Continuation patterns

What Are Continuation Patterns?

Continuation patterns are a category of chart patterns observed in technical analysis that suggest an existing market trend is likely to continue after a brief pause or consolidation. These patterns indicate that the forces driving the prevailing price action are still dominant, and the temporary halt in price movement is merely a period of accumulation or distribution before the trend resumes. Unlike reversal patterns, which signal a change in direction, continuation patterns imply a temporary hesitation within an ongoing uptrend or downtrend.

History and Origin

The study of chart patterns, including those that suggest continuation, is deeply rooted in the history of technical analysis. The foundational concepts of technical analysis emerged in the late 19th and early 20th centuries through the work of Charles Dow, co-founder of Dow Jones & Company and The Wall Street Journal. Dow's observations on market behavior and price movements laid the groundwork for what became known as Dow Theory, which posits that market prices move in trends and that these trends are confirmed by various market behaviors.¹¹

While Charles Dow himself did not explicitly categorize "continuation patterns" as such, his emphasis on recognizing and following trends provided the intellectual framework for later technical analysts to identify and codify these recurring formations. Early practitioners used hand-drawn charts to track price and volume data, noticing that certain patterns often preceded a resumption of the dominant trend.¹⁰ Over time, pioneers like Richard Schabacker and Robert D. Edwards and John Magee formalized the study of these patterns in influential works such as Technical Analysis of Stock Trends, categorizing shapes like triangles, flags, and pennants as signals for ongoing trends.

Key Takeaways

• Continuation patterns suggest that a prevailing market trend will resume after a temporary pause.
• Common examples include flags, pennants, symmetrical triangles, ascending triangles, descending triangles, and rectangles.
• These patterns are characterized by a period of consolidation following a strong price move, often accompanied by decreasing volume.
• A subsequent breakout from the pattern, typically on increased volume, confirms the continuation of the original trend.
• Traders and analysts use continuation patterns to identify potential entry and exit points in line with the existing trend.

Formula and Calculation

Continuation patterns are visual constructs within price charts and do not have a specific mathematical formula for their formation. However, their interpretation often involves measuring potential price targets after a breakout.

For patterns like flags and pennants, the typical calculation for a price target involves projecting the length of the prior trend (often called the "flagpole") from the point of breakout.

Let (P_{breakout}) be the price at which the asset breaks out of the pattern.
Let (L_{flagpole}) be the vertical length of the price move immediately preceding the pattern (the "flagpole").

For an uptrend continuation pattern:
$\text{Target Price} = P_{breakout} + L_{flagpole}$

For a downtrend continuation pattern:
$\text{Target Price} = P_{breakout} - L_{flagpole}$

For triangle patterns, the height of the widest part of the triangle is often projected from the breakout point.

Let (H_{triangle}) be the vertical height of the triangle at its widest point.

For an uptrend continuation triangle:
$\text{Target Price} = P_{breakout} + H_{triangle}$

For a downtrend continuation triangle:
$\text{Target Price} = P_{breakout} - H_{triangle}$

These are illustrative projections and not guaranteed outcomes. The measurement of the "flagpole" or "height" depends on the specific trend lines drawn by the analyst.

Interpreting the Continuation Patterns

Interpreting continuation patterns involves observing specific visual characteristics on a price chart and understanding their implications for market sentiment. When a continuation pattern forms, it typically follows a strong directional price move. This strong move represents the dominant trend, whether it's an upward surge or a downward slide. The pattern itself signifies a temporary pause where buyers and sellers are re-evaluating, leading to a period of indecision or mild counter-trend movement.

For instance, in an uptrend, a continuation pattern might appear as a small, contained pullback or sideways movement. This suggests that while some profit-taking may be occurring, new buyers are stepping in, or existing holders are not capitulating, thus maintaining the underlying bullish pressure. Conversely, in a downtrend, a continuation pattern indicates that despite a brief rally or sideways movement, sellers remain in control and are likely to push prices lower once the pattern resolves. The support and resistance levels within the pattern, combined with volume analysis, provide clues about the strength of the underlying trend and the likelihood of its continuation. A breakout from the pattern, particularly on increasing volume, is often interpreted as confirmation that the original trend is resuming.

Hypothetical Example

Consider a hypothetical stock, "Tech Innovations Inc." (TII), which has been in a strong uptrend, rising from $50 to $70 over several weeks. After reaching $70, TII's price begins to form a "bull flag" continuation pattern.

1. Prior Trend (Flagpole): The initial sharp rise from $50 to $70 forms the "flagpole" of the pattern.
2. Consolidation (Flag): The price then begins to drift slightly downwards in a tight, parallel channel, or trades sideways within a small rectangular area between $67 and $69. This sideways or slightly downward movement represents the "flag" portion of the pattern. During this period, trading volume is noticeably lower than during the initial flagpole rally, indicating a temporary lack of conviction from both buyers and sellers.
3. Breakout: After about a week of this consolidation, TII's price suddenly breaks above the upper boundary of the flag pattern, pushing past $69 and then $70, often accompanied by a sharp increase in volume. This breakout signals the likely resumption of the uptrend.
4. Target Projection: Based on the flagpole measurement (a $20 rise from $50 to $70), a technical analyst might project a potential target price by adding $20 to the breakout price of $70, aiming for a target of $90.

