Secrets of the Triangle Pattern

01/20/2016 7:00 am EST

Focus: STRATEGIES

Juan Sarmiento identifies several misconceptions about the triangle pattern and shows how proper Elliott Wave analysis can help traders predict market direction and structure trades appropriately.

The triangle is one of the most characteristic patterns on the charts for various financial markets, but I don't hear traders talk much about them. Yet, the triangle can be quite powerful if only one understands the larger Elliott Wave patterns where it fits. 

Most people refer to triangles as "pennants" and even "wedges" and technical analysis books talk about triangles in a generic way, without any reference to Elliott Wave.

Contracting triangles, in particular, are significant because the share volume of the stock and the implied volatility of the options tend to decline as traders lose interest in a chart that seems to be going nowhere.

As the triangle progresses, the more astute options trader may enter a straddle in advance of the conclusion of the pattern, hoping for a strong move in either direction. But here is my secret: the very structure of the triangle may give us a clear indication of the direction that the price chart will take after the triangle concludes. In fact, one can even get a clue as to how strong the trend is going to be.

As a result, we need not buy straddles, which are notoriously expensive and highly susceptible to time decay. Instead, by forecasting the direction of the market, we could buy a call, a put, or directional butterflies or vertical spreads that are much cheaper than the straddle. 

From Elliott Wave theory, we know that triangles are corrections in the middle of larger, trending patterns. They may occur as the fourth wave in an impulse, or the B wave in a zigzag, or the X wave in a double zigzag. Based on the trend that was in place before the triangle started, we can anticipate what the direction and strength of the trend is going to be at the end of the triangle.

The structure of the triangle defines the strength of the trend to follow. The contracting running triangle described by Glenn Neely in his book Mastering Elliott Wave is not symmetrical. Contrary to popular belief, triangles don't have to be horizontal, the waves don't have to be progressively smaller, and the two trending lines don't have to go in opposite directions.

In fact, if the two trend lines go up, but still converge, the exit of the triangle will be strong in the direction of both trending lines that surround the triangle. The contracting running triangle is easy to identify because the second wave (b wave) is larger than the first wave (a wave) and the fourth wave (d wave) is larger than the third wave (c wave). The tough part is identifying the beginning of the triangle so that we can properly place the trending lines around it. However, by enclosing the preceding trend in two parallel lines (channel), we could detect the end of the trend and thus the beginning of the triangle (see video below).

And here is one more secret: contrary to popular belief, not all six turning points of the triangle (including the beginning of wave a) have to touch the trend lines. In fact, each trend line must be at the very tip of only two turning points, for a total of four out of the six turning points. This single rule should open your eyes as to what a triangle is, where should it start and end, and what the direction of the market price will be as the apex is exceeded.

By Juan Sarmiento, independent trader, OptionsVet.com

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