Introduction
In financial markets, technical analysis is the practice of interpreting price action, volume and other trading data, with the goal of forecasting future price movements. Essentially, it relies on the premise that past price action can tell us something predictive about future price action.
Technical Analysis can be somewhat controversial, some people think it is absolute nonsense, and others think it is the most important predictive factor in price. For my own part, I believe that technical analysis is valuable because it gives us some insight into market psychology.
Humans seem to react emotionally and predictably (in aggregate) to prices, and hence it follows that price action can have predictive power. My thoughts on this work are derived from the psychologist turned trader Alexander Elder.
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As a trader and analyst focused on fundamentals (supply and demand), I personally do not recommend that someone place a trade based solely on price action. However, technical patterns can be a very useful way of interpreting market sentiment and psychology and so I do suggest that every trader should be familiar with them. (For more on the benefits and limitations of using technical analysis, read this article).
One of the key ways that traders use technical analysis to predict prices is by identifying patterns that signal possible reversals or continuations of market trends. Our view is that these patterns represent psychological phenomena or evoke an emotional crowd reaction. These patterns then can be a very useful way of keeping your finger on the pulse of the market.
Regardless of whether these patterns “work” or not, they are part of the general landscape and language when traders discuss the market. It is therefore useful to everyone, fundamental trader, chartist or other, to be familiar with the most widely used patterns.
In this article, we will discuss 5 of the most common chart continuation patterns and how to trade them.
Continuation Patterns
Continuation patterns are chart formations that signal the likelihood of the current price trend continuing after a brief pause or consolidation. They occur when a prevailing trend—either upward or downward—takes a temporary break before resuming its original direction.
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The official way of trading many technical analysis patterns is to identify the pattern components, the breakout point, the price target, and stop loss point.
Rectangle Pattern
Pattern Components: Horizontal support and resistance levels with price bouncing between them, forming a rectangle.
Breakout Point: Trend continuation is confirmed when price breaks out above resistance or below support.
Price Target: Measure the height of the rectangle and extend that distance from the breakout point.
Stop-Loss Point: Typically placed just inside the rectangle to manage risk in case of a false breakout.
Starting with one of the most common patterns in technical analysis, the rectangle is a continuation element that suggests a period of consolidation. During this time, the price will bounce between horizontal support and resistance levels.
The rectangle can appear when neither buyers nor sellers dominate the market, leading to a sideways movement in the price. This phase is seen as a pause in the prevailing trend before it resumes in the same direction.
In an uptrend, the rectangle pattern indicates that buyers are gathering strength before pushing prices higher. In the downtrend, it suggests that sellers are pausing before continuing to drive prices lower.
In both cases, there is a psychological stalemate between buyers and sellers. Traders who have been riding the prevailing trend begin to hesitate as the price repeatedly bounces off established support and resistance levels without breaking through.
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As the consolidation persists, tension builds among traders who anticipate an imminent breakout but are unsure of its timing and direction. When the price finally breaks out of the rectangle, it releases the built-up pressure, triggering a surge of trading activity.
In general, traders choose to enter a position when the price breaks out of the rectangle, aiming for a target by measuring the height of the rectangle and extending that distance from the breakout point. Volume, in turn, tends to decline during the consolidation phase and then rises sharply when the breakout occurs, offering further confirmation of the pattern's validity.
Triangle Patterns
Pattern Components: Three types—ascending (bullish with horizontal resistance and upward-sloping support), descending (bearish with downward-sloping resistance and horizontal support), and symmetrical (neutral with converging support and resistance lines).
Breakout Point: Confirmed when price breaks out of the triangle, typically in the direction of the preceding trend.
Price Target: Measure the height of the triangle at its widest point and extend that distance from the breakout point.
Stop-Loss Point: Placed just inside the triangle.
Following with more geometric shapes, we have the triangles, that are regarded as some of the most versatile continuation patterns. They can be classified into ascending, descending, and symmetrical, each with a period of consolidation followed by a breakout, typically in the direction of the preceding trend.
The ascending triangle is a bullish pattern characterized by a horizontal resistance line and an upward-sloping support line, indicating that buyers are pushing prices higher. A descending triangle, on the other hand, is a bearish pattern with inverse characteristics. In both cases a breakout across either the resistance or support level confirms the continuation of the trend, especially when validated by an increase in trading volume.
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Completing the family, a symmetrical triangle is formed when both the resistance and support lines slope toward each other, converging into a point. It represents a neutral consolidation, meaning the breakout could occur in either direction. However, the prevailing trend prior to the formation of the symmetrical triangle often continues after the breakout.
Regardless of the type, the triangle reflects a tightening between buying and selling pressures, as both bulls and bears lack the conviction to drive prices in any direction. However, they are gradually coming to agreement as to current value. This often precedes a major price movement, and when prices break out of this range it suggests a new dominant crowd opinion has emerged.
Flags
Pattern Components: Sharp price movement (flagpole) followed by a consolidation phase between two parallel trendlines that slope against the trend (flag).
