This Common Chart Pattern Offers a Clear Trade Setup
Triangles are chart patterns associated with periods of price consolidation.
A triangle is usually a continuation pattern. The market or stock that forms a triangle will usually continue trending after the brief consolidation is completed.
Chart patterns generally describe the picture they form on a chart. A triangle pattern connects higher lows and lower highs on a bar chart. As prices near the apex of the triangle (the pointed end), prices usually break out and continue their previous trend.
How Traders Use Triangle Patterns
Traders use triangles to set up trades. They’re made when prices close above or below one of the lines formed by the triangle. A stop can be placed at the level of the opposite line, offering a way to limit risk. Traders expect prices to move by the width of the pattern after the breakout.
As the markets were moving toward the top of the Internet bubble in late 1999, the Dow Jones Industrial Average and other indexes formed small triangles. This pattern included a false breakout, a move that is quickly reversed.
In this example, prices closed below the lower line of the triangle for one day before moving higher. False breakouts are fairly common in triangles and traders can delay acting on the signal to avoid this problem. That means waiting for two or more consecutive closes outside the triangle before trading.
Another example is shown in the chart below of Moody’s Corporation (NYSE: MCO). In this case, the triangle in the center of the chart was formed with one flat trendline instead of two sloping lines.
The triangle on the right side of the chart is the type of pattern traders must act on in real time. A trader would expect prices to break out to the upside.
The potential reward in this scenario is 17%, while risk is limited to about 5%. Many traders like to see a setup where the potential reward is more than three times greater than the risk.
Why Triangles Matter To Traders
The breakout from a triangle often signals a new price move has just started. This offers traders a chance to enter early and take advantage of a large portion of the move. With a price objective and a clearly defined risk level, traders can choose the trades offering the highest potential reward given a certain level of risk.
The pattern defines rewards and risk in terms of points, but this can easily be converted to percentages. Simply divide each by the current market price. Traders with multiple trading opportunities will usually choose the trade with the highest value of the reward-to-risk ratio. Many traders set a minimum reward to risk ratio of at least 2-to-1, or even 3-to-1.
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