Introduction What does a descending triangle look like? Why is the descending triangle pattern important? Is volume important in a descending triangle pattern? What are the details that I should pay attention to in a descending triangle pattern? How can I trade this pattern?

Introduction

The triangle pattern, also called the "coil," appears in three varieties:

1. descending,
2. ascending, and
3. symmetrical.

Ascending and descending triangles are also referred to as "right-angle" triangles.

Generally, a triangle pattern is considered to be a continuation or consolidation pattern. Sometimes, however, the formation marks a reversal of a trend.

Descending triangles are generally considered bearish, ascending triangles are bullish and symmetrical triangles are neutral. From a time perspective, triangles are usually considered to be intermediate patterns. Usually, it takes longer than a month to form a triangle. Seldom will a triangle last longer than three months. If a triangle pattern does take longer than three months to complete, Murphy advises that the formation will take on major trend significance. ¹

What does a descending triangle look like?

Converging trendlines of support and resistance gives this pattern its distinctive shape. This occurs, Kahn explains, because "the trading action gets tighter and tighter until the market breaks out with great force."² Buyers and sellers find themselves in a period where they are not sure where the market is headed. Their uncertainty is marked by their actions of buying and selling sooner, making the pattern look like an increasingly tight coil moving across the chart.

As the range between the peaks and troughs marking the progression of price narrows, the trendlines meet at the "apex," located at the right of the chart. The "base" of the triangle is the vertical line at the left of the chart which measures the vertical height of the pattern.

A descending triangle, like the other two triangles, features two converging trendlines. In this "flat-bottom" triangle, the bottom trendline is horizontal and the top trendline slopes downward. The pattern illustrates lows occurring at a constant price level, with highs moving constantly lower.

Why is the descending triangle pattern important?

A descending triangle pattern is relatively easy to identify. In addition, triangle patterns can be quite reliable to trade with very low failure rates. There is a proviso concerning trading these patterns, however. As mentioned previously, a triangle pattern can be either continuation or reversal patterns. Typically, they are continuation patterns. To achieve the reliability for which the triangle is well known, technical analysts advise waiting for a clear breakout of one of the trendlines defining the triangle.

Triangle patterns are usually susceptible to definite and dependable analysis, with the proviso that the investor must wait for a reliable, as opposed to a premature, breakout. Bulkowski advises that, in general, the failure rate for triangles drops significantly if the investor waits for a valid breakout and, once that breakout occurs, the pattern proves strongly reliable. ³

Murphy advises that a minimum penetration⁴ criterion would be a closing price outside the trendline and not just an intraday penetration. Similarly, Schabacker warns of the "false moves" and "shake-outs" which most commonly attend the triangle.⁵

Is volume important in a descending triangle pattern?

Volume is an important factor to consider when determining whether a formation is a true triangle. Typically, volume follows a reliable pattern: volume should diminish as the price swings back and forth between an increasingly narrow range of highs and lows. However, when breakout occurs, there should be a noticeable increase in volume. If this volume picture is not clear, investors should be cautious about whether the pattern is a true triangle.

This traditional volume pattern develops because of investor sentiment during the creation of a triangle. Investors are uncertain. This uncertainty means that they are buying and selling sooner, which translates into a narrowing of the highs and lows, creating the "coil" shape, indicative of the triangle. Because investors are uncertain, many are holding on to their stocks, awaiting the market's next move. When breakout finally does occur, there's a surge in market activity because investors are finally certain enough about the direction of the market to release their pent-up supply or demand.

What are the details that I should pay attention to in a descending triangle pattern?

