Chart Classics: Reversal And Continuation Patterns

By Mark Etzkorn

In "Basic Chart Analysis: Trends, Trading Ranges and Support and Resistance,"
we discussed some of the fundamental concepts of price action and chart
patterns. Here, we'll delve into a little more detail about some of the well-known
chart patterns, how they reflect basic price action principles and what to
understand about the trade signals they provide.

At the simplest level, chart patterns can be divided into reversal patterns and
continuation patterns, and both categories are exactly what they sound like:
Reversal patterns suggest the culmination of trends and a change in price
direction; continuation patterns imply a resumption of an existing trend and are
usually shorter in duration than reversal patterns. (Some short-term patterns that
consist of only one or two bars, such as gaps, reversal days and spikes, will be
discussed in an upcoming article.)

These reversal and continuation patterns include

Chart patterns
some of the "classic" chart patterns, such as double imply different
tops and bottoms, head-and-shoulders, triangles, price
flags and pennants. Rather than discussing these
patterns in detail, we will instead discuss their
developments,
characteristics and try to eliminate some of the depending on their
confusion surrounding them. It is actually more context
beneficial not to dwell initially on every idiosyncrasy of
every pattern variation, and instead understand what these patterns represent in
terms of possible price action. While the names of some chart patterns--and the
implications many traders attribute to them--can seem obscure or esoteric, the
ideas behind them are usually very simple.

The importance of context

Before discussing specific patterns, we need to make an important, but often

overlooked point: Chart patterns imply different price developments, depending
on their context. A pattern that occurs in the middle of a choppy trading range
may mean something completely different than a similar pattern that occurs in a
trending market.

It's also necessary to consider the time frame of a particular pattern to better
understand its potential. Shorter-term patterns (say, a five-day trading range, or
flag) generally imply shorter-term price reactions; longer-term patterns (such as a
slowly developing double top), signal the potential for much more significant price
reactions.
As noted in "Basic Chart Analysis: Trends, Trading
Ranges and Support and Resistance," the underlying A continuation
logic of these patterns and principles are constant, pattern is a period
regardless of the time fame chart you consult. Pattern of price congestion
examples will be shown on intra-day, daily and weekly
charts just to underscore this point. or consolidation
that interrupts a
A reversal pattern like a double top on a weekly chart trend
implies the same kind of price action it does on a 15-
minute chart, just of a different magnitude: The signal on the weekly chart
suggests the potential for a major trend reversal, while the signal on the 10-
minute chart would imply a reversal of the very short-term (probably intra-day)
trend.

Continuation patterns

A continuation pattern is a period of price congestion or consolidation that

interrupts a trend, a concept familiar to anyone who attempts to enter trends on
corrections, or pullbacks. A breakout of the pattern in the direction of the previous
trend is the standard entry signal and represents a resumption--a continuation--of
the trend. The best-known continuation patterns are triangles, pennants and
flags.

Triangles Figure 1 shows an example of a triangle: a congestion period in which

price swings progressively into a narrower and narrower range, and trendlines
drawn to define the upper and lower boundaries eventually intersect to form a
triangle. Triangles represent a progressive compression of prices (increasingly
low volatility), a condition from which markets often make sharp or dramatic price
moves. (There are a variety of triangle "types"--symmetrical, ascending,
descending--but for now these distinctions are not important; these variations all
share the same principles.)

While triangles also can act as reversal patterns after long trends, they are more
commonly continuation patterns. A breakout of the triangle in the direction of the
trend signals the trend has resumed, while a breakout through the opposite side
of the triangle would imply the trend is in jeopardy or has reversed.
Figure 1. Amazon.com (AMZN), 30-minute bar. A convincing breakout to the
upside or downside will be necessary to determine whether this triangle is a pause in
an uptrend initiated by the previous trading range breakout, or a top pattern that
reverses the quick up move. Note the different ways the upper boundary of the
triangle could be have been re-drawn (the red and blue lines). Using the red line that
connected the first high with the next swing high, price is already above the upper
boundary--but has not convincingly followed through. Source: Quote.com.

The triangle in Figure 1 developed immediately after a strong upside breakout

and accelerated rally (it's not surprising the market would "catch its breath" after
such a run-up). A convincing up move out of both the triangles outlined here (and
even better, and move above the relative high that began the larger triangle)
would cast the pattern as a continuation; a solid move below the low the triangle
would make the pattern a reversal.
Figure 1a. Update: Amazon.com (AMZN), 30-minute bar. The triangle pattern
extended the next trading day (10/4/99). Note that while the triangle boundaries
could be (subjectively) re-drawn as time passed, the fundamental logic of the
pattern--that price is consolidating and poising to break out--remains intact. Source:
Quote.com.