This scenario illustrates how a continuation pattern can provide a potential entry point for traders expecting the underlying trend to persist.

Practical Applications

Continuation patterns are widely applied in financial markets across various asset classes, including stocks, commodities, forex, and futures. They serve as visual cues for traders and investors aiming to identify opportune moments to join an existing trend or manage open positions.

One primary application is in identifying potential entry points. For instance, a trader might seek to enter a long position in an asset that has formed a bullish flag or pennant after a strong upward move, anticipating the uptrend to resume. Conversely, a bearish flag or pennant following a sharp decline could signal an opportunity to enter a short position as the downtrend is expected to continue.

Continuation patterns are also integrated into more sophisticated trading strategies, including algorithmic trading systems. While purely technical analysis-based algorithms focusing on chart patterns may have limitations, some automated systems incorporate these patterns as components of their decision-making process, often alongside other indicators.⁹ Professional traders frequently combine insights from technical patterns with fundamental analysis to form a more comprehensive view of an asset's potential future direction.⁸

Limitations and Criticisms

Despite their widespread use, continuation patterns, like other forms of technical analysis, face several limitations and criticisms. One significant critique stems from the Efficient Market Hypothesis (EMH), which posits that all available information is already reflected in asset prices, making it impossible to consistently achieve abnormal returns by analyzing historical price data.⁷ According to the weak-form EMH, past price movements cannot be used to predict future prices profitably, directly contradicting the premise of pattern recognition.⁶

Another key limitation is the subjective nature of identifying and interpreting these patterns. What one analyst perceives as a clear flag pattern, another might see as an unclear formation or even a different type of pattern altogether.⁵ The drawing of trend lines and the identification of pattern boundaries can vary between individuals, leading to inconsistent interpretations and potential false signals.⁴ This subjectivity makes it challenging to backtest strategies based on these patterns rigorously, as the rules for identification are not always precisely quantifiable.

Furthermore, even when a pattern is identified and a breakout occurs, there is no guarantee that the trend will continue as predicted. Markets can be influenced by unforeseen news events, economic data, or shifts in market sentiment that can negate the expected continuation. Critics often highlight that any apparent success from technical analysis might be attributed to luck or data-snooping bias, especially when considering the vast number of potential patterns and indicators that can be observed.³

Continuation Patterns vs. Reversal Patterns

Continuation patterns and reversal patterns are both categories of chart patterns used in technical analysis, but they signal opposite market behaviors. The primary difference lies in their implied outcome for the prevailing trend.

• Continuation Patterns indicate that a temporary pause or consolidation in an existing trend is likely to be followed by the resumption of that same trend. Examples include flags, pennants, and symmetrical, ascending, or descending triangles that break out in the direction of the prior trend. They suggest the underlying forces driving the trend remain dominant.
• Reversal Patterns, on the other hand, signal that the prevailing trend is nearing its end and is likely to reverse its direction. Common reversal patterns include head and shoulders, double tops/bottoms, and triple tops/bottoms. These formations suggest a shift in the balance of power between buyers and sellers, leading to a change from an uptrend to a downtrend, or vice versa.

The confusion often arises because some pattern shapes, like triangles, can act as either continuation or reversal patterns depending on the context of the preceding trend and the direction of the eventual breakout.

FAQs

What are the most common continuation patterns?

Some of the most common continuation patterns include flags, pennants, symmetrical triangles, ascending triangles, descending triangles, and rectangles. These patterns typically form after a strong price move and suggest that the original trend is likely to resume.

How do you confirm a continuation pattern?

Confirmation of a continuation pattern typically involves a clear breakout from the pattern's boundaries in the direction of the original trend, often accompanied by a notable increase in volume. The breakout should ideally be sustained, avoiding a quick fall back into the pattern.

Can continuation patterns fail?

Yes, like all technical analysis tools, continuation patterns can and do fail. Market conditions can change unexpectedly, or the pattern itself might be misinterpreted. A pattern failure occurs if the price breaks out in the opposite direction of the anticipated trend continuation or fails to sustain the breakout.² Effective risk management strategies, such as stop-loss orders, are crucial when trading based on these patterns.

Are continuation patterns more reliable in certain market conditions?

Some studies suggest that technical analysis patterns, including continuation patterns, may be more effective in trending markets or periods of strong market sentiment.¹ In highly volatile or range-bound markets, their reliability can decrease due to an increased frequency of false signals.

Do professional traders use continuation patterns?

Many professional traders and institutional analysts incorporate continuation patterns and other technical analysis tools into their trading strategies, often combining them with fundamental analysis for a more robust approach. While not relying solely on these patterns, they are used to identify potential entry/exit points and assess market strength.