Knowing which stock to trade is only half the battle; picking the right time and identifying the most opportune setups is your next challenge. Trading opportunities, or trade setups, generally fall into four broad categories: continuation, reversal, breakout and range-bound. Each presents opportunities if you are able to identify the setup, and have strategies for capitalizing on it. Below we offer a visual guide for how to take advantage of the most popular technical setups.
A continuation trade setup is based on finding an entry point in an existing trend. Trends are where traders are likely to make the most money, so having a few continuation setups in your strategy arsenal is crucial.
Perhaps the most important thing to remember with this setup is that prices never move in a straight line, at least not for long. Instead, a stock uptrend moves in waves – one step higher, half a step back, and so on. Downtrends are no different. The price drops, followed by a rebound and then another drop. Continuation setups attempt to exploit this movement by entering during the pullback stage, and then riding the next wave of the trend to a profit.
Figure 1 shows how a trend may develop. General Electric (GE) is moving higher overall, as the price is making new highs and higher lows. Notice the zigzag pattern – a strong price move higher, followed by a less strong pullback. By entering on the pullback you’re positioned for the next wave higher, but you still need to find an entry point. Please note that all example charts are created using FreeStockCharts.com:
There are a number of tools and indicators you can use to enter a trade when a stock provides a continuation setup.
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After a pullback, in order for the uptrend to continue the price must begin to move higher again. Trendlines can often be drawn around the correction, identifying its course; when the price breaks above the trendline it signals the correction is likely over, and the trend is resuming.
In Figure 2, simple trendlines have been added, connecting the high points in several pullbacks. The trendlines provide a frame of reference for the direction of the stock. When the price breaks above one of these trendlines it indicates that the trend may be continuing.
There are always multiple pullbacks, of varying degrees of intensity, during a trend. Active traders may wish to participate in many of them, while longer-term traders may only wish to participate on longer-term opportunities, such as the buy signaled in late November. For this particular entry method, a target is usually placed just beyond the previous high point, and a stop loss is placed below the recent low.
As the price moves higher, the stop can be moved up to just below new price lows that form, locking in a potential profit.
The main problem with this strategy is that the trendline may need to be drawn multiple times before a breakout occurs. In hindsight it is easy to draw a line connecting the high points of the pullback, but in real-time is can be a challenge and takes practice. The upside is that the reward significantly outweighs risk if the trend continues. Therefore, even if a couple losing trades occur before a winner, the strategy can still be profitable.
Indicators can be used to help verify price patterns, such as those discussed prior, or can be used on their own. During a trend, an indicator provides clues as to when a pullback is ending, and the trend is resuming.
The RSI is a commonly used indicator, but when a moving average is applied to it, not only can it help confirm trade signals from other strategies, it can also generate its own buy and sell signals.
In Figure 4, a 14-day RSI is shown, along with a moving average (15) of that RSI. When the RSI crosses above the moving average it indicates a buy signal. The buy signals are most powerful in a trending market, as the signal indicates the uptrend is continuing. When the RSI crosses back below the moving average the long trade is exited. These points are marked with arrows and corresponding vertical lines on the chart. When a signal occurs to exit a position, it is also signaling a potential reversal is underway.
Using an indicator can help confirm these types of continuation trades, and signal when a pullback is likely to continue instead of a breakout. Continuation price patterns can also be applied during a downtrend, to indicate when it is continuing.
This strategy is quite simple, and during a trending market can be very profitable as well. Yet if the price becomes choppy the RSI may also get choppy, producing signals that get traders into or out of positions too early. The RSI-moving-average strategy also does not have a specific stop loss, which can lead to large losses if the price changes direction quickly. This can be remedied by incorporating a similar stop loss strategy as discussed in the price pattern section above. After a buy signal, place a stop below the recent low to limit losses.
If trading with the trend is profitable, it is also necessary to be able to spot when a trend is potentially ending, and a new one beginning. Reversal setups are based on price patterns or indicators that signal an uptrend (or downtrend) is over or nearing completion, and the trend is likely to change direction.
Two main ways to spot reversal setups are using price patterns and indicators.
There are a number of price patterns that indicate a reversal, with the most popular being the head and shoulders and the wedge. The double and triple top are also popular reversal signals, and have a similar trade setup to the head and shoulders pattern.
