Traders may live for momentum but finding it is another story. Gaps, rectangles, flags, head and shoulders, and triple top chart patterns could help you figure out which way prices could move and with how much momentum.
You’ve heard it said: “The trend is your friend, until it ends.” But does it stay your friend all along the way? How about the more realistic, “The trend is your friend when it starts, but once it gets going, it drives you nuts!” Trends can be alluring. And deceptive. Sometimes a trend pretends to end, makes you run for the hills, and then—trends some more.
Nobody knows when a trend is going to begin or end. But you can analyze the markets from the perspective of “crowd behavior.” And that could potentially increase your chances of knowing which way price could move.
Crowds create momentum in the markets, but they can also influence you to make hasty trading decisions like buying at the top of a trend or selling at the bottom of one. How can you objectively analyze crowd action and gauge your entry points?
You may have heard of chart patterns with esoteric names like head and shoulders or broadening bottoms. Chart patterns tell a story about the battle between bulls and bears. When you see this battle play out, it exposes directional bias, which ultimately may help you manage options trades.
Chart patterns are visual, and analyzing them is more art than science. As an option trader, you want momentum. And that means looking for strong price breakouts when, for instance, volatility picks up and raises premiums. You don’t need to know every chart pattern. But it’s helpful to consider a few from three broad pattern categories—consolidation, continuation, and reversal—to get started.
First, start by pulling up a chart on your thinkorswim® platform from TD Ameritrade. Go back in time far enough to observe a trend, beginning to end. Look for areas of consolidation, continuation, and reversal. You’ll discover different characteristics in each of these categories.
Consolidation—After the initial downtrend in Figure 1, price consolidates for about four months before an uptrend begins. During consolidation, traders are unsure about price direction. The uptrend starts only when price breaks out of the rectangle’s top edge on high volume.
Continuation—Once an uptrend begins, notice several pauses within the trend, although the trend continues. During these pauses, continuation patterns such as flags, pennants, and triangles emerge. Notice gaps between price bars. These can also provide clues about price movement.
Reversal—The trend could end here (last green bar on chart), but the probability appears low. Price did make a huge move higher on an “up gap,” and with high volume, which suggests upside momentum is still present. On the following day, there was a selloff, but on low volume. So, bulls may still be in control.
Let’s take a deeper dive into these common patterns.
Consolidations usually form before a trend begins, while continuations take place when a trend pauses before resuming. Here’s what some of the more common patterns reveal.
1. Gaps
Price gaps occur frequently, as you can see from looking at any price chart. Gaps come in different types—common, breakaway, exhaustion, continuation—but we won’t explore those details for the moment. For now, keep in mind that gaps look like blank spaces on a chart, often accompanied by high volume. Several gaps are highlighted in Figure 1.
3. Flags
These are pauses in a trend that explode with strong momentum, usually in the original trend’s direction. They look like a parallelogram with a slope, opposite that of the prevailing trend. Flags often portray a tug-of-war between buyers and sellers. In the flag formation in Figure 3, note the slight uptick in volume when price touches the flag’s lower level. Although the prevailing trend is bullish, the bears try to take control over the bulls during this consolidation. Even after price breaks out of the flag, bulls have some hesitation. After a few low-volume trading days, the bulls regain their strength, and bullish momentum picks up. A strong breakout like this suggests bullish directional bias—think short put verticals and long call verticals .
Has the market topped or bottomed? Here are a couple patterns that typically appear at tops, and in reverse formation, at bottoms.
4. Head and Shoulders
In the classic head and shoulders pattern, the head isn’t spiky. But now that more traders have access to the markets, the head forms quickly as retail and institutional traders jump in and fuel the rally. Meanwhile, the bigger traders may take advantage of the price peak and sell off their positions.
Head and shoulders patterns have what’s called a “neckline,” which is the clear support (or resistance for an inverse pattern). Price needs to break out from the neckline on high volume to increase the likelihood of a true reversal. In Figure 4, the last four down bars show increasing volume—bears are taking over, and the trend is likely to reverse.
5. Triple Tops
When you have three somewhat equal price peaks after an uptrend, it may be an indication of the trend’s end and the beginning of a reversal. While the triple top is playing out, you may sense indecision among traders. It could become a double top, a rectangle, or some other continuation pattern, depending on where price bounces occur, and with how much volume. After the third peak, if volume increases during selloffs (a sign the bears are winning the battle), it’s likely the trend will reverse.
In Figure 5, after the third peak, you see a consolidation. Then price heads back toward the top, but doesn’t make it. The catalyst for the turnaround was one selloff day with huge volume. After that it was all downhill—price continued to drop, with high volume on down days. There were times when bulls attempted to push prices higher, but without success. The bears had the upper hand.
When looking for momentum, acknowledge the strength and power of crowds. There are two things crowds do: buy and sell. And while it’s never a sure thing, their behavior tends to be repetitive. Resist being drawn to the trend’s external appearance. Instead, try to recognize what’s going on behind those price bars to gauge your potential entry and exit points.