We often talk about how the stock market is a bit of a paradox as it's a place where people who want more certainty in their financial future come to invest their money. They invest with the hope of getting a large return so they can be more financially secure. Yet, at the same time, the stock market is itself a place of uncertainty, and many consider it so uncertain they liken it to playing cards in Los Vegas.
Just like professional card players have learned methods to put the odds in their favor, professional traders have also learned how to put the odds of winning in their favor as well. One such technique is the recognition of chart patterns.
Chart patterns are patterns in stock price that show up as a result of human behavior around particular price point on the chart. There are three broad categories:
As stocks begin to surge to new highs, the traders who own those stocks become a bit worried. They start to question if the trades can sustain the increase, and often times at the first sight of weakness, fair weathered traders will bailout.
But, what if, as a trader, you could have more confidence that a trade is going to continue? That's what continuation patterns tell us. They suggest current the trend will most likely continue.
In its most simple form, continuation patterns explain how stocks move during countertrend moves. We all know stocks cannot go straight up or straight down, they move in the primary direction and then retrace in the opposite direction before continuing. These little retracements are continuation patterns.
There are three classifications of continuation patterns. In reality, they are all three very similar, and when you understand one of them, you understand them all.
Again, these three patterns are so similar you can almost interchange them, but we're going to look at each of them individually so you can get a better sense for each.
Flag patterns are a type of continuation pattern that appears after the trend has already started. It is a small countertrend move that will often scare a lot of people out of the market. But the bullish flag pattern doesn't have enough fear in it to fully reverse the market.
In the image above, you can see how this small pattern is only a few days in size. It is moving counter to the main trend, and yet it does not have enough bearishness to allow the bears to gain full control of the trade.
To qualify as a flag pattern, the preceding trend should have been a pretty strong move. Usually, this pattern follows several days of strong bullish candlesticks.
Next, you will notice the small countertrend selling within a very small trading range. You can draw two short-term support & resistance lines, and they will both be to the downside. Typically, this short retracement will last until it gets to the previous support area.
If you look at the image above, you can imagine a flag flying from a flag pole; this is where the name "flag" comes from.
We refer to little patterns like this as small corrections or a pullback. They are small countertrend moves which stop the current progress for the moment but eventually lead to a continuation of the trend. The technical term is retracement.
If you already own this stock, you can take the flag as a probable signal that this trade is going to continue. A lot of people end up selling out, right at the bottom as they fear the selling will continue, and they want to preserve their capital. In reality, they are selling about the time they should be buying.
If you are a buy the dip kind of trader, you can wait for this stock to retrace to a support and then buy it. If you are the kind of person who likes a little more confirmation, you can enter the trade on a breakout to the upside. Either way, you may choose to trade the flag, it is a solid continuation signal, and you will be a better trader for identifying and using the pattern.
The next type of continuation pattern is what we call a stair-step pattern. Like the flag, the stair-step is going to occur after a sharp trend to the upside. For example, the stock will trade sideways for a few days and then surge to the upside. The result is an image that looks like a stair-step.
Like all of these patterns, the stair-step is just a retracement as part of a larger trend. They are counter-trend swings which move against the main trend and are exceedingly difficult to trade as they offer the counter-trend trader very little profit opportunity.
However, where they shine is in anticipating a continuation of the previous trend. Stair-step patterns are very good at anticipating a continuation of the previous trend. Notice in the image above, the stair-step was just a short-term resting spot while the stock would continue trading to new highs.
The final pattern is the pennant. This is one of the most popular and well-known patterns. It is a flag pattern which has the support and resistance collapsing in on itself.
Like the flag pattern, the pennant is a great continuation pattern. You can enter it on the pullback or, ideally, enter on a breakout as a continuation of the trend.
There is another feature that all of these patterns have in common. Typically, when a stock is in a continuation pattern, the volume will contract during the pattern, and expand on the breakout. This is just one additional confirmation that a continuation pattern is shaping up.
Continuation patterns are a great addition to the trader's toolbox. Learn to recognize the patterns when they are shaping up, and they will give you much greater confidence to stay in some trades, and in other cases, they will give you the confidence to enter some new trades.