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In this edition, I want to look at a few patterns and explore what they communicate to us in terms of price action, as well as how to trade them, how to manage risk and what to expect from potential trades based on these patterns.
As mentioned in my previous column (4?April edition), these patterns do not guarantee that the instrument price is going to move how we anticipate.
They rather represent potential future movements with a more than 50/50 probability of working out based on how similar price action patterns have worked out in the past.
Nothing in the market can be guaranteed and as traders it is our job to find opportunities where the odds of success are greater than the odds of failure.
There are three different types of price patterns, each pretty straightforward: continuation patterns, reversal patterns and bilateral patterns.
Continuation patterns indicate that the prevailing trend is likely to continue once the pattern breaks.
Reversal patterns indicate that the prevailing trend leading into the pattern might change upon break-out.
Bilateral patterns represent more of a 50/50-chance that the price moves either in the same direction as the trend or reverses and breaks out in the opposite direction as the prevailing trend.
Trend continuation patterns
Rectangle formations
This pattern indicates the two opposing forces of supply and demand (large buyers and sellers entrenched at specific levels) and a sort of ‘tug-of-war’ between them.
Here, whenever the price comes down to where the buyer is willing to buy, sellers are faced with a wall of bids that, no matter how hard they try, they just can’t sell through. Other buyers are now forced to bid higher than the large buyer and they force it up to the level where the seller is happy to sell stock.
This time no matter how much they buy, the seller is rock solid and eventually other sellers start getting desperate and offer stock lower than the large seller and start to push the price lower.
This action repeats a few times, thus forming the pattern.
In this case both the large buyer and seller are aware of each other and eventually one of them completes their order.
The other will notice and will then be forced to push the price in order to fill the rest of their order and thus the breakout.
Most commonly, rectangles are indicative of the prevailing trend continuing.
A breakout (signalled by a closing price outside of the formation) is traded with a stop-loss in the middle of the range.
For more conservative traders, the target price is calculated by measuring the price range of the rectangle and projecting that in the direction of the breakout.
More aggressive traders could allow the trade to run with a trailing stop-loss in place.
Wedge formations
This trend continuation pattern usually manifests as secondary or tertiary trends (counter trend pull-backs).
In this pattern the overall market trend is relatively strong and larger players are either entering counter-trend positions or taking profits off the table.
This forces the price in the opposite direction of the primary trend for a period of time, although (in the case of a falling wedge) demand is strong enough to rebound the price as soon as the hasty large trader has completed their order.
A breakout is traded with a stop-loss below the lowest low (or highest high) in the formation (will be the most recent).
Conservatively, the target price is calculated by measuring the price range of the first full move between the sloping support and resistance lines (the first move that touches both sides of the consolidation – on the fat end of the wedge) and projecting that in the direction of the breakout.
Aggressive traders could allow the trade to run with a trailing stop-loss in place.
Pennant formation
(symmetrical triangle)
This formation represents supply and demand compressing on each other.
It couldn’t be simpler.
Large buy volumes are being met with large sell volumes and both sides are in a relative hurry to fill their orders.
This is a tricky formation though, because, depending on who you ask, it is classified as both a trend continuation pattern as well as a trend reversal pattern, so it’s bilateral then.
Well, yes.
But also no.
It can be both a strong trend continuation pattern as well as a bilateral pattern, depending on where it is found.
Often too, these pennants (or symmetrical triangles) will give a false signal by breaking out in a specific direction first, then come back into the formation and then break out in the opposite direction.
The key is to watch the volume (as is the case with all formations).
If there is higher than usual volume trading when breakout happens, odds are that is the direction in which it will keep moving.
A breakout is traded with a stop-loss at the most recent high (or low) in the formation.
Conservatively, the target price is calculated by measuring the price range of the first full move inside on the fat end of the pennant and projected in the direction of the breakout.
Aggressive traders could allow the trade to run with a trailing stop-loss in place.
We will continue with reversal and bilateral patterns in the next edition.
Happy trading!
Petri Redelinghuys is a trader and the founder of Herenya Capital Advisors.
This article originally appeared in the 18 April edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.
