In part 1 of this series we introduce triangles, and here we continue that study by taking a closer look. Triangles appear in the following forms: ascending, descending and symmetrical (there is also a fourth category called the "expanding triangle"). The symmetrical triangle is best described as a continuation pattern, a formation that represents a slowdown or consolidation in a trend – whether an up or downtrend. Triangles are sideways trading actions, and the widest part of the correction occurs earliest in the development of the pattern. As the market continues in its sideways or horizontal pattern, the trading range narrows, forming the shape of a triangle.
In the formation of a triangle, there are two trendlines to draw. The upper trendline, which is referred to as the supply line, represents resistance. The supply line represents a lack of conviction by the buyers to commit more funds to the market in a particular issue, and because of that, there is enough profit-taking and short selling to turn prices back down. The lower trendline, however, is the demand line and represents support. In this situation, it is the buyers that come back to the party and drive the prices northward one more time.
There must be four reversal points in order for a triangle to be recognized, but one may also see as many as six reversal points (three peaks and three troughs). In John J. Murphy's text "Technical Analysis of the Financial Markets," he describes the time limit for the resolution of a triangle:
|"There is a time limit for the resolution of the pattern, and that is the point where the two lines meet-at the apex. As a general rule, prices should break out in the direction of the prior trend somewhere between two-third and three-quarters of the horizontal width of the triangle. That is, the distance from the vertical base on the left of the pattern to the apex at the far right. Because the two lines must meet at some point, the time distance can be measured once the two converging lines are drawn. An upside breakout is signaled be a penetration of the upper trendline. If the prices remain within the triangle beyond the three-quarter point, the triangle begins to lose its potency, and usually means that prices will continue to drift out to the apex and beyond."|
|Chart Created with Tradestation|
The chart shows Sun Microsystems and a very clear triangle. In the first week of October 2001, the market formed an isolated high. The market declined and formed an isolated low during the second week. Then, the market advanced and formed the second isolated high in the third week of October, at which time we drew the supply or resistance line. Three days later, the market traced out the final isolated low, and we drew the demand or support line. At this point, we anticipated the breakout to the upside because this stock was still in an uptrend based on an eight-week moving average. Then, on October 28, there was a gap up at the open and the stock took off. The perfect entry point was a penetration of the supply line, with a stop-loss point below the demand line.
Finally, you should use triangles to identify consolidation periods for strong market leaders that are in well-defined uptrends; watch how triangles or other continuation patterns are unfolding. As long as you can see the patterns acting as continuation patterns, the overall health of the market is strong. Failures by continuation patterns can forewarn of a more substantial market correction on the horizon.