Now we are getting towards the business end of this identification process for what is undoubtedly, for many, one of the most profitable trading techniques of all.

Why would I say that? Because, unlike many other techniques, continuation patterns work equally well whether going long or going short.

Therefore, because the combined trending time going up plus going down is longer than the time they go sideways, the informed and practiced trader is presented with more pattern entry opportunities than many other entry techniques.

During the Bull run from March 2003 to December 2007, there were approximately 10 pattern entry opportunities to every trend change opportunity. Now while this seems logical in hindsight, it wasn’t until late 2005, early 2006 that it was realised that we were in the biggest Bull run, in Australia anyway, since the run into 1987.

During November & December 2007, there were a large number of directional change  ( Trend Change )  entries which presented themselves. Since December 2007, however these continuation patterns have also presented a large number of entry opportunities during the downward run, and have continued to do so since the market changed direction in March of 2009.

At the risk of repeating myself, I think it important here to re-state a view I have long had, which is also backed by many successful traders – Price is King – Indicators are confirmation only. The share price itself will tell you everything you need to know about when to get in and when to get out – too many people look for the latest, you beaut, you can’t bend it indicator with a 100% success rate.

Please do not fall into this trap, it is an easy one to fall into. Why is this? The answer is simple, the above described indicator means that we don’t have to spend countless hours researching, testing, applying in real time, before we get to make squillions from the market with very little effort.

This is no more true than with continuation patterns. Price is what tells you whether it is a continuation pattern or retracement. Price tells you when to get in and when to get out.

Now we have established that price is king, let us look at how we can utilise what we have covered so far – what does a pattern actually tell us? It tells us which direction the price is expected to travel and gives us a minimum destination point or target for the price to reach.

Research has shown that a continuation pattern, as discussed in this series of articles, has a probability of directional continuation of in excess of 80%, and once that direction has been confirmed, target probability in excess of 90%. In other words, once a correctly identified pattern has broken out in the expected direction, there is a 90% or greater probability that it will reach its target.

This is very exciting news as we not only know the intended direction, but also the distance to be travelled, or in other words, the minimum expected profit from the transaction. This aids us enormously as it then tells us immediately, with a >=90% probability what reward to risk we are likely to achieve should we enter the transaction.

Many of the novice traders amongst us are, at this stage wondering why we should be excited by this, as many are not aware of what  good risk management strategies mean, or how they are an integral part of their survival as a trader.

Let me digress for a moment.

Reward: Risk

If you were to risk $1.00 per share on a transaction  ( $1.00 being the difference between your entry figure and your Stop Loss – otherwise known as Trade Risk per share ) – would you like to see a potential return of $1.00?

These guidelines have stood both myself, and my fellow students who followed them, in very good stead over the last 10years – Thanks Rob.

Getting back on track – the target allows us to pre plan, with great accuracy, more so than directional change trades, our R:R and therefore confirm whether the trade is viable.

Lets get more specific shall we?

Pattern identification guidelines:

All continuation patterns need to firstly be identified by the formation being a consolidation. After that we get more specific for each type of pattern.

Triangle

• Ascending
• Symmetrical
• Descending

Pennants

• Ascending
• Symmetrical
• Descending

With flags, we need to be able to place a pair of parallel lines around the consolidation  ( we will call these ‘momentum lines’ ). with at least 2 touches on each of the lines. The upper momentum line needs to be very accurate to ensure highest probability factor.

The lower momentum line can be a line of best fit, but it needs to have very little overlap and underlap, which will make more sense with a practical example.

In the case of flags, the target is determined in the following way. The distance  ( price difference )  between the beginning of the run into the consolidation to the peak of price action, is applied to the lowest point contained within the consolidation, and projected in the same direction as the run into the consolidation.

This will make more sense when we delve into the practical examples and show you the targets in real time application.

Market Analyst has a great tool to help determine these targets, and this is the Price Extensions tool under the “Levels” section in “Tools”.

We shall start here with Flags:

With a flag, we need to picture what a flag pole with a flag at the top looks like.

There is a run upwards, with an object at the top which is rectangular, and stands out from the pole; I have drawn several examples of this in the following chart.

On the left we see the shape we would actually expect to see with a real flag pole and a flag outside, in the real world, with a moderate wind blowing.

Because price action does not normally travel vertically or horizontally, we must adapt this vision to the reality of normal price action, so what we see in the next 3 examples are the reality of what we need to be able to read on our screens.

With a flag formation, examples 2 & 3 are what we are expecting to see in the real world of charts.

There is a decisive run upward, followed by a consolidation in the price action. Figures 2 & 3 demonstrate this. The consolidation can be either horizontal or in the opposite direction to the run into it. It CANNOT be in the same direction as some people mistakenly believe, and as is shown on the right side of the example.

Let us go back to our definition. There is a decisive run upward followed by a consolidation – plus the target is “The distance  ( price difference )  between the beginning of the run into the consolidation to the peak of price action, and is applied to the lowest point contained within the consolidation”.