The head and shoulders is a reversal setup because it shows the transition of an uptrend to a downtrend. The pattern is created by a price peak (right shoulder), followed by a higher peak (head) and then another lower peak (right shoulder). Since the right shoulder was unable to reach the former peak it indicates the former trend has lost steam.
A “neckline” is drawn connecting the low points after the left shoulder and head (often called “armpits”).If the price drops below the neckline, the pattern is complete and a downtrend is likely underway. Exit longs and/or take a short position. A stop loss is placed above the right shoulder to limit risk, and a target is calculated based on the height of the formation.
In Figure 5, the top of the head in Macy’s (M) is $50.77 and the low of the formation (left armpit in this case) is $45.72, therefore the height of the pattern is $5.05, rounded to $5. This is subtracted from the breakout price–or the price at which the price drops below the neckline–of $48, providing a target of $43.
A triple top is a very similar pattern to the head and shoulders. It’s traded the same way, except that the three peaks in a triple top all reach very close to the same level, whereas the head and shoulders has a higher peak in the middle. The double top formation is also similar, except there are only two peaks that reach approximately the same level. Exit longs or take short positions if the price breaks below the lows that occur between the peaks. Place a stop above a recent high, and the target is once again calculated by taking the height of the formation and subtracting it from the breakout price.
Head and shoulders are a higher probability pattern than double and triple tops, and typically provide a better risk-to-reward profile.
The allure of these patterns is that they are quite common, and with a little practice a skilled trader can spot many such opportunities. Depending how the formation is shaped, the risk/reward profile of the formation can vary greatly, therefore not all patterns warrant taking a short position, but still provide evidence to exit long positions.
False breakouts occur in any price pattern, therefore it is possible a number of false signals may occur before a valid reversal is found. Using a stop loss helps minimize the risk, and potential losses incurred, on such occasions.
The wedge is another common reversal pattern. A rising wedge is characterized by an overall upward direction, but within a narrowing band. This creates a wedge appearance. It indicates that buyers are becoming less aggressive, and will eventually be overtaken by strong sellers. Figure 6 shows a rising wedge formation in Lowe’s (LOW) stock.
When the price drops below the wedge, it indicates the uptrend has ended and the price will proceed lower. This is a signal to exit long positions, and/or enter a short position. If a short trade is taken, a stop is placed just above the recent high. Wedges do not provide an exact profit target; therefore, one of the indicator methods mentioned previously can be used to exit trades.
Wedges are not always easy to spot, and training your eyes to see them takes practice. Like other patterns that are drawn as new price waves develop, the wedge may need to be redrawn. False breakouts can occur, resulting in early profit taking on long positions, or losing trades on short positions. The pattern also doesn’t provide a profit target, but by utilizing an indicator or other price analysis tool already covered, traders can exit the trade when there is evidence the trend may reverse again.
The benefit of the wedge is that once a wedge breaks it often results in a medium- to longer-term trend in the opposite direction. Once that new trend begins, the trader can continue to profit from it by utilizing the trend continuation method described in the former section.
These price patterns also show up at the end of downtrends. When a price breakouts occur to the upside, it signals the downtrend is likely over a new uptrend is underway.
Indicators are another way to spot reversals. Applying a moving average to an RSI can act as both a continuation and reversal signal, as shown in the Continuation Setups section. When the RSI drops below the moving average it signals a correction and a potential reversal.
Another popular indicator, called the MACD, can also be used to spot impending reversals. The MACD provides a context for how forcefully a trend is moving. The MACD moves in waves just as price does, but can alert the trader to potential danger.
If the price is making higher and higher price highs, but the MACD is not moving past its former highs, this is called a divergence. Notice the strong divergence in Apple (AAPL) stock before it fell from its high.
The problem with divergence is that it’s not a trade signal by itself. Instead, it provides confirmation to other indicators providing a sell signal, or to a price pattern that indicates a reversal. In Figure 7 the divergence on the MACD gives an early warning of waning buying pressure, and therefore confirms the signal to exit a long trade and/or take a short position when the price breaks below a trendline in the stock.
Divergence can also confirm other indicator signals, such as the buy or sell signals of the RSI method discussed prior.
In a downtrend, MACD divergence occurs when the price makes lower lows, but the MACD doesn’t. This indicates selling pressure is weakening and traders should be on the lookout for a price pattern or indicator that signals the downtrend is over and an uptrend is potentially beginning.
