Today’s Trading Lesson From TradingMarkets
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Chart Classics:
Reversal And Continuation Patterns
By Mark Etzkorn
In “Basic
Chart Analysis: Trends, Trading Ranges and Support and Resistance,” we
discussed some of the fundamental concepts of price action and chart patterns.
Here, we’ll delve into a little more detail about some of the well-known chart
patterns, how they reflect basic price action principles and what to understand
about the trade signals they provide.
At the simplest level, chart patterns can be divided into reversal
patterns and continuation patterns, and both categories are exactly
what they sound like: Reversal patterns suggest the culmination of trends and a
change in price direction; continuation patterns imply a resumption of an
existing trend and are usually shorter in duration than reversal patterns. (Some
short-term patterns that consist of only one or two bars, such as gaps,
reversal days and spikes, will be discussed in an upcoming
article.)
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| Chart patterns imply different price developments, depending on their context |
These reversal and continuation patterns include some of the “classic” chart
patterns, such as double tops and bottoms, head-and-shoulders,
triangles, flags and pennants. Rather than discussing these
patterns in detail, we will instead discuss their characteristics and try to
eliminate some of the confusion surrounding them. It is actually more beneficial
not to dwell initially on every idiosyncrasy of every pattern variation, and
instead understand what these patterns represent in terms of possible price
action. While the names of some chart patterns–and the implications many
traders attribute to them–can seem obscure or esoteric, the ideas behind them
are usually very simple.
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The importance of context
Before discussing specific patterns, we need to make an important, but often
overlooked point: Chart patterns imply different price developments,
depending on their context. A pattern that occurs in the middle of a choppy
trading range may mean something completely different than a similar pattern
that occurs in a trending market.
It’s also necessary to consider the time frame of a particular pattern to
better understand its potential. Shorter-term patterns (say, a five-day trading
range, or flag) generally imply shorter-term price reactions; longer-term
patterns (such as a slowly developing double top), signal the potential for much
more significant price reactions.
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| A continuation pattern is a period of price congestion or consolidation that interrupts a trend |
As noted in “Basic Chart Analysis: Trends, Trading Ranges and Support and
Resistance,” the underlying logic of these patterns and principles are constant,
regardless of the time fame chart you consult. Pattern examples will be shown on
intra-day, daily and weekly charts just to underscore this point.
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A reversal pattern like a double top on a weekly chart implies the same kind
of price action it does on a 15-minute chart, just of a different magnitude: The
signal on the weekly chart suggests the potential for a major trend reversal,
while the signal on the 10-minute chart would imply a reversal of the very
short-term (probably intra-day) trend.
Continuation patterns
A continuation pattern is a period of price congestion or consolidation
that interrupts a trend, a concept familiar to anyone who attempts to enter
trends on corrections, or pullbacks. A breakout of the pattern in the direction
of the previous trend is the standard entry signal and represents a
resumption–a continuation–of the trend. The best-known continuation
patterns are triangles, pennants and flags.
Triangles Figure 1 shows an example of a triangle: a congestion
period in which price swings progressively into a narrower and narrower range,
and trendlines drawn to define the upper and lower boundaries eventually
intersect to form a triangle. Triangles represent a progressive compression of
prices (increasingly low volatility), a condition from which markets often make
sharp or dramatic price moves. (There are a variety of triangle
“types”–symmetrical, ascending, descending–but for now these distinctions are
not important; these variations all share the same principles.)
While triangles also can act as reversal patterns after long trends, they are
more commonly continuation patterns. A breakout of the triangle in the direction
of the trend signals the trend has resumed, while a breakout through the
opposite side of the triangle would imply the trend is in jeopardy or has
reversed.
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| Figure 1. Amazon.com (AMZN), 30-minute bar. A convincing breakout to the upside or downside will be necessary to determine whether this triangle is a pause in an uptrend initiated by the previous trading range breakout, or a top pattern that reverses the quick up move. Note the different ways the upper boundary of the triangle could be have been re-drawn (the red and blue lines). Using the red line that connected the first high with the next swing high, price is already above the upper boundary–but has not convincingly followed through. Source: Quote.com. |
The triangle in Figure 1 developed immediately after a strong upside breakout
and accelerated rally (it’s not surprising the market would “catch its breath”
after such a run-up). A convincing up move out of both the triangles outlined
here (and even better, and move above the relative high that began the larger
triangle) would cast the pattern as a continuation; a solid move below the low
the triangle would make the pattern a reversal.
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| Figure 1a. Update: Amazon.com (AMZN), 30-minute bar. The triangle pattern extended the next trading day (10/4/99). Note that while the triangle boundaries could be (subjectively) re-drawn as time passed, the fundamental logic of the pattern–that price is consolidating and poising to break out–remains intact. Source: Quote.com. |
Update: As of the close of trading on
10/4/99, the triangle pattern had extended (AMZN closed down 3/16) on a
relatively strong up day for the overall market (see Figure 1a). The stock tried
break through the lower boundary of the triangle, but did so unconvincingly.
