- 2000: Volume 9, No. 2 Chartist Corner: Continuation Patterns

Just like an automobile heading out for a long journey, trending markets need to rest occasionally to refuel. These "rest stops" are called congestion zones. Congestion zones are price levels where the bulls and the bears are taking their profits, licking their wounds and rethinking their strategies. In an earlier edition of Chartist Corner we talked about certain types of congestion zones as being reversal signals. In this edition we'll talk about the other variety of congestion zones called continuation patterns. Here, the market rests for a while and then continues on its way in the direction of the original trend.

Rectangles

A rectangle pattern is simply a region bound by a support line on the bottom and a resistance line on the top. The market trades up and down between these two levels for a number of periods (these periods can be days, weeks or even ticks), depending on the type of chart being used. Figure 1 shows the December MATIF bond contract, tick by tick, at the end of September 1993. The market began its short-term rally on the 24th of the month and on the 27th it began consolidating those gains in a rectangle pattern. After bouncing around all day in a less than 20 tick range, it broke out to the upside the next day with a strong morning rally.

Figure 1

This rectangle pattern can be seen in longer charts, too. Figure 2 shows a weekly chart of the U.S. Dollar Index from early 1989 to late 1991. Here, the market was falling from mid-1989 until it entered a rectangle pattern. Note that the last rally attempt within the rectangle failed to reach the top boundary. This is a sign of weakness in the market and is a very good indication that the trend will continue lower.

Figure 2

It is important to let the market prove that the rectangle is a continuation pattern by letting it actually break out. Rectangles and the other patterns described below usually break in the direction of the original trend but not all of the time.

Triangles

This type of continuation pattern has converging lines of support and resistance. Some traders refer to triangles as "coils" because the trading action gets tighter and tighter until the market breaks out with great force. Again, the breakout usually, but not always, occurs in the direction of the original trend. The triangle highlighted in the U.S. Dollar Index had a very strong breakout lower (Figure 2). The declining price range in triangles makes "buying volatility" a very good options strategy (buying volatility involves buying combinations of options such that the trader profits from large moves in either direction.).

Triangles come in several varieties. The U.S. Dollar chart showed a symmetrical shape. The December CBOT U.S. Treasury bond was in an ascending triangle pattern during much of the first half of 1993 (Figure 3-daily data). An ascending triangle has a relatively flat top boundary with a rising bottom boundary. Conversely, a descending triangle (see Figure 4) has a relatively flat bottom boundary and a falling top boundary. Both of these point in the direction of the likely breakout.

Figure 3

Figure 4

Another important point to keep in mind when analyzing triangles is that a breakout is significant if it occurs approximately two-thirds of the way from the left side of the triangle to the apex (the apex is where the two lines would meet if they were extended). If the price action continues to bounce around in the triangle close to the apex, a breakout is less significant and other technical indicators should be used.

Flags

The most common of the continuation patterns is called a flag because it resembles a flag flying on a flagpole. When a market is trending higher, it is more common for it to slowly give back some of those gains as the bulls take some profits. Since traders do not do this all at the same time, the market displays a small counter trend lower as more of them take their profits. When this is over, the market generally breaks out in the direction of the original trend as the bulls re-take their long positions and new bulls enter the market at the new attractive price level. The CME December S&P 500 fell sharply on September 21 due to the news of political unrest in Russia. Even during this fast market trading, prices staged a rebound as some of the bears took their profits and some bulls came in to buy at the lower price, thinking that the market had gone down enough. Prices eventually broke out lower than the flag and the market continued to plummet.

Michael N. Kahn is a columnist for Barron's Online based out of Florida. He also writes a free technical newsletter. To subscribe to this service, please visit www.midnighttrader.com. The complete collection of Michael Kahn's "Tips on Technicals" is available in Real World Technical Analysis.