1. Occurrence of a Breakout - Technical analysts pay close attention to how long the triangle takes to develop to its apex. The general rule, as explained by Murphy, is that prices should break out -and clearly penetrate one of the trendlines - somewhere between three-quarters and two-thirds of the horizontal width of the formation.⁶ The break out, in other words, should occur well before the pattern reaches the apex of the triangle. Elaine Yager, Director of Technical Analysis at Investec Ernst and Company in New York and a member of Recognia's Board of Advisors, strongly agrees that a breakout well before the apex and with significant volume is essential. To take the measurement, begin by drawing the two converging trendlines. Measure the length of the triangle from its base to the apex. Next, plot the distance along the horizontal width of the pattern where the breakout should take place. If prices remain within the trendlines beyond the three-quarters point of the triangle, technical analysts will approach the triangle with caution. Typically, warns Murphy, if prices don't breakout of the trendlines before that point, the triangle "begins to lose its potency"⁷ and prices will simply drift out beyond the apex with no surge in either direction.

2. Price Action - With its "flat-bottomed" shape, the descending triangle indicates that sellers are more aggressive than buyers. The pattern typically emerges when buyers feel that the stock is overvalued and decide that the fair value is at a specific lower level. These buyers are prepared to purchase the stock if it hits that specific price level. The floor does not hold because demand wanes - possibly buyers have run out of money or interest in the stock. Once the downside breakout occurs, the stock price continues to fall.

3. Measuring the Triangle - To project the minimum short-term price objective of a triangle, an investor must wait until the price has broken through the trendline. When the price breaks through the trendline, the investor then knows whether the pattern is a consolidation or a reversal formation.

To calculate the minimum price objective, calculate the "height" of the formation at its widest part - the "base" of the triangle. The height is equally determined by projecting a vertical line from the first point of contact with the trendline on the left of the chart to the next point of contact with the opposite trendline. In other words, measure from the highest high point on one trendline to the lowest low point on the opposite trendline. Both these points will be located on the far left of the formation. Next, locate the "apex" of the triangle (the point where the trendlines converge). Take the result of the measurement of the height of the triangle and add it to the price marked by the apex of the triangle if an upside breakout occurs and subtract it from the apex price if the triangle experiences a downside breakout.

For example, working with a descending triangle, assume the highest high is 180 and the lowest low occurs at 150. The height of the pattern is (180 -150 = 30). The apex of the descending triangle also occurs at 150. The pattern experiences a downside breakout. This means the pattern has a target price of 120 (150 - 30 = 120). If the pattern had experienced an upside breakout, the target price would have been 180 (150 + 30 = 180).

4. Duration of the Triangle - As mentioned before, the triangle is a relatively short-term pattern. It may take up to one month to form and it usually forms in less than three months.

5. Forecasting Implications - The descending triangle is considered to be bearish. Bulkowski, however, warns that only 55% of developing descending triangles actually prove to be bearish.⁸ However, if investors wait for a valid breakout, then the success rate increases to 96%. Statistics compiled by Bulkowski show that descending triangles are less likely to hit their target prices than ascending ones.⁹ According to Edwards and Magee, volume confirmation is more important for ascending triangles than descending ones.¹⁰

6. Shape of Descending Triangle - Prices should rise to hit the upper trendline at least twice (two highs), then fall away. Prices should fall to the lower trendline at least twice (two lows), then rise. The horizontal bottom trendline need not be completely horizontal but it often is and, in any event, it should be close to horizontal.

7. Volume - Murphy advises that in the descending triangle, volume tends to be slightly higher on dips and lighter on bounces.¹¹

8. Premature or False Breakouts - Bulkowski calls them "premature" false breakouts¹² and Schabacker refers to them as "false moves" or "shakeouts"¹³ Both agree that triangles are among the patterns most susceptible to this phenomenon. Because the pattern can be either a reversal or continuation pattern, investors are particularly susceptible to false moves or, at the very least, confused by them. In addition, because volume becomes so thin as the triangle formation progresses to the apex, it takes very little activity to bring about an erratic and false movement in price, taking the price outside of the trendlines.

