No Need to Pick Bottoms or Tops
11/17/2011 2:00 pm EST
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.
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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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 Powershares QQQ Trust (QQQ), which tracks the Nasdaq 100, from both a weekly and daily perspective.
The weekly chart shows a falling wedge formation (lines A and B) that was completed in November 2002 when the downtrend (line A) was broken.
On the daily chart, more details are revealed that would help the trader confirm that this was indeed a falling wedge formation. As the fund made lower lows (line D), volume decreased, as evidenced 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 fund 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 not wait for the pullback. While waiting, many become fearful of being left without a position (or are just plain impatient) and so they jump in, only to have their position 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 F), 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.
NEXT: Study Past Set-Ups in a Popular Energy ETF|pagebreak|
Many of the energy stocks bottomed between mid-2002 and mid-2003, and this was also true for the iShares Dow Jones Energy Sector ETF (IYE). It formed a two-year falling wedge formation on the weekly chart, lines A and B, which was completed in June 2003 when the downtrend was overcome.
The former downtrend (resistance) was tested in September 2003 as part of the triangle formation (box 1). In fact, on the weekly chart, three distinct continuation patterns are identified (boxes 1, 2, and 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 above, 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 of resistance (line C), which completed the flag formation (lines C and D).
This formation interrupts a previous trend and reaches completion once the resistance (in a bull market) or 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) or $5.70. This amount is then added to the break above resistance (line C), which gives a target of $50.12 ($44.42 + $5.70).
NEXT: Continued Study of This Classic Formation|pagebreak|
As you can see on the above daily chart, this target was hit in early 2004 before another continuation pattern developed, lines H and I. On the weekly chart (Figure 3), this rectangular type of continuation pattern was 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 buyers and sellers.
The buyers come in at support (line I), while the sellers took 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 Figure 5 above), 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 when 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, or $62.44.
After rallying from $55 to $67, IYE again took a rest as it formed another rectangle pattern (lines J and K on Figure 5), which is shown as box 3 on the weekly chart (Figure 3). 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 know, once resistance is convincingly overcome, it then 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 resistance 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 amid heavy volume. The rectangle was $5.70 wide and the first target at $74.10 ($68.40 + $5.70) 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 in order 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 often establish swing positions against the major trend and are stopped out.
Read Part 2 of this article series on continuation patterns.
Tom Aspray, professional trader and analyst, serves as senior editor for MoneyShow.com. The views expressed here are his own. Readers can post questions or feedback in the comments area below or send to TomAspray@MoneyShow.com.