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In this article we’re going to have a look at continuation patterns. These are in contrast to the reversal patterns we’ve already treated in a previous blog post here. My main source is the comprehensive Technical Analysis of the Financial Markets by John J. Murphy (purchase here in association with FuturesTechs).

As the name suggests, continuation patterns imply that the prevailing trend will be maintained, not reversed. They occur as relatively short phases of consolidation or uncertainty within a longer-term trend.

We’ll start by looking at triangles. These come in three varieties: symmetrical, ascending and descending.

The symmetrical triangle occurs in the situation when we can draw trendlines above and below the price action (connecting at least two, and preferably three points for each line). Its forecasting implication depends on the prior trend. Here’s an example during a major rally in Corn in 1996:

The prevailing uptrend ran into a little bit of resistance. We dropped back, proceeded to find some support, and then created a lower high and a higher low. This narrowing consolidation was resolved to the upside with a clean break through the down-sloping trendline, when the uptrend continued strongly. The pattern is complete and the prior trend has resumed.

Next up is the ascending triangle. This is when we have a flat trendline at the top of the pattern, but a rising trendline at the bottom. It shows that demand is getting firmer, causing shorter pull-backs, but with the same resistance level being tested at the top of the pattern. So buyers are gaining in strength sufficiently to produce higher lows, but sellers are failing to do likewise by producing lower highs.

This is psychologically bullish and thus gives the positive forecastings implications for the pattern. We generally see this pattern during bull markets, and expect it to be resolved to the upside. Here’s an ascending triangle for BAY:

Now let’s look at the descending triangle. As you might imagine, we’ve got a descending upper line and a flat lower line with this one, and bearish forecasting implications. We see it in a downtrend, and we expect the trend to be maintained, just as we should have with TWOD:

There are measuring targets with all of these, which are simple to calculate: find the vertical distance between the lines at the first high or low being used for a trendline (this is the length of the base) and project that distance up or down from the breakout point.

Note that none of the forecasting implications described here are cast-iron certainties, merely tendencies. Sometimes, a triangle will turn out to be a reversal and not a continuation pattern. We are only ever dealing in probabilities when we try to forecast using price patterns.

Next, let’s look at the flag. We’ll look at an example which occurred during a downtrend in Natural Gas:

The flag is generally a shorter-term pattern than the ones we’ve already mentioned. It is really just a “blip” within a long-term bull or bear market, when the price briefly trades in the opposite direction to the prevailing trend. In the above bear market, then, we see a series of sessions when the price showed a bit of strength. We get parallel trendlines above and below the price, and the pattern was resolved when we were seen conclusively through one of the lines (this should be the lower line in a bear market, or the upper line in a bull market).

Here’s a flag visible on the 180-minute chart of a bull market in Copper:

Finally, let’s look at the pennant, a closely related pattern.

This could be possibly be described as a “small symmetrical triangle”. Like the flag, it appears as a short period when the prevailing trend loses its vigour. However, instead of seeing highs and lows in an opposite direction to that prevailing trend, we see the range narrow with higher lows and lower highs. Here’s an example in the CAC:

Flags and pennants should occur during a strong up or down move, and these patterns should just be a minor pause in that move. One method of projecting targets is to measure the length of the prior move and to project that far from the breakout point (i.e. assuming that the pattern happened roughly halfway along a bull or bear run).

As far as volume considerations for all of these patterns are concerned, the general principle is that volume goes with the major trends: that means it should initially be at normal levels for bulls or bear markets, calm down as the market consolidates, and than increase again when the pattern is resolved. Within the pattern, we would be encouraged to see the volume relatively larger during the small movements aligned with the major trend.

That rounds up our discussion of continuation patterns. None of them are fool-proof, but they can help to map out short term corrections and sideways movements. For more detail, and for other patterns, I recommend Murphy’s book.

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Graham Neary MSTA (graham@futurestechs.co.uk)

One of the premises of tecnical analysis is that price patterns tend to repeat themselves. But what are these patterns? Today, we’re going to lookat reversal patterns, i.e. where a change of trend is indicated.

Perhaps the most famous of these is the Head and Shoulders pattern.

Here is the Dow weekly candlestick chart, showing how this topped out in 2007.

The general picture behind the Head and Shoulders is as follows: we start off with an uptrend, which proceeds as normal creating higher highs and higher lows.

