Module 4 – Reversal and Continuation Patterns
So far, we have looked at some of the basic theories behind technical analysis and the way prices move on charts; we’ve also discussed support and resistance and how they impact the price; and looked at trendlines and other lines that also can be seen to affect, or be caused by, the way prices move. This module looks at the actual shape of the price curves on the chart, and how this can tell us more about future price behavior.
What you must also keep in mind, however, is that this is not engineering or mathematics. There is no one simple answer to a set of data or circumstances, and sometimes the same inputs result in a totally different outcome. That is why when we discuss patterns and, later, indicators, we are trying to identify the most likely outcomes based on what has happened in the past.
But you also have to know that it doesn’t matter if the outcome is sometimes different. The way trading works is that you put the odds in your favor and finish up on top. If you have a losing trade, it doesn’t necessarily mean you misunderstood the lesson. It’s just the business that you are learning.
When a chart is showing a definite trend, either up or down, there is not much more to be said. As we saw in the previous module, the price behaves predictably, bouncing off the support line in an uptrend, and being deflected down by the resistance line in a downtrend. It is clear that while the trend lasts, you can see where to trade to make the best profits.
But when the price is not so consistent, and perhaps the trend becomes sideways for a while, then the price can move in ways that create patterns that we can learn to recognize, and that suggest where and when it is going to go next.
A lot of the time these changes happen slowly. A strong trend weakens, and we can see signs of this and realize we may need to exit our trend following trade and await further developments. But just because the trend weakens, it doesn’t mean it will inevitably reverse – sometimes there is a period of consolidation sideways rather than a retracement before the original trend continues.
Obviously, if we can find a way to anticipate when and in what direction the price will continue, we are back in the game and can start thinking about an appropriate trade. Sometimes in these wandering sideways periods we can find patterns or formations that will give us an early indication. That is what this module is an introduction to.
The patents we are considering can be broken down into two groups – reversal patterns and continuation patterns. The meaning of this is probably obvious to you. Reversal patterns indicate that the original trend is over, and the price will start going in the other direction, and continuation patterns imply that the trend in place just paused for a time, and will start off again shortly. Sometimes the patterns can look very similar, and the trick is to identify them as soon as possible.
You will learn that it is not enough to just see a particular shape on the price chart. Although we look for the shape, there are other factors that must be considered to determine whether the pattern means what we expect it to mean. One of these other factors is the volume of trading, and this is important in getting confirmation that the sentiment of the market is what we imagine.