Triangle Patterns Signal Continuation

02/22/08 08:58:28 AM

by Alan R. Northam

Triangle patterns signal the continuation of the current market or stock trend and provides a method of measuring the minimum expected extension of that trend.

Security: $UTIL
Position: N/A

Triangle patterns often show up on stock price charts and are formed over a period of several weeks when price peaks form a downward sloping trendline and price lows form an upward sloping trendline. To be a valid triangle pattern, volume must decrease as the triangle pattern is formed. Figure 1 shows such a pattern.

Figure 1 shows a price chart for the Dow Jones Utility Average (DJUA). In early December 2007 through early January 2008 the DJUA formed a double-top reversal pattern. Subtracting the lowest low price between the two price tops from the highest high price of the two price tops, and then subtracting this difference from the lowest price between the two price tops a minimum lower price target for this market is calculated. On January 22, 2008, the price target was hit as the market traded downward and went on to make a lower low for that day. Since hitting the price target, the DJUA went on to consolidate its losses over a four-week period, forming a symmetrical triangle.

Symmetrical triangles also forecast the minimum price objective for the next leg up in a bull market and the next leg down in a bear market. This price objective is calculated by taking the highest price in the symmetrical triangle formation and subtracting the lowest price in the formation from it. This difference is then subtracted from the breakout price. The result is the minimum price distance that the market is expected to move in the direction of the breakout.

According to trading analyst and author Thomas Bulkowski (Encyclopedia Of Chart Patterns, copyright 2005, John Wiley & Sons, publisher), symmetrical triangles forecast the continuation of the current trend 55% of the time and forecast a reversal of the trend 45% of the time. Further, Bulkowski has determined that symmetrical triangles in bull market trends meet price objectives 66% of the time, a good statistic, while symmetrical triangles in bear markets only meet their price objectives 57% of the time, not quite as good. According to these statistics, symmetrical triangles are somewhat overrated as continuation patterns but do tip the balance between a continuation pattern or a reversal pattern in favor of continuation.

FIGURE 1: DOW JONES UTILITY AVERAGE. Here's a symmetrical triangle continuation pattern.

Graphic provided by: StockCharts.com.

In Figure 1 the symmetrical triangle made a price minimum of 477.82 on January 22, 2008, and a price peak of 521.20 on February 4, 2008. After consolidating for another two weeks, the symmetrical triangle formation was completed when the market broke out to the downside on February 21, 2008. By subtracting the price peak from the price minimum a calculated difference of 43.38 is obtained. This difference is then subtracted from the breakout price of 496.34 to determine the minimum expected price objective to the downside of 452.96. However, since price objectives are statistically met only 57% of the time, the market must be monitored closely to determine if the price objective will be met before turning back upward. To monitor the DJUA to see if it will continue downward and meet its price objective, a momentum oscillator such as the stochastic, the relative strength index (RSI), or rate of change indicator should be used. By monitoring one of these momentum indicators, traders will be able to determine if the momentum continues to remain strong during the move down or if momentum starts to weaken. Weakening momentum could be a sign that the DJUA may turn back upward before hitting its price objective.

Alan R. Northam

Alan Northam lives in the Dallas, Texas area and as an electronic engineer gave him an analytical mind from which he has developed a thorough knowledge of stock market technical analysis. His abilities to analyze the future direction of the stock market has allowed him to successfully trade of his own portfolio over the last 30 years. Mr. Northam is now retired and trading the stock market full time. You can reach him at inquiry@tradersclassroom.com or by visiting his website at http://www.tradersclassroom.com. You can also follow him on Twitter @TradersClassrm.