The initial warning sign is a failure to create a higher high. This is the top of the “Right Shoulder” on the above chart.

Our technique then is to connect the two most recent lows. This isn’t a proper trendline (which should really connect three points) but instead is the “Neckline” of what is still only a potential Head and Shoulders pattern.

The Head and Shoulders pattern is completed by the break through the Neckline. Sometimes, the bulls will have a go at recapturing it, just as they did in the case of the Dow. What really strengthens the bear story, and is something you can look for, is if the broken Neckline then turns resistance. This happened with the Dow, making this a textbook case of the Head and Shoulders pattern.

Note that the Neckline was broken briefly on the retest; the danger of getting a false signal in this way is limited by placing certain conditions on what sort of a break is required. For example, demanding two consecutive closes above the Neckline (the “Two Day Rule”) would have prevented us from getting whipsawed by thinking that the Head and Shoulders pattern was being negated.

The above chart shows the standard method for constructing measuring targets with the Head and Shoulders pattern. Find the height of the head and then target that distance below the Neckline, measuring from where it broke (so we would target the red horizantal line in the above case).

The Inverse Head and Shoulders is based on the same idea, reversing a downtrend. Here’s Light Sweet Crude Oil changing direction in this way in 2007. Observe the broken Neckline providing support twice:

Now let’s look at Double Tops and Double Bottoms. The Double Top is formed when, in an uptrend, we run into resistance twice at the same level. We then fall through the intermediate low, completing the pattern and providing a sell signal. The broken Neckline can turn resistance, as it did with the DAX futures between 2007 and 2008; see the weekly candles chart below

Here’s an example of a Double Bottom, this time on a bar chart. It’s Vodafone at the bottom of the bear market in 2009, finding support at the same level twice, then beating the intermediate high and continuing the move.

In this case, our measuring target would be similarly calculated as with the Head and Shoulders patterns, i.e. the height of the pattern projected from the breakdown point. In this case, it’s 123.60 plus 12.40, i.e. 136.00.

Here’s an example of a Spike, or V-Reversal.

The Spike is really just the name for a market which reverses direction without giving any proper clue in tertms of hte preceding pattern that this was likely. This is the market turning “on a dime”, and the most difficult to trade.

The only clue at the top of the above chart that Wheat was turning was the “Harami Cross” candlestick pattern at the top (that’s the Doji contained within the range of the long green candle). When a Spike happens, our only recourse is to short-term signals such as candlesticks.

Finally, here’s a Saucer Bottom in Corn futures (the Saucer Top is the equivalent reversal of an uptrend). This is the opposite to the Spike, the price very gradually changing direction.

As technicians we much prefer to see a Saucer Bottom or Top than a V Reversal, with the slow move giving us lots of time to change skew.

Volume

One thing we haven’t mentioned much so far in this article is the role of volume in all of these patterns. Volume - the level of trading activity taking place over any period - is an essential component of technical analysis and an important part of pattern recognition.

The general principle is that volume accompanies movements with the trend. In terms of trend reversals, then, we should see the volume faltering during those final movements with the old trend, and eventually picking up as the new trend takes over.

In the case of the Head and Shoulders pattern, for example, volume should be weakest during the Third Shoulder, as enthusiasm for the dying bull market begins to evaporate.

A distinction can be made here between tops and bottoms. It is generally recognised that volume is not so important for tops as it for bottoms: at tops, market can “fall of their own weight” with buyers simply failing to show up, and volume not increasing.

Bottoms, on the other hand, generally involve mass participation, with active buyer enthusiasm being the main driving force behind the move.

Variations

There are several variations on the patterns mentioned here, in particular the Complex Head and Shoulders, the Triple Top and Triple Bottom. The Triple Top and Triple Bottom are fairly self-explanatory, while the Complex Head and Shoulders generally involves multiple shoulders on one or both sides of the Head.

The principles of volume analysis and the measuring techniques for these patterns are much the same as for the patterns already described here.

Conclusion

These patterns, without being infallible, help us to map out major changes in trend. They are generally medium and long-term patterns, with their significance and measuring targets in proportion to their size.

We incorporate these patterns into our daily analysis of the futures and FX markets. If you would like to sign up for a trial of our services, click here. For a free trial, click here.

Graham Neary MSTA (graham@futurestechs.co.uk)