This Common Chart Pattern Offers a Clear Trade Setup
Triangles are chart patterns that are associated with periods of price consolidation. A triangle is usually a continuation pattern, and the market or stock that forms a triangle will usually continue trending after the brief consolidation is completed.
Chart patterns are named to describe the picture they form on a chart. A triangle is made by connecting higher lows and lower highs on a bar chart. As prices near the apex of the triangle (the pointed end) prices usually break out and continue their previous trend.
How Traders Use It
Triangles are used to set up trades. Trades are entered when prices close above or below one of the lines formed by the triangle. A stop can be placed at the level of the opposite line, offering traders a way to limit risk. Prices are expected to move by the width of the pattern after the breakout.
The Dow Jones Industrial Average and other indexes formed small triangles in late 1999, as the markets were moving toward the top of the Internet bubble. This pattern included a false breakout, a move that is quickly reversed.
In this example, prices closed below the lower line of the triangle for one day before moving higher. False breakouts are fairly common in triangles and traders can delay acting on the signal to avoid this problem. That means waiting for two or more consecutive closes outside the triangle before trading.
Another example is shown in the chart below of Moody's Corporation (NYSE: MCO). In this case, the triangle in the center of the chart was formed with one flat trendline instead of two sloping lines.
The triangle on the right side of the chart is the type of pattern traders must act on in real time. Traders would expect prices to break out to the upside and there is a potential reward of 17%, while risk is limited to about 5%. Many traders like to see a setup where the potential reward is more than three times greater than the trade's risk.
Why It Matters To Traders
The breakout from a triangle often signals a new price move has just started, which offers traders a chance to enter early and take advantage of a large portion of the move. With a price objective and a clearly defined risk level, traders can choose the trades offering the highest potential reward given a certain level of risk.
While the pattern defines rewards and risk in terms of points, these can easily be converted to percentages by dividing each by the current market price. The reward can then be divided by the risk and traders with multiple trading opportunities will usually choose to take the trade with the highest value of the reward to risk ratio. Many traders also set a minimum reward to risk ratio of at least 2-to-1, or even 3-to-1, and price patterns such as the triangle help them select trades.
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