The figure on the right side of the example does not have a consolidation – it has a slow down in price direction. This normally precedes a change in direction, and is a dangerous piece of price action to trade.

In addition, there is no way in which to determine the target if it was a flag, as there is no peak in price action yet until it changes direction. I have seen some people, with misinterpreted identification rules, use the illustration on the left only to fail and lose money in most instances BEWARE THE EXAMPLE on the right.

We are going to look at a potential flag formation as it forms in real time, with real price bars, then we will apply the target identification to it and then determine whether it reached its target or not.

Supercheap is the company we will look at in this illustration.

We can see that Supercheap changed direction in June 2006, and then had a strong upward run, with a couple of pauses during that run.

Is this pause another of what we saw earlier in August & September??

Time will tell.

The first thing we need to look at is whether we can apply our parallel lines around the pause at the top of the upward run, and the current answer is yes we can.

We can see here that there is a little under and overlap on the lower momentum line. This is acceptable for this formation.

We can also see that the average ROM within the formation is lower than the average ROM during the run into the peak.

What do we do with this chart now? If we believe this is actually a flag, we need to plot targets, determine risk management parameters and providing all is well, place a conditional order for entry should the price breakout next week.

First thing we need to do is apply our market noise parameters to determine entry and stop loss positions. We the need to calculate our Trade Risk per share, then determine the target level. The trade risk per share should be relative to the normal ROM of the share price being examined. In this case we are using an entry – stop spread of around 5% or around $0.14.

The run starts at $1.55 and goes through to $2.86 before consolidating, giving a pole of $1.31 in length. The lowest price inside the consolidation is $2.65, so when we apply $1.3 to the low, our target price becomes $3.96, which is off the top of the screen in this case. This shows us a very high R:R potential.

Using the vertical line function, we can see where the breakout, if it happens next week, will provide our entry. I do believe in calculating this exactly, as I have seen some very large discrepancies based on the use of cursors and assumption that the line was correctly drawn exactly where it should have been.

In this case the entry, should it occur next week, will be approximately $2.84.

As we can see in the next chart, our price penetrated the upper momentum line, but not the entry price. However we now have to relocate our upper and lower momentum lines to keep to our identification criteria, as shown below.

Sometimes at this point we cannot get a parallel lower momentum line to work properly with minimal under & overlap. Should this be the case, be prepared to discard this as a trading pattern. Observation indicates that at this time the pattern is no longer viable within the same probabilities which we have come to expect.

It may be as simple as us being too enthusiastic in the first place and identifying something which wasn’t really there Desperation, self confidence, enthusiasm

made us see things which weren’t there in the first place. I know that I have been guilty of this same thing in the past.

This week our entry price is approximately $2.83, with our stop around $2.70.

So what does next week bring?

More disappointment as our price action failed to hit our entry. Damn, this is getting frustrating isn’t it?

Or is it? For every week our price action does not hit our entry price, the entry price falls does it not? The question we need to ask here is, what has happened to our target price, has it fallen, or is it still the same?

The fact is that the target has not changed, and every week that our entry price falls without being triggered is increasing the distance between our entry and the target, allowing us to expect a higher amount of profit is it not?

There is no need to worry yet, what happens next week.

Hooray, our entry is triggered, we are in the trade and expecting to reach our target of $3.96 from our entry price of$2.82, which should show us a nice profit of $1.14 per share, thank you very much. Go you good thing gooooo.

Let us jump a few weeks ahead to see what actually happens.

Supercheap reached its target in 10 weeks. We would have made $1.14 profit from a $2.83 entry or 40.28% profit from our entry price.

This is not a normal profit to be expected from a pattern entry. Reality needs to step in here and bring us back to earth. This was a continuation pattern entry during what was to become the biggest Bull Run in living memory for most of us. These were exceptional circumstances and should not be expected to be repeated within the near future.

Make no mistake, however, these sort of situations will repeat themselves. Markets have cycles, they have booms and busts, and those who do the work now, who are consistently accurate in their determinations, who  spend the time necessary to become very proficient in the use and application of these, and other techniques, will be in the best position to make large profits from these situations as they arise in the future.

My own experience has shown that with patterns, when they are correctly identified, they usually reach their targets within 10 weeks. The normal profit seems to fall into the 17 – 22% range per transaction as an average.

There is nothing wrong with these figures, and they are very good if you are able to consistently identify correctly continuation patterns in excess of 80% of the time. Let us also bear in mind, that even those patterns which do not reach their targets still give you an opportunity to make a profit.

Imagine with Supercheap if it only reached $3.50 and then fell away, an effective trailing stop would have locked in some profit, albeit not as much as we ended up with, but still a good profit.

Continuation patterns are a highly reliable, very profitable entry technique.

Next time we will explore triangular patterns. These patterns have their own unique quirks, and we will explore these in detail.

Until then – may the markets go with you  ( thanks for that saying Rob ). and have an awesome time.

Pete