We often hear about the directional nature of triangle patterns in charts (ascending versus descending), but we don’t often hear about the structure or shape of them. However, it is at least as important to recognize whether a triangle is contracting or expanding. The following is an overview of contracting and expanding triangles, with insights on relevant trading strategies!
Contraction: “the process of becoming smaller.“
When a triangle contracts, it gradually shifts from its widest range to its most narrow. Contracting triangles in charts are known as consolidation patterns. In addition to a tightening price range, we typically see volume erode as the pattern approaches its endpoint. Think about a pinball bouncing back-and-forth; initially, it has plenty of room to bounce between two “walls,” but as the lines narrow, the bounces are shorter and quicker. Breakout occurs just after what I refer to as “peak consolidation,” where price and volume reach maximum constriction. The break usually brings a rush of volume, largely driven by computer algos tracking the narrowing support and resistance levels.
Trading Contracting Triangles
It is difficult to recognize a contracting triangle early, although we know consolidation is most common in Elliott Wave 4 (impulse) or Wave B (Corrective). Often, overzealous traders buy into the volatility that forms the height of the triangle, and find themselves trapped in a narrowing range with little opportunity to exit profitably (in the near-term). In this scenario, time and opportunity cost become the enemy. Ideally, if you pick up on a contracting triangle as it reaches the end of its (standard) Wave D-E extension, you can get in just before the breakout. Alternatively, some traders wait for a breakout (to ensure it is in the right direction), and look to enter on a retest of the break point.
In this example, you see three successive contracting triangles. The first two had a significant upward breakout after the pattern culminated. Note that we label patterns based on left-to-right (ascending chronology) movement. If you read this chart from right-to-left (descending chronology), you see three successive expanding triangles.
Here is the most simple and concise definition of expansion:
Expansion: the action of becoming larger or more extensive.
In contrast to the contracting triangle, the expanding triangle reveals its narrowest point early, and shows a widening range with expanding swing ranges. Referring to the pinball analogy, the ball bounces quickly with limited moves initially, but has larger and longer bounces over time. Whereas contracting triangles reveal consolidation, expanding triangles demonstrate volatility. For that reason, they are most common in Forex, where trading is more speculative and influenced by global economic events. However, we do so expanding triangles in stocks based on market uncertainty, fear, enthusiasm and global/political events. These triangles can prevail in broader markets or in particular industries/stocks.
Trading Expanding Triangles
Expanding triangles present a much greater risk-reward proposition than contracting triangles. The volatility is difficult to discern early, since the pattern evolves from a relatively low volume and price range. However, traders that recognize leading indicators like economic uncertainty, surprise news or policy decisions, and other events that could trigger market emotion and fear, are more equipped to know when expansion is more likely.
It is always best to avoid momentum trading, but especially so when volatility is present. Traders in both directions (long and short) are often fooled by an expanding triangle because it doesn’t showcase the common relationship between higher/lower highs and higher/lower lows that we expect to see in a trend move. Instead, it sees higher highs on up swings and lower lows on down swings.
Traders who pick up on the volatility early can look for an ideal entry above the previous swing high or below the previous swing low. Conservative traders identify an ideal entry and accept the outcome if it isn’t reached. If you wait patiently for the right price, profit potential is huge on the next expansion swing. It is wise to take profit (at least some) ahead of, or at, the previous swing high/low, as the volatility and expansion ends at some point. Counting waves is also useful, as expanding triangles typically have 5 waves just as contracting ones do, before breakout.
In this example, you see an expanding triangle that forms from the $23.91 low. The swings gradually increase in range before the triangle eventually breaks to the topside. After the breakout, the expanding triangle resistance shifts to support that will likely be tested after the new pattern plays out. At that point, the pattern again either continues to the upside (breaking the new resistance) or breaks through the previous resistance, now support, and potentially forms a head-and-shoulders pattern.
If you look closely, triangles are a big part of investment charts on short, medium and long-term time-frames. It is important to note that triangle transitions are common. For instance, contracting triangles often transition into expanding triangles after breakout, and expanding triangles often segue into contracting triangles. Alternatively, we may see the breakout serve as a lead into the next similar pattern (as in the first example above).
This triangle transition is part of the basis for diagonal triangles and mirror patterns, which I discuss separately.
Conclusions and Recommendations
Trading triangle chart patterns (directionally and structurally) requires skills and discipline. There are drawbacks and risks with both contracting and expanding triangles, and different strategies to achieve profit optimization with mitigated risks. Know your strategy and determine your best approach to trading triangles, and exiting on a bad trade (downside risk and/or opportunity cost).