One of the simplest, yet most effective technical patterns I use is triangles. Triangles are developed by combining trendlines and resistance/support levels. Triangles are unique in that they call for distinct movements to occur within set time horizons. I find the time aspect to be crucial as it provides an answer to when events should occur and allows us to move to the next idea if these events fail to materialize.
Triangles come in different types and have a few key traits we must remember. The three types are:
Symmetrical —Symmetrical triangles occur when a downtrend and an uptrend converge. As shown with Amazon.com (AMZN), symmetrical triangles are normally continuation patterns that allow the dominant trend to continue.
Descending —A descending triangle, also shown by AMZN, combines a downtrend with an existing support level.
Ascending —An ascending triangle, shown by Baidu (BIDU), combines an uptrend with an existing resistance level.
When studying charts, keep in mind the following traits of triangles:
1. Reversal points —Since a triangle is a combination of trendlines, we must see adequate reversal points. A trendline requires three points of contact. Therefore, a triangle requires six points. As seen with Motorola (MOT), three points on the downtrend combined with three points on the support level indicate a valid descending triangle.
2. Timing —A triangle should break one of the two trendlines within two thirds to three fourths of the triangle shape. Looking at Coca Cola (KO), a downtrend began in June 2008 and would meet the support level by December. With a six-month triangle, we should expect prices to either break below support or move higher through the downtrend in four months (as indicated by the black box). As expected, the shares moved through support in that time frame as the triangle predicted. Were prices to remain in the triangle beyond this time frame, it would call into question the pattern itself.
3. Volume —Volume should remain low as prices consolidate within the triangle and spike higher once the triangle is broken. The black circle on the chart of Goldman Sachs (GS) shows the spike in volume that accompanies the decisive move lower.
4. Price Expectation —The base of the triangle is measured as the difference between the trendlines when the triangle begins. Once prices move outside the triangle, the expected price move is equal to the base. Whole Foods Market (WFMI) offers an excellent application of this. When the ascending triangle formed, we see a base of $5. When the prices move higher through resistance of $13, we establish an upside price target of $5 beyond that point, or $18 (blue box). Within weeks that price target is met.
The combination of drastic price movements, measurable results, and expected time frame makes triangles an excellent trading tool. Study charts for patterns while applying these rules and I am sure you will like them as much as I do.
Sean Hannon, CFA, CFP is a professional fund manager.
Further Education, Technical Analysis:
- Critical Support and Resistance Rules
- 5 Key Guidelines for Trading Stock Chart Channels
- Breaking Down Stock Chart Types
- How to Read Stock Charts
- 5 Main Assumptions Behind Using Technical Analysis
- Top 5 best Free Stock Chart Websites
- 5 Rules for Predicting Stock Market Trends
- Stock Chart Education Test (Answers)