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Continuation Patterns
The Smart Profits Report: Issue #317
Tuesday, June 13, 2006
Continuation Patterns: Cashing In On Technical Analysis
by Jim Stanton
Advisory Panelist, Mt. Vernon Research
When I was a stock and bond broker back in the early 1980s, I used an archaic “Quotron” machine to get prices. As for technical analysis, the only investors using that trading method did so using a large, printed edition of the weekly Daily Graphs publication. This was a laborious and time-consuming task, since it required the use of a ruler and pencil to determine support and resistance levels along with uptrend and downtrend lines - certainly none of the fancy computer graphics available today.
One of the first companies to offer computerized technical analysis was CQG (Commodity Quote Graphics). I came across it in 1985 while visiting a client and the range of built-in analytical tools fascinated me.
I’ve been hooked on technical analysis ever since and, after years of research and fine-tuning, have developed a proprietary technical trading model. And it can generate a lot of money, especially when you are using continuation patterns within your charts…
The Trend Is Your Friend
My system is based on chart pattern recognition - and is a vital tool in identifying trends such as consolidation patterns (what many traders refer to as trading ranges) that you can profit from.
Consolidation patterns represent investor indecision and usually occur after a sharp or extended up or down move. While they can take on different forms - pennants, flags or triangles - there is one type of consolidation pattern that is easy to recognize. And, if you’re patient, it can be traded with a high degree of success.
It’s called a continuation pattern, which basically means the stock will continue moving in the same direction once the consolidation is complete. It occurs after a significant high or low is made and is followed by a sharp reversal.
Bullish Continuation Pattern
Take a look at the daily AT&T/SBC (NYSE: T) chart below, which illustrates a bullish continuation pattern at work.
Charts Courtesy of Trade Navigator Software (www.genesisft.com)
Having plodded downward for over a year, AT&T then staged a sharp reversal in October of 2005. It went on to rally more than 17% before the consolidation phase began.
Here’s the key to recognizing that it’s a bullish pattern: Note that throughout December 2005 and January 2006, the stock traded in a fairly narrow range and did not retrace back down by more than 38% of the initial move up.
As I mentioned above, you do need to show a little patience before trading. But if you bought some call options at the breakout point, it was well worth the wait.
Bearish Continuation Pattern
Now let’s look at the system in reverse. Take a look at the weekly Dell (Nasdaq: DELL) chart below that shows a “bearish” continuation pattern.
As you can see, DELL made a significant high in December 2004, and then retested it in July 2005 before falling almost 30%. It hit an initial low in November 2005, and although it moved back up again, it bounced around in consolidation mode for the next five months without ever exceeding its 38% retracement level. Again, exercising patience and then buying puts on the eventual breakdown would have chalked up another winner.
Consolidate And Accumulate
Technical analysis doesn’t have to be difficult.
Recognizing consolidation and continuation patterns is relatively simple. They show up on both longer-term stock charts, as well as intraday charts. Just look for an extended move after a significant move either up or down. Within the consolidation pattern, there are usually at least three smaller up and down moves, depending on how bullish or bearish the markets are acting.
Once you become familiar with these patterns, your knowledge will tell you the best time to invest at a better price, before the stock breaks out or breaks down.
In these examples, I used the 38% Fibonacci retracement line. Usually, the steeper the decline, the less of a retracement you’ll see as the consolidation pattern forms.
Another characteristic you need to be aware of is that while the stock is consolidating, it’s not unusual for the stock to set a new low or high while it’s in the consolidation pattern. It’s not shown in the chart above, but this happened with DELL, as it ticked down from its initial November low of $28.62 to $28.60, only to pop back above $30 before the full breakdown occurred.
But if you learn how to read consolidation and continuation patterns and spot trends, you’ll be able to take profitable advantage.
Good investing,
Jim Stanton
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Today’s Smart Profits Cribsheet
- Want to know more about Fibonacci and 38% retracement lines? I explained it all in Smart Profits #313: “Fibonacci Retracement Levels: Let “Leo” Calculate Your Support and Resistance”
- For more than 20 years, I’ve used technical analysis as the foundation of my approach to investing profitably. Get the key definition on exactly what this is, as well as other terms such as “breakout” and “resistance” in the Smart Profits Glossary.
Related articles:
- Head and Shoulders Pattern: A Proven Sell Signal Called Breaking the “Neckline”
- Breakout and Resistance: How to Anticipate and Profit From These Twin Concepts
- Technical Indicators: How to Overcome the “Evil Twins of Trading”
