Pennants as Continuation Patterns
Technical analysis is based on finding repetitive patterns with the idea of projecting future price action on the right side of the chart to speculate from that move. Either bullish or bearish, these repetitive patterns can be reversal or continuation ones. Reversal patterns are numerous, and here on the Forex Trading Academy project, we’ve covered almost all of them: double and triple tops and bottoms, rising or falling wedges, triangles at the end of complex corrections, as well as the classical reversal patterns given by the Japanese candlestick techniques. As you can see, reversal patterns are well represented in the technical analysis field. It is not the same thing when it comes to continuation patterns, though. There are not that many of them and are happening not that often. So far we’ve treated the doji candle as a continuation pattern, as well as some triangles part of complex corrections within the Elliott Waves theory are continuation patterns as well. Still, in the triangular formations, a pennant is the most powerful continuation pattern of them all.
Treating a Pennant
Like mentioned above, a pennant is a continuation pattern, that is, it indicates price will continue in the same direction as the one before the pennant formation. However, there is another important thing to consider: a pennant appears only in bullish trends. It means that in a bearish market we cannot talk above a pennant forming, even though sometimes market seems to form similar formations in bearish trends as well. This is a very important statement and traders are mistakenly using the rules of a pennant in bearish trends as well. This is wrong.
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Defining a Pennant
A pennant is a triangular formation that follows an aggressive move higher. This move higher is most of the times an almost vertical one and the fact that market is taking some time to consolidate before another leg higher it means it is trying to overcome resistance. Retracement levels within the pennant formation are quite small. When compared with the aggressive move higher prior to the pennant formation, the market is rarely retracing more than 38.2%, with a move between 23.6% and 38.2% being more likely. The consolidation area that characterizes a pennant, or the triangular formation, should always give the impression that market is being on a verge to break higher. Such areas are forming ahead of important resistance levels, such as the area given by a stronger moving average, or a confluence area given by a multiple dynamic and/or horizontal support.
The chart above shows a pennant formation on the hourly time frame on the EURJPY cross and it is depicting the bullish nature of it. Price is simply not able to retrace much of the previous strong bullish move, mostly finding support on the 23.6% retracement, while the move that follows is quite aggressive. The triangular formation is supposed to act as propelling the price higher after the break. Sometimes the upper side of the triangle, or the b-d trend line, is retested, but this is not mandatory. As a matter of fact, if the b-d trend line is retested, it means that the pennant is not such a strong pattern after all.
Trading a Pennant
There are different approaches to trading a pennant, and they differ based on the trading tool/theory used. If traders use the Elliott Waves theory, it should be noted that pennants are most likely to be found during complex corrections, as part of them. Therefore, it would be inappropriate to label a pennant (or the triangle) as a b-wave in a zigzag or the 4th wave in an impulsive move, as this is having little chances to come true. What is most likely is the fact that the pennant will be part of a complex correction, most of the times an x-wave in a running corrective move. Nevertheless, trading a pattern should follow the following steps:
– Look for a strong, almost vertical move, followed by a small consolidation. Ideally, the time frame should be the four hours’ chart or higher, as traders need a bit of a time to spot the pennant. Otherwise, if it is forming, say, on the five minutes’ chart, by the time it is spotted, it is most likely breaking higher already.
– Take a Fibonacci retracement tool and use it to measure the move prior to the pennant formation. This is going to be helpful in finding the 38.2% and 23.6% retracement levels.
– Place a pending buy limit order or simply go long at the market by the time price is retracing into the 23.6%, and add on a move to 38.2%. If the time frame is big enough, like the daily or even weekly ones then simply draw the Fibonacci levels and then go on the lower time frames to trade the future triangle.
– Check the Forex Trading Academy articles dedicated to the Elliott Waves theory that shows how to trade a triangle. All that information is very useful in finding the moment a triangle breaks higher as well as what the whole pattern should be part of.
– Look for the moment when the triangle breaks higher. By the time this is happening, simply take the whole length of the move prior to the pennant formation and project it from the moment the b-d trend line corresponding to the triangle is broken higher. This should act as a measured move (similar to the measured move of a head and shoulders pattern) and represent the take profit for the long trade/trades. As for the stop loss, use the lowest point in the triangular formation as being the invalidation point.
As you can see, trading a pennant is straightforward as the pattern is simple and easy to understand. However, these steps mentioned above will keep a trader on the right side of the market as otherwise it is very easy to mess around the pennant. What traders should look to avoid is for the pennant to transform into a bullish flag. Not that the outcome is going to be different when it comes to the overall direction the market is going to break, but a bullish flat is simply taking more time before breaking higher. If it is forming on the bigger time frames, you can imagine how frustrating this can be. Having said that, it is time to move on to the last article in our section dedicated to other things to consider in technical analysis. This coming article is perhaps the most important one of them all, as it deals with the time element that should be part of the holy grail when trading the Forex market.
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