Update: As of the close of trading on 10/4/99, the triangle pattern had extended
(AMZN closed down 3/16) on a relatively strong up day for the overall market
(see Figure 1a). The stock tried break through the lower boundary of the triangle,
but did so unconvincingly.

Pennants Pennants are essentially shorter-term triangle patterns--less than a

month in length on a daily chart, for example. They are still congestion patterns,
however, and are interpreted the same way as their larger counterparts.

Flags Like pennants, flags are also shorter-term congestion patterns, but the
lines defining their upper and lower boundaries run parallel instead of
converging.

Flag patterns are really short-term trading ranges; a minimum number of bar
would be 3-5; as is the case for pennants, a flag that extends to approximately
twenty or more bars is more properly classified as a trading range. Flags may
form both diagonally (usually against the direction of the trend, as in a correction
or pullback formation) instead of horizontally. Figures 2 and 3 show examples of
pennants and flags.
Figure 2. Oct. '99 sugar futures (SBV9), daily. Flags and pennants (or triangles?)
interrupt trends on this daily chart and offer short-term support and resistance
levels at which to enter trades and place logical stop-loss orders (at the opposite
boundary of the pattern from which the trade is entered). Source: Quote.com.

One interesting aspect of this chart is the congestion pattern that forms in May
and early April in Figure 2. Is it a pennant or triangle? In a sense, this example
shows how subjective chart analysis can be. The pattern is a little over 20 bars in
length--a little over a month. It’s a little long for a pennant, and would probably
best be labeled a short triangle.
Figure 3. Bristol-Meyers Squibb (BMY), five-minute bar. Flags and pennants on an
intra-day chart. Source: Quote.com.

However, it’s not the name that's important, it's what a pattern suggests the
market might do. In this case, a downtrending market is consolidating in an
increasingly narrow range. The astute chartist would not get hung up on counting
the precise number of bars and labeling the pattern, he or she would be more
interested that the pattern was offering the potential to enter the downtrend on a
downside breakout of the pattern, or possibly go long (or liquidate existing shorts)
if price instead broke out of the upside of the pattern.

Further, chart patterns are rarely contained perfectly inside the lines defining their
upper and lower levels; slight penetrations are the rule rather than exception, as
is clearly illustrated in these examples.

Continuation patterns imply indecision in a market; it

It’s not a pattern's
is during these periods that traders look for new name that's
opportunities to enter an existing trend (or add important, it's what
additional positions) on a breakout in the direction of
the trend or to lighten up or liquidate positions if the
the pattern
pattern "fails"--that is, resolves against the direction of suggests the
the trend. market might do
As these charts make clear, there's nothing too complex going on here. All
continuation patterns reflect the same kind of market behavior--congestion. As
far as the price action they imply, they are really no different than trading ranges.
When the pattern is resolved, the trend should resume. If price breaks out of the
opposite side of the pattern, it suggests a disruption in the trend. The tighter and
longer the congestion pattern, the greater the chances of a forceful move out of
the pattern.

Effective risk control Notice in all these examples, the patterns offer clear entry
points and stop levels. Chart pattern boundaries allow you to place logical,
market-based stops that take you out of trades when the price action suggests
the market's outlook has changed. (This will hold true for the reversal patterns we
discuss in the next section as well.)

For example, if entering a long trade on the upside breakout of a flag, the bottom
of the flag (in practice, somewhat below it) makes a perfect stop level: If the
market reverses and trades below this level, it suggests the outlook and
dynamics that justified the original long trade are not longer valid. If that's the
case, common sense dictates it's time to get out of the trade--or take one in the
opposite direction if the evidence is there to support
the decision.

Seasoned traders
Having the flexibility to trade such failed signals is one go with what the
of the hallmarks of seasoned traders. They know to market is telling
go with what the market is telling them now, rather
than brooding on what it was telling them five days
them now, rather
ago. The flag in Figure 3 fails to break out in the than brooding on
expected direction (up); the alert trader would what it was telling
recognize this as a sign of weakness and would either
liquidate or lighten existing positions, or choose to go
them five days ago
short.

Also, in the case of very narrow continuation patterns, the small risk makes it
easier to take a second shot at a trade signal if stopped out the first time. Again
using a hypothetical flag example, if the market reversed to just below the lower
range of the flag (stopping you out), you could re-enter on another move above
the upper range of the flag if the market reversed again to the upside with
nothing much lost. Figure 2 shows two especially short, narrow flags that would
have offered low-risk opportunities.

Reversal patterns

Reversal patterns occur at the tops and bottoms of markets and imply a change
in direction of the major trend. Most of them are really specialized versions of the
support and resistance principles discussed in "Basic chart analysis: Reversal
and continuation patterns."

Using such patterns involves recognizing them as they are developing, and
finding logical entry points and stop levels.