To avoid taking an inadvisable position in a stock, some investors advise waiting a few days to determine whether the breakout is a valid one. ) Typically, a false move corrects itself within a week or so.¹⁴ A key sign of a possible false move is low volume. Yager cautions that the pattern immediately will be suspicious without an accompanying high volume breakout. If there's no pick-up in volume around the breakout, investors should be wary. Typically, a good breakout from a triangle formation will be accompanied by a definite surge in volume.

There are situations, however, where a false move will occur with high volume. According to Schabacker, these are the most dangerous variety of false moves.¹⁵ The only advice experts can give to investors who fall prey to one of these false moves is to reverse their positions as soon as they become aware of the true movement of the stock.

It is also advisable to be increasingly suspicious of triangle patterns where the breakout occurs very close to the apex. Because trading is so thin at this point, there is an increased likelihood that a false move could occur.

How can I trade this pattern?

Edwards and Magee offer different trading strategies depending on whether you already have a position in the stock or whether you do not have a position in a stock experiencing a triangle formation. If an investor already has a position in a stock, he or she may be "locked" into that position as the formation takes shape because it is not possible to definitively predict which way the breakout will take the price of the stock.¹⁶ The key is waiting and watching for a valid breakout before making an investment decision.

If an investor does not have a position in a stock, Edwards and Magee advise staying away from the stock when it's in the process of forming the triangle pattern. Consider a position when a dependable breakout has occurred. "After such a breakout, if on the upside, buy on the next reaction if the Major Trend is up, or if on the downside, sell short on the next rally if the Major Trend is down." ¹⁷

Given the contradictory nature of the direction of breakouts from triangles, all experts advise caution with triangles while they're in the process of forming. (". . . it might be better policy to note such formations in the making, and wait until the decisive breakout before making the new commitment." ¹⁸) However, once a valid breakout has been detected, the same experts agree that triangles are a reliable pattern to trade.

As mentioned, this pattern has a tendency to premature breakouts and false moves. To avoid mistaking a false move for a valid breakout, experts advise waiting a few days to see if the breakout is dependable. According to Murphy, a minimum penetration criterion would be a closing price outside the trendline and not just an intraday penetration.¹⁹ Investors do have time once a breakout has occurred.

Because premature breakouts (where prices close outside of the trendline) are so common, don't dismiss the pattern if it has experienced such a breakout. According to Bulkowski, however, "premature breakouts do not predict the final breakout direction or success or failure of the formation." ²⁰

Be wary of breakouts from triangles where the breakout does not occur until the apex of the triangle. Experts, including Edwards and Magee, maintain that the most reliable breakouts occur about two-thirds of the way along the triangle. ²¹

The triangle pattern should not show too much "white space," states Bulkowski.²² If there's too much white space in the middle portion of the triangles created as price moves from lows to highs, then the pattern may not be a triangle. In a valid triangle, price should bounce back and forth in a fairly regular pattern, as price moves toward the apex.

Bulkowski advises that it is very common for a triangle formation to experience a throwback (where prices break upward and then fall back to the formation) or a pullback (where prices break downward and then rise up again to meet the formation). Throwbacks and pullbacks tend to complete within a couple of weeks and the breakout continues as before. ²³

¹Murphy, p. 130
²Kahn, p. 51
³Bulkowski, p. 512
⁴Murphy, p. 133
⁵Schabacker, p. 352
⁶Murphy, p. 133
⁷Murphy, p. 133
⁸Bulkowski, p. 536
⁹Bulkowski, p. 536
¹⁰Edwards and Magee, p. 484
¹¹Murphy, p. 140
¹²Bulkowski, p. 514
¹³Schabacker, p. 350
¹⁴Schabacker, p. 350
¹⁵Schabacker, p. 355
¹⁶Edwards and Magee, p. 482
¹⁷Edwards and Magee, p. 484
¹⁸Edwards and Magee, p. 485
¹⁹Murphy, p. 133
²⁰Bulkowski, p. 523
²¹Edwards and Magee, p. 484
²²Bulkowski, p. 517
²³Bulkowski, p. 523