Two weeks ago I devoted this "Educational Bonus" section to the discussion of continuation patterns. A continuation pattern is a formation that occurs when a trend takes a breather, but when its pattern during that breather is usually predictive of a resumption of the prior trend. In that issue our lesson focused on the three major triangle types: Symmetric, Ascending and Descending.

These patterns represent the lion's share of most major continuation patterns. You may recall that I included the wedge pattern in our discussion of reversals (see our ETF Authority issue from September 15, 2003 for further details), although some people term it a continuation. Head and shoulders patterns can also appear as a continuation (ETF Authority, August 25, 2003). For further background information, you should also review our two articles on gaps (ETF Authority, July 28, 2003 and August 4, 2003), as some gaps provide excellent continuation signposts.

(Note: John Murphy discusses the broadening formation in his book, "Technical Analysis of the Financial Markets," in his chapter on continuation patterns. However, in the context in which he presents that formation, it is indeed a reversal pattern. The formation is relatively rare, and should be considered a reversal and not a continuation.)

In this week's lesson we will cover several other continuation patterns -- rectangles, flags and pennants.

RECTANGLES: A MANY-NAMED THING
Rectangles are rarely ever referred to in any market commentary as "rectangles." Instead, they are often referred to as a "trading range" or "consolidation." That's a much better description of exactly what a rectangle is: A period of range trading during which prices swing between an approximate high and low price level. The pattern typically traverses at least two weeks, but can at times extend for months or longer.

WHICH WAY SHOULD THE MARKET BREAK AFTER THE RANGE TRADING ENDS?
Consolidations, by definition, mean that the normal expectation is for prices to continue in the same direction the market was trading before the consolidation began. If the particular security you're examining entered into a trading range after an upward thrust, then the normal expectation would be for prices to ultimately continue higher. The same is true on the downside. If the security you're looking at entered into a rectangle pattern after a downtrend, then the normal expected breakout will be to lower prices.

ARE THERE ANY OTHER WAYS TO IMPROVE THE FORECASTING CAPABILITY OF RECTANGLE BREAKOUTS?
I wouldn't have posed that question if there weren't! There are two tools that should help you nail down the direction of the trading range breakout. The first involves a close analysis of volume patterns. Typically, volume rises in the direction of the ultimate breakout, so that's an important factor to consider in your analysis.

The other method requires an understanding of the Elliott Wave Theory. If a period of range trading occurs after a completed major pattern, then I would typically expect the rectangle to result in a reversal. Normally, however, periods of range trading appear in second, fourth or B-waves, which are corrections. For a complete explanation of the Elliott Wave Theory and how you can apply it to your own trading and investing, please see my book: "Applying Elliott Wave Theory Profitably."

AN EXAMPLE: SPY
The S&P 500 SPDR (SPY, $103.39) recently broke above and moved back into a rectangle, or trading range. Note that volume spiked at both the lows and the highs, giving us very few clues as to which direction SPY is likely to break out next. If we can glean any information from the volume pattern, I would have been bearish because turnover was lower as prices rose. That said, the period of low volume occurred during the month of August, which is typically a slow time in the market. This highlights why it is very important to be aware of seasonal volume patterns. It probably would have prevented you from becoming too bearish in August despite the poor volume as prices rose.

One way to make money during trading ranges is to get long at the low and sell at the high. This is very difficult because normal human emotions will likely leave you bearish at the low and bullish at the high. Also, because you really do not know a priori whether or not the market is truly in a range trade, this can be difficult. One tool that can assist you here is stochastics (a technical indicator that I will cover in a future lesson). If the stochastic indicator is oversold and crosses positively, and price is near support, then you should buy. If the stochastic indicator is overbought and crosses negatively, and price is near resistance, then you should sell.

FLAGS AND PENNANTS: SHORT-TERM HIGH PROBABILITY FORMATIONS
Flags and pennants usually take from anywhere between several minutes to several days to complete, and day traders use them regularly as trade entry signals. A flag looks like a small channel against the larger trend. A bullish flag, which corrects an up move, slopes down and is predictive of a continuation towards higher prices. A bearish flag, which slopes up, corrects a down move and is predictive of continued falling prices.

A pennant is little more than a very short-term symmetric triangle. Volume should weaken in both flags and pennants until prices break out in the direction of the prior trend.

Note that a break against the trend is also bad news, especially if turnover increases. Such an action would not fit in with the normal development within pennants and flags. Market lore says that pennants and flags form after sharp moves and typically occur "halfway up the flag pole." This, of course, refers to bullish flags and pennants. It means that after a sharp run-up, you will see a pennant or flag develop. Once prices break higher, the measured objective is for prices to rise as far as the initial sharp rally.

My experience shows that the measuring technique's success depends largely on where you are in the trend. If the pennant occurs after a series of very large rallies or drops, then the target will likely never be achieved. However, if the pennant takes place early in the game, then the objective will probably be way too conservative. Once again, if you view all of this analysis within a larger framework from Elliott Wave (or perhaps other longer-term patterns), then this should help you find better price measurement guidance. The sample chart above shows the Nasdaq-100 Trust (QQQ, $34.19) during the huge rally on Wednesday, October 1, 2003. T here were multiple opportunities to buy breakouts of flags there!

SUMMARY
Continuation patterns often allow you to enter into a position even if you missed the optimal entry point. Since it is very difficult to pick absolute tops and bottoms, as a trader, your ability to recognize consolidation patterns will give you many opportunities to capture solid swing trading profits. These patterns will assist you in entering into trades at advantageous price levels even if you did not identify the original top or bottom.

Good trading!

Steven Poser
Editor
The ETF Authority
New York, NY

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