One of the most important skills you can develop as a retail trader is identifying candlesticks and candlestick patterns. It is far from instrumental in knowing them all, but a solid understanding of the most common is a boon to your trading skillset. When it comes to identifying candlestick patterns, three of the most common are chart patterns, continuation patterns, and flag patterns.
Chart patterns fall into three broad categories:
As stocks begin to surge to new highs, traders who own those stocks become a bit worried. They start to question if the trades can sustain the increase, and frequently, at first sight of weakness, fair-weathered traders will bail out. But, what if, as a trader, you could have more confidence that trade will continue? That's what continuation patterns tell us as they suggest the current 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 minor retracements are continuation patterns.
There are three classifications of continuation patterns that are similar in form and function.
Even though these three patterns are almost interchangeable, we will cover each of them individually so you can get a better sense of the subtle differences.
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 does not have enough fear in it to fully reverse the market.
You can see how this small pattern is only a few days in size in the image above. It is moving counter to the primary trend, and yet it does not have enough bearishness to allow the bears to gain complete 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 minimal 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, imagine a flag flying from a flagpole; this is where the name "flag" comes from.
We refer to little patterns like this as minor corrections or a pullback. They are small countertrend moves that stop the current progress for the moment but eventually lead to a continuation of the trend. The technical term is a retracement.
If you already own this stock, you can take the flag as a probable signal that this trade will continue. Many 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 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 more significant trend. They are countertrend swings that move against the primary trend and are exceedingly difficult to trade as they offer the countertrend trader minimal 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 that the stair-step was just a short-term resting spot while the stock continued 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 that 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.
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.