Triangle Chart Patterns and Day Trading Strategies
The triangle pattern, in its three forms, is one of the common stock patterns for day trading that you should be aware of. These are important patterns for a number of reasons: they show a decrease in volatility that could eventually expand again. Triangles provide analytical insights into current conditions, and give indicators of types of conditions that may be forthcoming. The triangle pattern also provides trading opportunities, both as it is forming and once it completes.
An understanding of these three forms will give you an ability to develop breakout or anticipation strategies to use in your day trading, while allowing you to manage your risk and position size.
A symmetrical triangle occurs when the up and down movements of an assets price are confined to a smaller and smaller area over time. 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 moves are 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.
Applied in the real-world, 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 as demonstrated in figure two.
The price is still being confined to a smaller and smaller area over time, but it is reaching a similar high point each time the low moves 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 continuously lowering swing highs over time, and swing lows that reach similar price levels as the last lows. 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 a descending triangle (figure three).
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 (sell the asset before it hits a lower price, intending to buy it back even lower) when the price of an asset drops below the lower trendline of the triangle.
Breakout refers to a market situation where prices move above resistance levels or below support levels. These breakouts are used as indicators of opportunities for traders.
Since each trader may draw their trendlines slightly differently, the exact entry point may vary between traders. To help isolate when the price is breaking out of the support or resistance levels, observing an increase in volume can help highlight when the price is starting to gain momentum towards a breakout.
The objective of the breakout strategy is to capture profit as prices move away from the trend lines forming 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).
It helps to have exit strategies in place when purchasing, so you can sell when it is the right time based on your criteria.
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 their position.
More advanced forms of the breakout strategy are to anticipate that the triangle will hold and 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.
For instance, assume a triangle forms and a trader believes that the price will eventually break out to the upside. In this case, they can buy near triangle support (the bottom of the low), instead of waiting for the breakout. This creates a lower entry point for the trade; by purchasing near the bottom of the triangle the trader also gets a much better price.
Placing a stop-loss just below the triangle reduces the amount of risk on the trade. If the price does break out to the upside the same target method can be used as 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.
Upsides are the upswings in prices, while downsides are the downswings.
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 the support and/or resistance level at least three times. This is because it is on the third (or later) touch of support or resistance that the trader can generally take a trade—peaks and troughs generally run in series of three.
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 shown in figure four would not work for an 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
You should 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). Having a stop-loss means most of the risk is controlled. The trader with a stop-loss exits a trade with a minimal loss if the asset doesn't progress in the expected direction.
Having a stop-loss in place also allows a trader to select their ideal position size. Position size is how many shares (stock market), lots (forex market) or contracts (futures market) are taken on trade.
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.
Using 1% of your balance in a trade is a good rule of thumb for mitigating risk.
Once you know the amount you can risk, 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 of 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 that 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 causing slippage (an increase in price in the time it takes the transaction to occur) 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 you're not in a trade and the price makes a false breakout in the opposite direction you were expecting, you should consider jumping into the trade.
For example, assume a triangle forms and you 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 your original expectation.
Final Word on Day Trading Triangle Patterns
Knowing how to interpret and trade triangles is a good skill to have when these types of patterns occur. They are common, but won't occur every day in every investment. Day traders will typically require a broader range of strategies than only trading triangles. The concepts discussed here can be used to trade other chart patterns as well—such as ranges, wedges, and channels.
You should practice spotting, drawing and trading triangles in a demo account before attempting to trade these patterns with real money. Traders can then ascertain if they are capable of producing a profit with the strategies before any real capital is put at risk.