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Continuation Patterns - Part 3

This article is reproduced with the permission of Investopedia.com. Back to Trading 101 Index

In part 1 and part 2 of this four-part series we began our examination of triangles. In this article, we focus on ascending and descending triangles. In part 2 we explain how a chartist draws a triangle as well as the breakout points of the pattern. Here we help you recognize these often missed valuable indicators.

Triangles are a classic type of chart formation that can signal either a reversal or a continuation of a trend. You will recall from last week’s article that a triangle is formed by the convergence of two trendlines - an upper resistance and lower support line. The ascending triangle is particularly significant because it forms less frequently than the other descending or symmetrical triangle patterns and is more likely to be signaling an upward movement in the security.

As an ascending triangle formation occurs, it usually signals a continuation pattern in an uptrend, but sometimes can be found at the bottom of a downtrend, signaling a reversal. The ascending triangle has a flat upper trendline while the lower trendline slopes upward. This is indicative of more aggressive buying than selling as the lows get progressively higher, while the highs make it to about the same level each time before breaking out to the upside.

The completion of the formation occurs when prices break through the upper, flat trendline before finishing the apex of the triangle. Prices could retrace to the horizontal trendline before resuming their upward path but not reenter the triangle. Unlike symmetrical triangles, which are neutral in predicting breakout direction, ascending triangles usually break to the upside. This is also true when preceded by an uptrend, and when this happens ascending triangles act as a continuation pattern, rather than a bottom.

Typically, volume is heavy at the beginning and contracts during the formation of an ascending triangle. It again increases during the breakout above the flat trendline. This corresponds to the number of shares for sale diminishing at the upper trendline price, as buyers bid the stock up and try to catch the breakout. In this situation a tight stop could have been placed right along that upward trendline (bottom of the triangle). This would have minimized the risk for a long trade. Now a trader can view the previous support line as a possible resistance level.

The descending triangle can signal the reversal of an uptrend in the market being charted. It is formed when a run-up in a security's price levels off and is followed by a series of lower highs and relatively equal lows. This chart of Orphan Medical Inc. (ORPH) illustrates a descending triangle pattern. As you can see in the chart, a trendline was drawn connecting the descending peaks, and another line connecting the valleys. These lines were extended to the right until they formed a descending triangle. Volume, typically heavier at the beginning of the pattern, decreases as price moves toward the apex and then increases during the breakout.

Chart Created with Tradestation

The minimum number of lows and highs required to form the descending triangle, or any triangle for that matter, is two of each, for a total of four. The descending triangle is referred to as a right-angle triangle because if a vertical line is drawn at the open end of the triangle, a right-angle triangle is formed. If this pattern were followed by a breakout to the downside from within the triangle formation, it would be a triangle top. Or if the price breaks out to the upside, it would become a continuation pattern rather than a reversal.

The successive lower highs forming the descending side of the triangle indicates more aggressive selling than buying. Frequently, prices will break out to the downside after a number of reversals (minimum of four) within the bounds of the two trendlines. Breakouts usually occur after moving about two-thirds to three-quarters of the distance between the start of the formation and the apex, but there are exceptions.

It is not uncommon for prices to retrace back to the trendline after breaking out of the triangle and then reverse again, continuing in the direction of the breakout. The breakout is considered to have failed if prices move significantly back into the triangle pattern, which does happen occasionally.

For this particular security, the breakout was to the upside and a continuation pattern occurred instead of a reversal. It is a good idea to keep an eye on descending triangles and make sure that the breakouts are in the direction that you choose.

I placed this particular chart in this article to reinforce the fact that nothing about this science is set in stone, and traders and investors alike should always be aware of the opposite direction an issue can take, giving no prior warning.

In part 4, the final article of this series, we look at flags and pennants.

Next chapter: Part 4

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