After rapid price movement, markets need
time to absorb instability generated by that trends momentum. They
pause to catch their breath while both volume and price rate of change
drop sharply. During this consolidation period, the new price level
undergoes continuous testing for support and resistance. To the pattern
reader, this range phenomenon reveals itself through the familiar shapes
of Flags, Pennants and Rectangles.
Relatively simple mechanics underlie the
formation of these continuation patterns. The orderly return to a markets
mean state sets the foundation for a new thrust in the same direction. An
instructive example of this process is found in the current secular bull
market. The popular strategy of buying on the dips reflects the core
psychology seen with these patterns.
In a series of sharp trend moves,
congestion tends to alternate between simple and complex in both time and
size. Trade defensively when the prior pattern was both short and simple.
Go on the offense after observing an extended battle in the last range.
When examining continuation patterns,
the technician must pay close attention to proportionality. This visual
element will validate or nullify all other predictive observations: constricted
ranges should be proportional in both time and size to the trends that
precede them. When they take on dimensions larger than
expected from visual examination, odds increase that the observed range
actually relates to the next trend larger in scale than the one being
viewed. This can trigger devastating trend relativity errors, in
which positions are executed based on patterns longer or shorter than the
time frame being traded.
All patterns must be evaluated within
the context of this trend relativity. The existence of any range depends
upon the time frame being considered. For example, a market may print a
strong bull move on the weekly chart, a bear on the daily and a tight
continuation pattern on the 5-min bar, all at the same time. A range drawn
through one time frame does not necessarily signal swing conditions in the
other periods that market trades through.