Breakout Point: Confirmed when the price breaks above the upper trendline (bull flag) or below the lower trendline (bear flag).
Price Target: Measure the length of the flagpole and project that distance from the breakout point.
Stop-Loss Point: Typically placed just outside the flag pattern.
Moving on to a different family, flags are short-term continuation patterns that occur after a sharp price movement, either up or down, forming the "flagpole." Following the short rally, the price consolidates within two parallel trendlines that slope against the prevailing trend, creating the "flag" portion. The consolidation is often interpreted as a temporary pause before the trend resumes.
A bull flag forms after a rapid upward price movement, where the consolidation is downward-sloping, suggesting that buyers are taking a breather. Once the price breaks above the upper trendline of the flag, it signals the continuation of the uptrend, and traders often target a price move equal to the length of the flagpole.
Conversely, a bear flag occurs after a steep decline in price, with the flag sloping upward during the consolidation. A breakout below the lower trendline of the flag indicates the continuation of the downtrend. Just like the bull flag, traders use the height of the flagpole to estimate the potential price drop after the breakout.
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The flag patterns represent an attempt at a counter trend movement after a fast rally or drop in prices. If the prevailing sentiment remains strong, this consolidation will be short lived. A breakout of this range in the direction of the trend suggests that the contrarians have exhausted their efforts.
Pennants
Pattern Components: Sharp price movement followed by consolidation with converging trendlines forming a small triangle.
Breakout Point: Confirmed when the price breaks out of the pennant in the direction of the previous trend.
Price Target: Measure the height of the preceding sharp movement and project that distance from the breakout point.
Stop-Loss Point: Typically placed just inside the pennant to manage risk in case of a false breakout.
Next, we have the Pennants. This pattern is closely related to the flags but has converging trendlines, resembling a small triangle. They also follow a sharp price movement, during which the price consolidates before breaking out in the direction of the previous trend. While both flags and pennants suggest continuation, the key difference here is that the price range narrows during a pennant's formation, creating a triangle shape.
Another important difference is that pennants form over a shorter period than flags, offering quick opportunities for traders looking to capitalize on fast-moving markets. It also means, though, that traders looking to apply this pattern must be ready to take advantage of its appearance as soon as it happens, otherwise they risk being left behind.
The breakout is expected to occur in the same direction as the initial movement, and traders often enter positions as soon as the price breaks out of the pennant, setting a price target based on the height of the preceding sharp movement.
The psychology behind the pennants will be very similar to that of the flags, the contrarians attempt to move the market in the opposite direction but their attempt is stymied by the mainstream as the contrarians gradually agree on a price. When the main trend breaks out of this price, it suggests that trend will continue and the crowd pyshology remains in favor of the trend.
Cup and Handle
Pattern Components: A rounded "U"-shaped cup followed by a short, downward-sloping consolidation forming the handle.
Breakout Point: Confirmed when the price breaks above the handle's resistance, signaling a continuation of the uptrend.
Price Target: Measure the depth of the cup and add it to the breakout point from the handle.
Stop-Loss Point: Typically placed just below the handle to manage risk in case of a false breakout.
At last, we have the cup and handle. When comparing to the others, this is a longer-term bullish continuation pattern. It resembles the shape of a teacup, with a rounded bottom forming the cup and a short period of consolidation creating the handle. Like the other patterns in this article, it follows an upward price trend and indicates a continuation of that trend after a brief consolidation phase.
The cup forms when the price declines, rounds out, and rises back to the previous high, creating a "U" shape. After reaching a high, the price enters a consolidation phase, forming what is called the handle, typically a downward-sloping channel. When trading the cup and handle, traders usually look for the breakout above the handle's resistance as a signal to enter long, expecting the uptrend to resume. Another way to identify it is by looking at the volume, that will generally decline as the pattern develops but will present a sharp increase once the breakout happens.
Similar to other continuation patterns, this begins with a contrarian attempt to buck the current trend. This is more successful than the flags/pennants though, until the contrarians gradually run out of money. The main stream trend then begins to slowly pick back up as the crowd psychology shifts. This is followed by the handle, which is effectively a small flag, which finalizes the pattern.
Conclusion
Technical analysis is more akin to a social science, than a mathematical science.
In other words, it is a skill about interpreting the collective psychology of the market.
For those of us in the commodity world, whether as specs, physical traders, consumers or producers, understanding market psychology is essential. For even the most devoted fundamental trader will admit as Lord Keynes supposedly said that, “the market can remain irrational longer than we can remain solvent.”
As fundamental traders, we believe that ultimately the market will eventually come back to the value as denoted by supply and demand, but only in the long term.
In the present, though, technical analysis can help us understand the human behavior behind momentum and trends, that will provide some insight into what comes next. At the end of the day, markets are dictated by people, with their own beliefs, biases, anxieties, hopes and fears.
For traders, continuation patterns are an essential tool for finding opportunities. They establish criteria that allow us to determine when a - seemingly weakening trend - might actually be set to continue.
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