Pennants Pennants are essentially
shorter-term triangle patterns–less than a month in length on a daily chart,
for example. They are still congestion patterns, however, and are interpreted
the same way as their larger counterparts.
Flags Like pennants, flags are also shorter-term congestion
patterns, but the lines defining their upper and lower boundaries run parallel
instead of converging.
Flag patterns are really short-term trading ranges; a minimum number of bar
would be 3-5; as is the case for pennants, a flag that extends to approximately
twenty or more bars is more properly classified as a trading range. Flags may
form both diagonally (usually against the direction of the trend, as in a
correction or pullback formation) instead of horizontally. Figures 2 and 3 show
examples of pennants and flags.
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| Figure 2. Oct. ’99 sugar futures (SBV9), daily. Flags and pennants (or triangles?) interrupt trends on this daily chart and offer short-term support and resistance levels at which to enter trades and place logical stop-loss orders (at the opposite boundary of the pattern from which the trade is entered). Source: Quote.com. |
One interesting aspect of this chart is the congestion pattern that forms in
May and early April in Figure 2. Is it a pennant or triangle? In a sense, this
example shows how subjective chart analysis can be. The pattern is a little over
20 bars in length–a little over a month. It’s a little long for a pennant, and
would probably best be labeled a short triangle.
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 |
| Figure 3. Bristol-Meyers Squibb (BMY), five-minute bar. Flags and pennants on an intra-day chart. Source: Quote.com. |
However, it’s not the name that’s important, it’s what a pattern suggests the
market might do. In this case, a downtrending market is consolidating in an
increasingly narrow range. The astute chartist would not get hung up on counting
the precise number of bars and labeling the pattern, he or she would be more
interested that the pattern was offering the potential to enter the downtrend on
a downside breakout of the pattern, or possibly go long (or liquidate existing
shorts) if price instead broke out of the upside of the pattern.
Further, chart patterns are rarely contained perfectly inside the lines
defining their upper and lower levels; slight penetrations are the rule rather
than exception, as is clearly illustrated in these examples.
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| It’s not a pattern’s name that’s important, it’s what the pattern suggests the market might do |
Continuation patterns imply indecision in a market; it is during these
periods that traders look for new opportunities to enter an existing trend (or
add additional positions) on a breakout in the direction of the trend or to
lighten up or liquidate positions if the pattern “fails”–that is, resolves
against the direction of the trend.
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As these charts make clear, there’s nothing too complex going on here. All
continuation patterns reflect the same kind of market behavior–congestion. As
far as the price action they imply, they are really no different than trading
ranges. When the pattern is resolved, the trend should resume. If price breaks
out of the opposite side of the pattern, it suggests a disruption in the trend.
The tighter and longer the congestion pattern, the greater the chances of a
forceful move out of the pattern.
Effective risk control Notice in all these examples, the patterns
offer clear entry points and stop levels. Chart pattern boundaries allow you to
place logical, market-based stops that take you out of trades when the price
action suggests the market’s outlook has changed. (This will hold true for the
reversal patterns we discuss in the next section as well.)
For example, if entering a long trade on the upside breakout of a flag, the
bottom of the flag (in practice, somewhat below it) makes a perfect stop level:
If the market reverses and trades below this level, it suggests the outlook and
dynamics that justified the original long trade are not longer valid. If that’s
the case, common sense dictates it’s time to get out of the trade–or take one
in the opposite direction if the evidence is there to support the decision.
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| Seasoned traders go with what the market is telling them now, rather than brooding on what it was telling them five days ago |
Having the flexibility to trade such failed signals is one of the
hallmarks of seasoned traders. They know to go with what the market is telling
them now, rather than brooding on what it was telling them five days ago. The
flag in Figure 3 fails to break out in the expected direction (up); the alert
trader would recognize this as a sign of weakness and would either liquidate or
lighten existing positions, or choose to go short.
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Also, in the case of very narrow continuation patterns, the small risk makes
it easier to take a second shot at a trade signal if stopped out the first time.
Again using a hypothetical flag example, if the market reversed to just below
the lower range of the flag (stopping you out), you could re-enter on another
move above the upper range of the flag if the market reversed again to the
upside with nothing much lost. Figure 2 shows two especially short, narrow flags
that would have offered low-risk opportunities.
Reversal patterns
Reversal patterns occur at the tops and bottoms of markets and imply a change
in direction of the major trend. Most of them are really specialized versions of
the support and resistance principles discussed in “Basic chart analysis:
Reversal and continuation patterns.”
Using such patterns involves recognizing them as they are developing, and
finding logical entry points and stop levels.
