Get to the point
By David Land from CMC Markets - Wed Dec 01, 4:55 pm
One of the most versatile technical trading methods involves the identification and then trading of triangle formations. Like all forms of ‘pattern recognition’ you will need to put a lot of practice into looking for set-ups which can be quite time consuming but is a necessary process with few shortcuts available. The real upshot for the trader is that you can apply your stop-loss and profit target placements in a repeatable fashion, which is not always easy to do.
There are three main types of triangles but before we look at specific setups it’s important to think about what this pattern is signifying. A triangle is specifically demonstrating price being compressed between a support and resistance level – you would expect one or both of the support and resistance lines to be sloping, as you will see in later examples. Few technical references look at the positioning of the triangle relative to the trending movement that leads into it. What I am suggesting here is that the trader may be better served looking for triangle setups as part of a trending movement (either continuation or reversal) and avoiding those that fall within an existing ranging movement.
A triangle is about seeing price squeezed into a narrowing range until eventually the breakout leads to a new and potentially rapid movement in price. Something that traders typically look for by traders is a decline in volume while the pattern is setting up – the idea being that there is less interest from the market in either forcing the price higher or lower – that is until there is breakout from the pattern and then the situation should change dramatically.
Sometimes I think that traders probably like the idea of having the price move a single increment out of the pattern and then take their position immediately. While the feeling may be that this gives the best risk-reward pay-off it may signal that the breakout is not as strong as the trader would generally like. Don’t get me wrong, this type of outcome is still more than satisfactory if you get the price to move in the way you anticipate but it may be preferable to get something a little bit more aggressive in terms of the move that you receive on the breakout. In addition it may be a good idea to wait for at least one close outside of the pattern before entry – the idea here is to try and avoid being forced into trades that breakout and then quickly reverse.
A good example of the strong break may be something like a ‘breakout gap’ which sees price gap significantly at a time that coincides with price breaking out of the pattern. This type of occurrence may suggest that there is a large amount of buyer interest. Despite the fact that this will make the traders risk-reward ratio outcome suffer it may improve the win-loss ratio and hopefully improve the number of trades that actually make it to their profit target.
Profit targets with triangle patterns can often be quite effective and no matter what triangle you are using the target is measured in the same fashion – the height of the pattern extrapolated out from the breakout point. I for one can’t see the rationale behind having a fixed profit target point where the trader closes the position immediately if it reaches the chosen level. Instead, the idea of tightening the stop and then trailing it means that you have the potential to improve your outcome while the market continues to move in your favour. Naturally, if it quickly reverses then the outcome won’t be as good, but sadly you can’t predict what will happen next anyway.
The placement of a stop loss in the case of triangles is well and truly open to debate with the main difference coming down to risk-reward and the possibility of being forced out of a trade. I often consider a good way of rationalising stop placement is to think about getting out at the first point at which your reason for entry no longer exists. Sadly this is one of those things that sounds excellent in principle but needs to be given just a little bit more in the way of flexibility for it be effective. Often the trader can see price breakout of the triangle, then retrace back to the breakout area and then reverse once more and continue in the direction of the breakout. Ideally price won’t move back inside the price pattern but it may do so by some amount. Depending on what sort of trader you are you will likely apply different levels of flexibility to the price moving inside the pattern before stopping out the trade.
The most common type of triangle that you will be exposed to is the symmetrical triangle. This pattern forms up with a falling resistance level and a rising support level and represents an excellent example of price being squeezed into a progressively narrowing range.
You can see in figure 1 how the price is being pushed into the triangle with the trader waiting to see in what direction the price breaks out in. Interestingly enough you can see that the trend leading into this pattern was relatively strong so the trader may prefer a break to the high side looking for a trend continuation. This is not a requirement for the pattern to be genuine but may well be a preference.
Another consideration is for the trader to prefer any breakout to occur before the price has moved more than 75% of the way from the start of the pattern to the apex of the triangle. The reason for this is because otherwise you are not really seeing the price consolidating within the pattern before a breakout but instead are seeing price just starting to drift sideways, which is the last thing that a breakout trader wants.
The next pattern that you can see here is an example of a descending triangle (figure 2). You can see that the basic premise of this type of triangle is very similar to its symmetrical counterpart. Again the direction of the breakout is not key to its success and in fact as this position has continued you can see that the breakout to the downside was very successful as a short side trade. I am not showing a specific example of the ascending triangle because it is essentially the reciprocal of the descending triangle with the same rules applying.
You can see that I have marked the price target at $5.70 with a horizontal line which the share price has successfully found (figure 3). You can see that after the breakout that the price rallied back inside the pattern which means that if you had used the support line as your stop level your position would have been closed out. You can see here that in both breakout points there was no significant spike in volume. This doesn’t rule out the trade but if you are assessing the ‘for and against’ points of the pattern this will go in the ‘against’ column.
If we take a closer look at figure 4 there are a couple of observations that can be made about where stops may be placed.
You can see here that the second breakout involved a very strong candle which would add a degree of confidence whilst the first was comparatively benign. If you had entered on the initial break and placed your stop on the far side of the pattern directly above then you would have been able to have a successful trade. Potentially better though in terms of risk-reward is to look for any areas of short term support and resistance that exist within the pattern. You can see an example of this on the chart in figure 5.
This may act as something of a halfway house between the best and the worst case risk-reward scenarios.
Profit targeting methods for most people would be a fairly cut and dried situation but there are alternatives. One of which is to start trailing your stop after the price has moved a proportion of the way to the target. Another to consider is the 61.8% Fibonacci extension point, which is an area that can sometimes see price reverse. You don’t want to be giving your positions too little opportunity to succeed but you don’t want too many reversing on you either.This is a starting point for traders to begin working with triangles. I always think that these patterns are useful to recognise even if you don’t trade them specifically because you can recognise potential areas of pause within price and points where breakouts may occur. The more examples you look for and track, the more effective you will become at spotting and trading them in the future.