Continuation patterns are an important instrument to each trader’s success. Still, especially new traders shy away from trading continuations patterns because of their similarity, thereby surrendering good trading opportunities.
Conversely, your ability to correctly determine which pattern you are dealing with can greatly benefit your trading success. Therefore, this article will compare the most important continuation patterns, and help you find out which one is currently developing in your chart.
The difficulty in comparing continuation patterns
The three most important continuation patterns are:
Each of them is created when an established trend needs to go through a consolidation period to generate enough momentum to continue in its original direction. During this time, a stock’s price is confined to a narrow trading range between an upper resistance level and a lower support level.
The shape these two levels form defines the pattern:
- When both lines are converging, they form a pennant or a triangle pattern.
- When both lines are parallel, they form a rectangle pattern.
- When both lines are parallel, yet inclined or declined, they form a flag pattern.
Knowing which pattern you deal with is important. For example, if you are planning on trading the price breaking out of the pattern, it is important to know where the resistance level and the support level are. In a pennant pattern both levels will continually become narrower, which will make a big difference to the parallel lines of a rectangle pattern, especially near the end of the pattern.
The same applies to trading a No Touch option. In this case, you have to define a price outside the trading range of the pattern. Depending on which pattern you see, the trading range can vary greatly.
To understand how hard it can be to tell one pattern from the other, take a look at the picture below. You will see a flag pattern drawn into the chart. Yet, when looking at the relatively constant upper trading range of the pattern, a trader could have easily defined this as a triangle pattern, too.
How to figure out the right continuation pattern
This uncertainty about which formation is developing makes many traders shy away from trading continuation formations, thereby surrendering good trading opportunities. There are, however, a number of tools to help you figure out which formation you are dealing with.
First of all, there are candlestick formations. If you are looking to invest in a No Touch option, but are unsure whether you are dealing with a pennant pattern or a rectangle pattern, you can look for candlestick formations near the price range where the resistance or support levels of a pennant would be. If you find them, you are probably dealing with a pennant pattern. If there is none, you are probably dealing with a rectangle.
- Further reading: Comparing candlestick formations
Secondly, if you are completely unsure what pattern you are dealing with, focus on the resistance or support level in trend direction. As you can see in the picture above, prices were in a downtrend. Therefore, the upper resistance level is hard to determine. Depending on which candlestick you start with you can easily come up with a straight or a declined resistance level, resulting in a rectangle or a pennant pattern. When you look at the lower support level, however, you can easily see it is inclined. This eliminates the rectangle pattern. Now you know you are dealing with a pennant pattern.
In general, because there are less confusing candlesticks on the far side of a trend, the price level in trend direction is usually the stronger indication on which pattern you are dealing with. In a downtrend, focus on the lower support level. In an uptrend, focus on the upper resistance.
Thirdly, if all else fails, you can use the momentum to judge when the pattern is complete. If you are unsure whether you are dealing with a pennant pattern or a rectangle pattern, it is hard to determine whether prices have already broken out of the pattern or are still moving within its range. To overcome this problem, remember that you will see a strong price movement with a lot of momentum once the pattern is completed.
As long as this movement has not occurred, the pattern is still ongoing. If the lines of your pennant pattern have crossed, but there is no movement with momentum, you have to either adjust your resistance and support levels for the pennant or reevaluate whether you might be dealing with a rectangle pattern.