Triangle Chart Patterns and Day Trading Strategies
The triangle, in its three forms, is a common chart pattern that day traders should be aware of. It is an important pattern for a number of reasons. Triangles show a decrease in volatility, that could eventually expand again. This provides analytical insight into current conditions, and what type of conditions may be forthcoming. The triangle pattern also provides trading opportunities, both as it is forming and once it completes.
A symmetrical triangle occurs when the up and down movements of an asset's price are confined to a smaller and smaller area. A move up isn't quite as high as the last move up, and a move down doesn't quite reach as low as the last move down. The price is creating lower swing highs and lower swing lows.
Connecting the swing highs with a trendline and the swing lows with a trendline create a symmetric triangle where the two trendlines are moving towards each other. A triangle can be drawn once two swing highs and two swing lows can be connected with a trendline. Since the price may move up and down in a triangle pattern several times, traders often wait for the price to form three swing highs or lows before drawing the trendlines.
In real-world application, most triangles can be drawn in slightly different ways. For example, figure one shows a number of ways various traders may have drawn a triangle pattern on this particular one-minute chart.
An ascending triangle is formed by rising swing lows, and swing highs that reach similar price levels. When a trendline is drawn along the similar swing highs it creates a horizontal line. The trendline connecting the rising swing lows is angled upward, creating the ascending triangle.
The price is still being confined to a smaller and smaller area, but it is reaching a similar high point on each move up.
An ascending triangle can be drawn once two swing highs and two swing lows can be connected with a trendline.
A descending triangle is formed by lower swing highs, and swing lows that reach similar price levels. When a trendline is drawn along the similar swing lows, it creates a horizontal line. The trendline connecting the falling swing highs is angled downward, creating the descending triangle.
The price is being confined to a smaller and smaller area, but it is reaching a similar low point on each move down.
A descending triangle can be drawn once two swing highs and two swing lows can be connected with a trendline.
In the real-world, once you have more than two points to connect, the trendline may not perfectly connect the highs and lows. That is okay; draw trendlines that best fit the price action.
The breakout strategy can be used on all triangle types. The execution is the same regardless of whether the triangle is ascending, descending or symmetrical.
The breakout strategy is to buy when the price of an asset moves above the upper trendline of a triangle, or short sell when the price of an asset drops below the lower trendline of the triangle.
Since each trader may draw their trendlines slightly differently, the exact entry point may vary from trader to trader. To help isolate when the price is actually breaking out of the formation, increases in volume can help highlight when the price is starting to gain momentum in the breakout direction.
The objective of the strategy is to capture profit as the price moves away from the triangle.
If the price breaks below triangle support (lower trendline), then a short trade is initiated with a stop loss order placed above a recent swing high, or just above triangle resistance (upper trendline).
If the price breaks above triangle resistance (upper trendline), then a long trade is initiated with a stop loss order placed below a recent swing low, or just below triangle support (lower trendline).
To exit a profitable trade, consider using a profit target. A profit target is an offsetting order placed at a pre-determined price. One option is to place a profit target at a price that will capture a price move equal to the entire height of the triangle. For example, if the triangle was $1 in height at its thickest point (left side), then place a profit target $1 above the breakout point if long, or $1 below the breakout point if short.
Profit targets are the simplest approach for exiting a profitable trade since the trader does nothing once the trade is underway. Eventually, the price will reach either the stop loss or profit target. The problem is that sometimes the trade may show a nice profit, but not reach the profit target. Traders may wish to add additional criteria to their exit plan, such as exiting a trade if the price starts trending against the position.
A more advanced form of this strategy is to anticipate that the triangle will hold or to anticipate the eventual breakout direction. By assuming the triangle will hold, and anticipating the future breakout direction, traders can often find trades with very big reward potential relative to the risk.
It works like this: assume a triangle forms and a trader believes that the price will eventually break out of it to the upside. In this case, they can buy near triangle support, instead of waiting for the breakout. By buying near the bottom of the triangle the trader gets a much better price. With a stop loss placed just below the triangle risk on the trade is kept small. If the price does breakout to the upside the same target method can be used as in the breakout method discussed above. Because of the lower entry point, the trader that anticipates stands to make much more than the trader who waited for the breakout.
If a trader thinks the price will eventually break below the triangle, then they can short sell near resistance and place a stop loss just above the triangle. By going short near the top of the triangle the trader gets a much better price than if they waited for the downside breakout.
To use the "anticipation strategy" a triangle needs to touch support and/or resistance at least three times. This is because it is on the third (or later) touch of support/resistance that the trader can take a trade. The first two price swings are only used to actually draw the triangle. Therefore, to establish the potential support and resistance levels, and take a trade at one of them, the price must touch the level at least three times.
The trade in figure four would not work for the anticipation strategy since the price broke higher before coming back to touch the recently drawn support line. Figure five, on the other hand, shows the anticipation strategy in action.
Position Size and Risk Management
Always utilize a stop loss. Even if the price starts moving in your favor, it could reverse course at any time (see false breakout section below). By having a stop loss means risk is controlled. The trader exits the trade with a minimal loss if the asset doesn't progress in the expected direction.
To calculate the ideal position size, determine how much you are willing to risk on one trade. Professional traders typically risk 1% (or less) of their account balance on any one trade. Calculate 1% of your account, as a dollar amount. For example, if your account is $36,500, you can risk up to $365 per trade.
Once you know this, take the difference between your entry and stop loss prices. For example, if your entry point is $15 and your stop loss is $14.90, then your risk is $0.10 per share. To calculate how many shares you can take on your trade, divided $365 by $0.10. You can take a position size up to 3,650 shares.
This is the maximum position you can take to keep your risk on the trade limited to 1% of your account balance. Make sure there is an adequate volume in the stock to absorb the position size you use. If you take a position size that is too big for the market you are trading, you run the risk of getting slippage on your entry and stop loss.
False breakouts are the main problem traders face when trading triangles, or any other chart pattern. A false breakout is when the price moves out of the triangle, signaling a breakout, but then reverses course and may even break out the other side of the triangle.
False breakouts are a part of trading and can result in losing trades. Don't be discouraged. Not all breakouts will be false, and false breakouts can actually help traders take trades based on the anticipation strategy. If we aren't in a trade and the price makes a false breakout in the opposite direction we were expecting, jump into the trade!
For example, assume a triangle forms and we expect that the price will eventually breakout to the upside based on our analysis of the surrounding price action. Instead, the price drops slightly below the triangle but then starts to rally aggressively back into the triangle. Consider taking a long trade, with a stop loss just below the recent low. Since the move to the downside failed, it is quite likely that the price will try to go higher, in line with our original expectation.