From the June 01, 2012 issue of Futures Magazine • Subscribe!

Trading stocks with triangles

Symmetrical triangles

A symmetrical triangle pattern comprises price fluctuation where each swing high and swing low is smaller than the previous swing. Volume tends to fall as the pattern develops. A sharp increase in volume confirms any break higher from the dominant pattern. In general, trading activity diminishes until the apex of triangle is formed.

A symmetrical triangle pattern should contain at least two lower highs and two lower lows. Also, the second high should be lower than the first high, with the upper trendline sloping downward. Similarly, the second low should be higher than the first low, with the lower trendline sloping higher. 

As seen in “Sideways pattern” (below), Tata Motors is trading within the price range of $16 to $22. As time went by, Tata made lower highs of $19.60 and $18.50 to form a downward sloping trendline. Tata Motors also made higher lows of $16.70 and $16.90 to form an upward rising trendline. Also true to form, volume activity diminished with the contraction in the trading range. At the apex of the triangle, we witness a strong breakout upward.

There are two key components to a symmetrical triangle breakout: Price and volume. With regard to price, the breakout confirmation should be on a closing basis only. For an upside breakout, the stock should close decisively outside of the triangle formation with a pickup in volume. Breakdowns also require a decisive price break of the formation, but the volume does not need to display a significant increase in activity. 

You can calculate the extent of the subsequent breakout move from a triangle formation by taking the difference between the top and bottom of the range and adding it to the breakout point. For Tata Motors, it would be $19.40 (the price at the breakout point) + $20.80 (the high of the range) – $16 (the low of the range) = $24.20. Keep in mind that this type of target calculation is a rough estimate, and price often trends higher (as it does in the Tata Motors example); however, the target typically is a good level to reduce market exposure or tighten risk control measures, such as stops.

Symmetrical triangles provide little, if any, indication as to which direction the stock ultimately will break out. This is not a problem because the nature of the formation allows for tight stops in case of false breakouts. Other types of triangles, however, can offer some clues. 

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