Pattern recognition and trend-following can be combined to form a useful trading system. The particular pattern being reviewed is the triangle chart pattern, while the trend indicator is the 20-day exponential moving average (EMA). Both techniques can be used as a basis for an entry rule for trading opportunities. For an exit rule, we will rely on a trailing stop based on the parabolic indicator.
TRADING TECHNIQUES
Combining Patterns With Indicators
by William Q. Smith
Combining a technical indicator with another technical method can be the start of a viable trading system. Here's how one trader combined a technical indicator with a chart pattern to form one.
With that in mind, let's take a look at each of the methods individually and then determine how to use the techniques together.
TRIANGLES
The symmetrical triangle consists of two converging trendlines, with the upper or resistance line falling and the lower or support line rising. The point of intersection at the right where the two trendlines meet is referred to as the apex. The triangle is called symmetrical when the angle of both trendlines with reference to the apex is approximately equal. The minimum requirement for a triangle is four reversal points. It takes at least two points to draw a trendline, and in order to draw two converging trendlines, each line must be touched at least twice by the price action.
Traditional technical analysis theory holds that the symmetrical triangle is usually a continuation pattern. In general, the breakout will be in the same trend direction as before the triangle occurred; it is impossible to determine which direction the breakout will go. This trading system does not rely on the triangle being a continuation pattern, as it will take advantage of the breakout in either direction.
This chart pattern has intrigued me for years as I observed one tradable breakout after another form from a triangle pattern. The triangle is just a representation of a lessening of volatility; the market is slowing down. The battle between buyers and sellers has become a tug of war, with neither side winning. When the market reacts to an event such as a surprise news announcement, the breakout is usually pronounced and sustained, as those on the wrong side begin to close out their positions as protective stops are hit, adding fuel to the fire.
This is not to say that every triangle is going to provide instant profits. What is needed is a complementary indicator to help traders be more selective.
Excerpted from an article originally published in the November 1998 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 1998, Technical Analysis, Inc.
