Magazine article Modern Trader

Trading Stocks with Triangles: Chart Pattern Analysis Is One of the Simplest and Cleanest Forms of Forecasting Stock Prices. Here, We Show How Triangle Patterns Form and Discuss What Their Various Types Mean for Price Moves

Magazine article Modern Trader

Trading Stocks with Triangles: Chart Pattern Analysis Is One of the Simplest and Cleanest Forms of Forecasting Stock Prices. Here, We Show How Triangle Patterns Form and Discuss What Their Various Types Mean for Price Moves

Article excerpt

Price patterns are a powerful, elegant tool for market analysis. Not only can you apply them without additional indicators or tools, but because patterns reflect price directly, there often is little to no lag between signals and subsequent price movement. These relationships are just as strong in equities as they are in commodity markets.

Stock traders can use price patterns to set up positions, time trades with a fundamental basis or as a signal to take money out of the market. They can operate as an early warning system because of their minimal lag, or as a buy or sell trigger within a larger trading approach.

Among price patterns, one of the most useful and simple is the triangle. As with all price patterns, triangles fall into one of two broad categories: Reversal or continuation. Reversal patterns signal that the previous trend will reverse upon completion of the pattern. Continuation patterns signal that the trend will continue upon completion of the pattern.

Playing with shapes

When the price of a stock trades in a range as time goes by and that range becomes smaller, it can be described as a triangle pattern. The process involves the contraction of price with the convergence of trendlines creating the triangle shape (see "Tightening price").

Triangle patterns generally mark a consolidation of the trend and are concluded with a strong breakout in either direction. Clearly, identifying a triangle pattern allows for trading opportunities not only during the formation of the pattern, but when price breaks out at the end of the formation.

How a triangle pattern plays out depends on the type of triangle it is. They generally fall into one of three categories:

1) Symmetrical triangles

2) Ascending triangles

3) Descending triangles

Each pattern can be described in different terms with respect to price behavior and can be expected to generate a different type of price signal.

Symmetrical triangles

A symmetrical triangle pattern comprises price fluctuation where each swing high and swing low is smaller than the previous swing. Volume tends to fall as the pattern develops. A sharp increase in volume confirms any break higher from the dominant pattern. In general, trading activity diminishes until the apex of triangle is formed.

A symmetrical triangle pattern should contain at least two lower highs and two lower lows. Also, the second high should be lower than the first high, with the upper trendline sloping downward. Similarly, the second low should be higher than the first low, with the lower trendline sloping higher.

As seen in "Sideways pattern", Tata Motors is trading within the price range of $16 to $22. As time went by, Tata made lower highs of $19.60 and $18.50 to form a downward sloping trendline. Tata Motors also made higher lows of $16.70 and $16.90 to form an upward rising trendline. Also true to form, volume activity diminished with the contraction in the trading range. At the apex of the triangle, we witness a strong breakout upward.

There are two key components to a symmetrical triangle breakout: Price and volume. With regard to price, the breakout confirmation should be on a closing basis only. For an upside breakout, the stock should close decisively outside of the triangle formation with a pickup in volume. Breakdowns also require a decisive price break of the formation, but the volume does not need to display a significant increase in activity.

You can calculate the extent of the subsequent breakout move from a triangle formation by taking the difference between the top and bottom of the range and adding it to the breakout point. For Tata Motors, it would be $19.40 (the price at the breakout point) + $20.80 (the high of the range)--$16 (the low of the range) = $24.20. Keep in mind that this type of target calculation is a rough estimate, and price often trends higher (as it does in the Tata Motors example); however, the target typically is a good level to reduce market exposure or tighten risk control measures, such as stops. …

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