Another trade setup occurs when the price of a stock consolidates. At times, these consolidation patterns will act as continuation patterns, and at other times reversal patterns. Traders who trade breakouts are not necessarily interested in determining or guessing on which direction a breakout will occur (continuation or reversal), they simply seek to trade the breakout when it occurs.
Common consolidation patterns are triangle and ranges. Traders monitor these patterns and watch for the price to break out of the pattern.
In Figure 8, Amdocs (DOX) was moving in an overall uptrend higher, then pulled back and continued to make a number of smaller price swings resulting in a tighter and tighter price range – this is called a triangle pattern. Eventually the price will move out of this consolidation and begin to trend again, although not always necessarily in the direction it was trending before.
The chart highlights the basic strategy. When the pattern is noticed, trendlines are drawn around the pattern. When the price breaks out of the pattern, an entry is taken and a stop loss placed on the opposite side of the triangle. The target is attained by taking the width of the triangle and adding to the breakout price. For a downside breakout, the width of the triangle would be subtracted from the breakout price to attain the target.
The major downfall of the strategy is that false breakouts can occur, and the triangle will need to be redrawn. On the flip side, by the time the price breaks out, risk is often much smaller than the potential reward; since the triangle converges over time, risk gets smaller as the price approaches the apex, yet the target is always based off the widest part of the triangle.
Ranges are another common form of consolidation. This is when the price moves in an overall sideways direction, finding support near a certain price area, and resistance at another.
The strategy for trading a range breakout is similar to that of a triangle. Draw the range, and wait for the price to break out of the pattern to signal an entry. In the case of an upside breakout, as shown in Figure 9, the stop loss is placed just below a recent low. For a downside breakout the stop loss is placed just above a recent high.
For an upside breakout the target is attained by adding the height of the range to the breakout price (subtract the height for a downside breakout).
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Range breakouts can be quite hard to trade in real-time. The price rarely stops at the exact support or resistance level it did before. Notice how many times the price edged past a former high or low in Figure 9. Therefore, trading range breakouts can result in multiple false signals and losing trades. Some false breakouts can be avoided by waiting for a very strong price bar to break the range, such as the large up bar indicated in the Figure 9.
The upside of trading this pattern is that once it does break out, the ensuing move can be quite strong. Generally, the longer the range lasts, the bigger the move following the breakout. The target is a guide, but if the range lasted a long time, the trend may continue well beyond the target.
Stocks are often range bound, as shown in Figure 9. While some traders wait for a breakout, others will trade the range while the price is bouncing back and forth between support and resistance.
Trading simply off price movements in a range can prove difficult. Figure 10 shows a range in Procter and Gamble (PG) stock. Notice how the price, on a number of occasions, either overshoots support or resistance, or falls short of it. Traders waiting at support to go long may get stopped or think a breakout is underway when the price overshoots. Other trades may be waiting at resistance to go short, but never get filled because on a number of occasions the price reverses before reaching the level.
Using a stochastic indicator can help with entering and exiting a range trade. Long trades occur only when the price is in the vicinity of support, and both stochastic lines have been below 20. The entry occurs when the fast stochastic line (yellow in figure 10) crosses back above the 20 line.
Short trades (and exits for longs) occur only when the price is in the vicinity of resistance, and both stochastic lines have been above 80. The short entry occurs when the fast stochastic line crosses back below the 80 line.
The strategy works well when the stock is moving relatively rhythmically, as in Figure 10, and generally captures a good percentage of the range as profit. The downside is that a valid signal may occur right before a breakout, which will result in a loss. The strategy also doesn’t have a specific stop loss strategy.
To remedy this, when a buy order is placed, a stop can be placed below the recent low. When a short trade is placed, a stop can be placed above the recent high. Traders may want to leave a little extra room below and above these levels to accommodate for false breakouts, but doing so does increase the risk of the trade.
The Bottom Line
Knowing a number of ways to handle continuation, reversal, breakout and range setups provides you with tools to handle nearly every market condition you’ll face. Keep in mind that these setups are not mutually exclusive; understanding the nature of trends will help you notice when a range is forming, and knowing about breakouts can make you more aware of the implications of a trading within a range. The price action of a stock is always the most critical element of analysis and trading, but when price action is unclear, indicators can help you make a decision.
Disclosure: No positions at time of writing.