Last update: August 2021

At technical analysis kindergarten, they teach you all sorts of patterns. I remember flashcards, repetition, and more than a few spankings to drive the points home. While kids on main street were learning about squares, circles, ovals, and stars; I was being schooled in retracements, breakouts, double tops, pennants, saucers, and dozens of other formations.

To bring organization to the mess, all patterns were grouped into two buckets: continuation and reversal.

My teachers, Edwards & McGee, used alliteration to etch the key difference between the two into our minds.

“Continuation patterns are common; reversal patterns are rare!”

If you’re looking for a reason behind both interrelated truths, it’s this – stock prices trend. Since a trend in motion stays in motion, it is full of continuation patterns. The reversal formations don’t generally arise until the end. Actually, sometimes they develop along the way, but they frequently fail!

This is why it’s hard to pick tops and bottoms.

Despite learning this, many rookie technicians seem to try harder to spot reversal patterns than continuation ones. Allow me to list the most popular types of each to make sure we’re on the same page.

Continuation patterns are otherwise known as trend-following patterns. They form in the middle of a trend and signal its continuation. These are all common examples in an uptrend: bull retracements, bull breakouts, bull flag, ascending triangle, bull pennant, cup-and-handle.

Reversal patterns include double tops, slowing momentum, head-and-shoulders, rounded top.

I had a memorable run-in with an epic failed topping patterns in 2010. It will live in infamy as the cause of my biggest losing month ever.

That One Time I Lost 5 Figures

In mid-2009, it wasn’t yet apparent that the great sub-prime bear market was over. Pessimism ran thick, and fear continued to hobble investors. Having just witnessed the largest market plunge since the Great Depression, I was knee-deep in recency bias and licking my chops for the next leg lower.

It never came.

But that didn’t prevent me from trying to pick a top and getting blown to smithereens in the process.

Throughout May and June, a gorgeous head and shoulders pattern developed on the S&P 500. It even triggered with a break and closed beneath the neckline. I was loading the boat with bear calls throughout the right shoulder and support break.

Then, when I had finally pushed all my chips in, the market went higher

and higher

and higher.

Over the next five weeks, SPY rallied 17% on a rope. I was short the entire way up.

We’ve seen many such false tops in the decade since, but I’d argue none of them had quite the sex appeal as this initial one.

Remember this next time you’re salivating over a double top or thinking the trend’s about to be murdered. Trend reversals do occur, but they’re few and far between. For everyone that works, there are a handful of others that will burn you.

I’ve learned through painful experience that it’s far better to wait for reversal patterns to fail in the direction of the long-term trend. Then, climb aboard for the continuation.

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