55 to $67, IYE again took a rest as it formed another rectangle pattern (lines J and K on Fig. 4), which is shown as box 3 on the weekly chart (Fig. 2). It is important to observe that this entire formation developed above the previous resistance as indicated by the extension of line H (dashed line). As most of you know, once resistance is convincingly overcome, it becomes support. For this new rectangle, support is present in the $60.80 - $61.30 area (line K), which was tested three times during late 2004 and early 2005. Two levels of resistance were noted: The initial at $65.48 and the major resistance at $67.00 (dashed line J). Within the rectangle formation, a smaller flag formation was also evident, formed by the downtrend (line 1) and line K. On January 14, 2005, IYE broke through this downtrend with the close at $64.31 (see green circle). Several weeks later, the major resistance at line J was overcome and the volume was heavy. The rectangle was $5.70 wide and the first target at $68.40 + $5.70 = $74.10 was met and exceeded in the next month.
Continuation patterns such as these are important for any good chartist. The ability to identify and understand them will allow the trader to capitalize on their easily recognizable attributes to set up favorable risk/reward trades. Conversely, the failure to identify them can cause the trader to close out intermediate-term positions at the wrong time, while short-term traders may establish swing positions against the major trend before it reasserts itself. Therefore, in the next article, we will continue our discussion of continuation patterns, featuring examples from both up and down markets.
As always I welcome your feedback on these articles and can be contacted at email@example.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.