Summary:
In the context of the stock market, a continuation pattern refers to the concept of technical analysis which indicates a momentary pause or consolidation in the current trend of an asset or stock. This blog explains how investors use it for making informed trading decisions.
Introduction to continuation patterns
In the context of the stock market, a continuation pattern refers to the concept of technical analysis which indicates a momentary pause or consolidation in the current trend of an asset or stock. Usually, these patterns indicate that after a small period of consolidation, the current trend will in all likelihood resume. To put it simply, the continuation patterns suggest that the asset or stock is taking a pause before resuming the previous movement in price, irrespective of whether it is a downtrend or uptrend.
Types of continuation of patterns:
Continuation patterns are of two types:
- Bullish continuation patterns: These patterns take place during an uptrend and indicate that the upward trajectory will continue after the consolidation phase. Bullish continuation patterns usually include:
- Flag pattern: Here, the pattern is similar to a flag on a flagpole and entails a sharp movement in price (the flagpole), which is followed by a consolidation that is rectangular (the flag).
- Pennant pattern: Like the flag pattern, this pattern has a sharp movement in price, which is followed by a brief triangle-shaped, symmetrical consolidation.
- Bearish continuation patterns: These types of patterns take place during an existing downward trend and suggest that the movement will continue along that path after a consolidation period. Some of the common bearish continuation patterns are:
- Descending triangle: This pattern is seen when there is a downward trend and entails a flat support level and a trend line that is descending. It indicates that the sellers are still in control.
- Bearish flag: Like the bullish flag, this pattern includes a sharp decline in price, which is followed by a rectangular consolidation, suggesting the possibility of further downside.
Trading techniques using continuation patterns:
The use of continuation patterns for formulating trading strategies includes the identification of these patterns on price charts and then making trading decisions depending on the expected direction of the price breakout. The following are a few of the common trading strategies that rely on the use of continuation patterns:
Breakout trading:
- Entry: This includes waiting for the price to break out from the continuation pattern. In the case of a bullish flag pattern, there is a need to wait till the price breaks above the upper trendline.
- Stop-loss: Traders usually set a stop-loss order just a little below the breakout point of the pattern in order to curb possible losses.
- Take profit: Investors set a take-profit order by studying the projected price movement of the pattern.
Volume confirmation:
Traders keep a close eye on trading volumes when there is a formation of a continuation pattern. With high volume, a breakout tends to be more reliable because it suggests conviction and strong market participation. Investors look for escalating volumes when the price nears the breakout point of the pattern.
Trend confirmation:
Traders look to confirm the alignment of the continuation pattern with the prevailing trend. In the case of bullish continuation patterns, traders try to ensure that there is an existing upward trend. In the case of bearish continuation patterns, they look to make sure that there is a downward trend. The stronger the trend, the greater the chances of a successful breakout.
- Pattern combos: Investors who are looking to make informed decisions use continuation patterns in combination with other types of technical analysis tools and indicators. In the scenario when moving averages are being used, the use of 'Relative Strength Index' and 'Moving Average Convergence Divergence' can be used to ascertain a breakout and its direction.
- Risk management: Investors implement risk management tools such as the setting of stop-loss orders and position sizing so that they can protect their capital if the trade turns in an unfavourable direction.
- Multiple timeframes: Investors who try to have an edge analyse the same continuation pattern using several; these include daily and hourly charts. Through these, traders are able to have an enhanced understanding of the significance of the pattern and the possible direction of the breakout.
Summing up
Investors and traders rely on the use of continuation patterns in combination with other technical analyses to make decisions with regard to trading. When they are able to see the formation of a continuation pattern, they try to predict the direction of the breakouts (down or up). They put this information to use and enter/exit positions.
However, it is needed to be said that no technical analysis tool, continuation pattern, in this case, is foolproof. Factors such as volume, market conditions and fundamental analysis need to be taken into consideration when trading decisions are being made. Continuation patterns can often be unreliable because of false breakouts, low volatility, market whipsaws, pattern failures, excess reliance, false sense of security and inability to factor in unforeseen events. With a little caution though, continuation patterns can be a handy tool for investors looking for trends in assets and stocks of their liking.