Double tops and bottoms For example, the double top pattern
pictured in Figure 4 reflects the idea that if a market makes a new high,
corrects, advances again toward the previous high, and then falls again, it has
failed to break through the resistance implied by the first high, and a reversal
is likely. Obviously, such a signal would be more meaningful after a long
uptrend, as in this example. The situation would be reversed for a double
bottom. Triple tops are the same concept except that, not surprisingly, one more
high (or low) is involved.
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| Figure 4. IBM (IBM), weekly. Penetration of relative low between the peaks of the double top marks a logical downside entry point (or liquidation point for existing longs); a stop would be placed above the high of the pattern–the same spot at which a breakout trader would go long on the resumption of the major trend (This stock dropped–but did not close–below the relative low entry point on 10/1/99.). Source: Quote.com. |
A logical point to enter trades on double tops or bottoms is on a move below
the relative low between the two peaks of a double top, or above the relative
high separating the two troughs of a double bottom. The relative lows and highs
represent shorter-term (secondary) support and resistance, that when violated,
confirm price reversals. Conversely, stops can be placed above the high of a
double or triple top, or below the low of a double or triple low. A surge past
the high of a double top or below the low of a double top negates the original
premise of the pattern, so such levels are prudent choices both for stops and
for trade entries based on the failure of the original reversal pattern.
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Head-and-shoulders The head-and-shoulders pattern is really just a
more complex version of the double and triple top price behavior discussed in
the previous section. You can
click here
to go to an in-depth discussion of this pattern in the Trading Q&A section that
includes an analysis of an interesting example in the S&P 500 index.
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| Figure 5. Dec. ’99 S&P futures (SPZ9), weekly. “H” marks the head and “S” marks the shoulders of this nearly textbook head-and-shoulders pattern on the weekly S&P chart. Source: Quote.com. |
Figure 5 shows an head-and-shoulders pattern forming in the S&P futures. Note
that the pattern would be much less significant had it occurred formed in the
middle of a choppy, trading range period, or after only a small rally. In this
case, the pattern’s appearance after an extended uptrend makes it especially
worthy of consideration.
Common Characteristics
What do these reversal patterns have in common? They represent declining
market momentum, assuming we are only considering patterns that form after
established trends.
Again, this is only common sense. All trends must end. The longer a market
trends, the closer it is to its eventual reversal. When a market enters a
congestion period and/or hits resistance overhead or support below after a long
trend (which is a good working definition of a reversal pattern) it is only
natural to consider the possibility the market may reverse. As was the case with
the continuation patterns in the earlier section, the boundaries of reversal
patterns offer clearly defined entry and stop levels.
Being practical about chart patterns
As we’ve pointed out, one good thing about simple chart patterns is that it’s
easy to tell when things go wrong: If the market goes in the opposite direction
implied by a chart pattern, you know you should get out–or reverse your
position. And as we’ve illustrated, it’s easy to find logical levels at which to
place your stops: slightly above or below the opposite side of the pattern.
Of course, because common-sense stop levels are so easy to determine, you
also run the risk of having your stop triggered (with all the other traders who
have placed their stops at the same level) when floor traders and other pros go
“stop hunting”–pushing prices up or down to areas they think stop orders are
clustered to take advantage of the quick price burst that occurs when many stops
are triggered at once.
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| Not every wiggle on a chart is significant; all charts contain a great deal of “noise” |
Also remember that every wiggle on a chart is not necessarily
significant–there’s a great deal of meaningless fluctuation–noise–on any
chart. Unfortunately, a valid criticism of chart analysis is that it’s too
subjective–that is, patterns are in the eye of the beholder. This complaint is
absolutely true. It is difficult to test trading strategies based on many of the
patterns described here, and some traders never feel comfortable with techniques
that do not submit to rigid mathematical definition.
The only way to improve chart analysis is through experience and by applying
a little common sense when interpreting patterns. Remember, the context of a
particular pattern is just as important as the pattern itself. Something that
looks like a pennant in the middle of a trading range is not significant; the
same pattern in the middle of a trend, is.
Confirming trade signals
Chart patterns are not magic signals, they’re simply price developments that
suggest the possibility of certain kinds of market behavior–e.g., trend
continuation or trend reversal–and are based on the simple concepts of support
and resistance.
Successful chart-based trading requires knowing when to get out of a trade
that isn’t working by using stop orders placed at levels representing the
failure of a pattern–a sign the market’s character and outlook has changed–and
confirming trade signals when they occur with other patterns or filters that
support taking the trade (such as going short only after two closes below the
relative low between the two peaks of a double top).
While we’ve only touched on the types of chart patterns, the basic principles
of interpreting and trading different varieties remain constant. The most
important thing to remember about chart patterns is that they all revolve around
either trend, price congestion or price extremes–all very simple concepts. It’s
not necessary–and certainly not advisable–to make trading more complex than it
has to be.