Price charts can appear to be completely random movements. Yet, within those movements price patterns can be found. Price patterns are distinctive formations which reflect the interaction between buyers and sellers. Which means they are formed and guided by the laws of mass human behavior, suggesting that they often lead to predictable market movement. The longer it takes for a pattern to form, the more significant it is. This post will be the first one on continuation patterns will be the first of two posts on Chart Patterns.
There are two types of price patterns; continuation and reversal patterns. When a continuation pattern occurs it indicates that the trend is likely to continue after the pattern completes. A pattern is considered complete when the pattern is formed and makes a “break out” in the direction of the original trend direction.
Continuation patterns often occur when an established trend pauses, before resuming the original direction. Common continuation patterns are: Triangles, Rectangles, and Flags. Each of them will be discussed.
A triangle is formed when two trend lines meet at a point. Each of these trend lines must touch price action at least twice, while most strong triangle patterns have at least six turning points (in total). The easiest way to identify triangles is by connecting the cycle highs with each other, and the cycle lows with each other.
When trading triangles we’re looking to trade the breakout of the triangle. This breakout should take place somewhere between ½ and ¾ of the horizontal length of the triangle. After a break of the trend line, we often see a pullback towards this trend line.
Dependent on the slope of the triangle trend lines we can identify three types of triangles:
- Symmetrical triangle (Bullish in an uptrend, Bearish in a downtrend): The upper trend line falls away at roughly the same angle as the lower trend line is rising.
- Ascending Triangle (Bullish): Flat upper trend line and a rising lower trend line.
- Descending Triangle (Bearish): Flat lower trend line and a falling upper trend line.
Often the symmetrical and descending triangle occurs in consolidation of the downtrend. A more difficult situation takes place when we witness an ascending triangle in a downtrend, nice versa for a descending triangle in an uptrend. In such cases it is, of extra, importance to consult indicators or different chart reading techniques to find more clues for a likely direction in trend.
It is suggested for beginning and novice traders only to execute triangle traders that are in the direction of momentum on a higher time frame.
Triangle Trading: When price breaks out of a triangle patterns we can determine what are target should be. One basic technique that holds for all three kinds of triangles is: determine the price difference of the triangle at the basis. This amount of pips can be added (if the breakout is positive) or deducted (negative breakout) from the breakout price.
For a symmetrical triangle a second technique is used. When price breaks out to the upside, we can draw a parallel line at support trend line of the triangle. If price breaks to the downside, a parallel can be drawn from the declining resistance trend line.
Rectangles are often found in a trading market, or consolidation period. A rectangle is formed by price moving between two horizontal support and resistance levels (should touch at least two times). A rectangle often represent indecision in the market, buyers and sellers are not strong enough to move price into one direction.
Since rectangles are typical patterns that occur in trading markets, indicators such as the MACD and RSI flourish due to their ability to signal when price is likely to reverse within the rectangle.
A flag pattern is similar to a rectangle, only it is has a slope instead of being horizontal. A flag is a small trading channel that moves against the dominant trend. We usually find flag patterns after a sharp run in price. Once a flag pattern is broken in the direction of the dominant trend it often signals a continuation of the initial trend.
What a flag pattern usually implicates is that the previous move has been too strong and market participants need some time to breathe. In a downtrend these breaks to get some air are usually shorter than in an uptrend. Think of the parallel of running up and down a mountain. On your way up you probably need longer breaks to recovers as on your way down. These patterns are usually very reliable and only seldom reversal points.
A wedge pattern is like a triangle but with a clear directional bias. It is a triangle that is clearly pointing up- or downward. An rising-wedge has a support and resistance that are both sloping upwards, but with a stronger sloping support level. Vice versa is the case for a falling-wedge; support and resistance are sloping downwards, but with a stronger sloping resistance level. A wedge pattern is complete once price breaks formation. With a rising wedge it is most like that it breaks formation on the downside, while for a falling wedge pattern a break usually occurs through the upside. Same as with triangles, a breakout should occur on about ¾ of the horizontal length of the pattern. A rising-wedge occurring in a downtrend is bearish, while a falling-wedge is bullish in an uptrend.
Research of T. Bulkowsky (2000) provides us insight in statistical probabilities/reliabilities of these chart patterns. According to his published work a falling wedge has a probability of 90% that it will break formation to the upside, meaning that it only has a failure rate of 10%. After a break of formation price makes on average a move up between 20-30%. For a rising wedge the probability of a break on the downside is 76%, with an average decline in price of around 15%. For more of Bulkowski’s work consult “The Encyclopedia of Chart Patterns”.
Continuation patterns provide important pieces of information about the likely direction of price. Especially in confluence with other indicators and former support/resistance levels a strong case can be build for an awesome trade setup. Continuation patterns include triangles, flags, rectangles and wedges. Often such patterns occur mid-trend and indicate a continuation of that trend, once the pattern is completed.
Not always such patterns are reliable so always try to find extra clues in favor of your trade.