Double tops and bottoms For example, the double top pattern pictured in
Figure 4 reflects the idea that if a market makes a new high, corrects, advances
again toward the previous high, and then falls again, it has failed to break
through the resistance implied by the first high, and a reversal is likely.
Obviously, such a signal would be more meaningful after a long uptrend, as in
this example. The situation would be reversed for a double bottom. Triple tops
are the same concept except that, not surprisingly, one more high (or low) is
involved.
Figure 4. IBM (IBM), weekly. Penetration of relative low between the peaks of the
double top marks a logical downside entry point (or liquidation point for existing
longs); a stop would be placed above the high of the pattern--the same spot at which
a breakout trader would go long on the resumption of the major trend (This stock
dropped--but did not close--below the relative low entry point on 10/1/99.). Source:
Quote.com.

A logical point to enter trades on double tops or bottoms is on a move below the
relative low between the two peaks of a double top, or above the relative high
separating the two troughs of a double bottom. The relative lows and highs
represent shorter-term (secondary) support and resistance, that when violated,
confirm price reversals. Conversely, stops can be placed above the high of a
double or triple top, or below the low of a double or triple low. A surge past the
high of a double top or below the low of a double top negates the original
premise of the pattern, so such levels are prudent choices both for stops and for
trade entries based on the failure of the original reversal pattern.

Head-and-shoulders The head-and-shoulders pattern is really just a more

complex version of the double and triple top price behavior discussed in the
previous section. You can click here to go to an in-depth discussion of this
pattern in the Trading Q&A section that includes an analysis of an interesting
example in the S&P 500 index.
Figure 5. Dec. '99 S&P futures (SPZ9), weekly. "H" marks the head and "S" marks
the shoulders of this nearly textbook head-and-shoulders pattern on the weekly S&P
chart. Source: Quote.com.

Figure 5 shows an head-and-shoulders pattern forming in the S&P futures. Note

that the pattern would be much less significant had it occurred formed in the
middle of a choppy, trading range period, or after only a small rally. In this case,
the pattern's appearance after an extended uptrend makes it especially worthy of
consideration.

Common Characteristics

What do these reversal patterns have in common? They represent declining

market momentum, assuming we are only considering patterns that form after
established trends.

Again, this is only common sense. All trends must end. The longer a market
trends, the closer it is to its eventual reversal. When a market enters a
congestion period and/or hits resistance overhead or support below after a long
trend (which is a good working definition of a reversal pattern) it is only natural to
consider the possibility the market may reverse. As was the case with the
continuation patterns in the earlier section, the boundaries of reversal patterns
offer clearly defined entry and stop levels.

Being practical about chart patterns

As we've pointed out, one good thing about simple chart patterns is that it’s easy
to tell when things go wrong: If the market goes in the opposite direction implied
by a chart pattern, you know you should get out--or reverse your position. And as
we've illustrated, it's easy to find logical levels at which to place your stops:
slightly above or below the opposite side of the pattern.

Of course, because common-sense stop levels are so easy to determine, you

also run the risk of having your stop triggered (with all the other traders who have
placed their stops at the same level) when floor traders and other pros go "stop
hunting"--pushing prices up or down to areas they think stop orders are clustered
to take advantage of the quick price burst that occurs when many stops are
triggered at once.

Also remember that every wiggle on a chart is not

Not every wiggle
necessarily significant--there's a great deal of on a chart is
meaningless fluctuation--noise--on any chart. significant; all
Unfortunately, a valid criticism of chart analysis is that
it’s too subjective--that is, patterns are in the eye of
charts contain a
the beholder. This complaint is absolutely true. It is great deal of
difficult to test trading strategies based on many of the "noise"
patterns described here, and some traders never feel
comfortable with techniques that do not submit to rigid mathematical definition.

The only way to improve chart analysis is through experience and by applying a
little common sense when interpreting patterns. Remember, the context of a
particular pattern is just as important as the pattern itself. Something that looks
like a pennant in the middle of a trading range is not significant; the same pattern
in the middle of a trend, is.

Confirming trade signals

Chart patterns are not magic signals, they're simply price developments that
suggest the possibility of certain kinds of market behavior--e.g., trend
continuation or trend reversal--and are based on the simple concepts of support
and resistance.

Successful chart-based trading requires knowing when to get out of a trade that
isn't working by using stop orders placed at levels representing the failure of a
pattern--a sign the market's character and outlook has changed--and confirming
trade signals when they occur with other patterns or filters that support taking the
trade (such as going short only after two closes below the relative low between
the two peaks of a double top).

While we've only touched on the types of chart patterns, the basic principles of
interpreting and trading different varieties remain constant. The most important
thing to remember about chart patterns is that they all revolve around either
trend, price congestion or price extremes--all very simple concepts. It's not
necessary--and certainly not advisable--to make trading more complex than it
has to be.

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