A triangle is the most common way for market consolidation and therefore understanding how a triangle is forming is vital to any successful trader.
There are two types of triangles; contracting and expanding ones, and out of these two, contracting triangles are to be found more often than the expanding ones. Not to say that expanding triangles are not forming, but when one is looking for a consolidation, then a contracting triangle is most likely to form.
In terms of their appearance, a triangle has five segments, no more, no less, and the moment it is completed should be found by connecting the end of those segments and interpreting the resulting trend line.
In terms of Elliott Waves, a triangle is labeled with letters, a-b-c-d-e and the two trend lines are the a-c and b-d. Therefore, a triangle is completed by the time the b-d trend line is broken so that would be the moment a new move should start.
Staying with Elliott, all of those five waves of a triangle must be corrective as well, so one should look for either complex or simple corrections to form, and not impulsive waves.
Sometimes the b-d trend line is retested, actually most of the times it is retested, but that is not mandatory, like is not mandatory for the triangle to have a measured move.
The nature of a triangle is given by the way the two trend lines are shaping up, in the sense that if they are moving towards a common point on the right side of the chart, it is said that the triangle is contracting, while the opposite is true in the case of an expanding triangle.
The way to trade a contracting triangle is to measure the length of its longest leg with a Fibonacci retracement tool and find the 50% level. If the triangle is forming at the end of a complex correction, it will act as a reversal pattern, while if it is forming in a trending market, it will act as a continuation pattern.
In both cases, the 50% level should be decisive when considering when to enter the market as due to the nature of a contracting triangle, its legs will retrace beyond that level. This means in a bullish triangle we can look to buy on any dip below 50% for a break of the b-d trend line, while in a bearish one, we should look to sell on any move above the 50% level.
Triangles can also be ascending or descending, and when this is happening usually the b-d trend line is almost horizontal. However, both ascending and descending triangles should respect the rules of a contracting triangle and it must be said here that they can only appear as a continuation pattern.
Because of that, it is vital to know the trend prior to the triangular formation and then look for the triangle to break in the same direction.
The time frame the triangle is forming on is also important in the sense that a triangle on the monthly chart is clearly more powerful than one on the hourly chart. Trading a triangle on a bigger time frame should be similar with trading it on any time frame only that the time expectations should be different.
In Elliott Waves Theory a triangle can be either a simple or a complex correction and the confirmation for a simple correction would come from the way the b-d trend line is broken. It can form as a B wave in any correction, an E wave in a triangle of a bigger degree, an X wave in a complex correction, or simply being the end of a complex correction.
As you can see, there are many possibilities and places where a triangle can be found and this tells much about the common pattern a triangle is.
Triangles can be spotted using divergences as well as during the formation of its legs usually price and an oscillator will diverge. Therefore, if the triangle is a bullish one then by the time waves C and E are forming, most likely price will diverge from an oscillator, showing us a nice possibility for a trade.
Look for more about trading divergences here on ForexGator.com by searching our educational section for the dedicated article.
Next article will deal with fundamental analysis and the importance of central banks.