Triangle Formation Rules - Part 10

The Nuances of Trendline Drawing

The accurate drawing of trendlines is the foundation of successful triangle pattern trading. A poorly drawn trendline can lead to a false signal and a losing trade. A trendline should connect at least two swing highs or two swing lows. The more touches a trendline has, the more significant it is. A trader should use the highs and lows of the candle bodies, not the wicks, to draw the trendlines. The wicks represent intraday volatility, while the bodies represent the opening and closing prices, which are more significant.

There is an element of subjectivity in drawing trendlines. Two traders may draw slightly different trendlines on the same chart. However, the general shape of the pattern should be clear. If a trader has to force the trendlines to fit the price action, the pattern is likely not valid. A clean and obvious pattern is more reliable because it is being watched by a larger number of market participants. A trader should practice drawing trendlines on historical charts to develop a feel for what constitutes a valid pattern.

The Breakout Confirmation Checklist

Before entering a trade on a triangle breakout, a trader should run through a mental checklist to confirm the validity of the signal. This checklist can help to filter out low-probability trades and improve the consistency of the results. The checklist should include the following points:

1. Is the pattern well-formed? The trendlines should be clear and have at least two touches each.
2. Is the volume confirming the pattern? Volume should diminish as the pattern forms and surge on the breakout.
3. Is the breakout decisive? The price should close significantly outside the trendline, not just poke its head out.
4. Is the breakout in the direction of the primary trend? A breakout in the direction of the trend on a higher timeframe is more likely to succeed.
5. Is the risk-to-reward ratio favorable? The potential reward of the trade should be at least twice the potential risk.

Worked Example: AAPL Symmetrical Triangle and Checklist

A symmetrical triangle forms on the 15-minute chart of Apple (AAPL). The upper trendline connects the highs of $175 and $174. The lower trendline connects the lows of $172 and $173. A breakout occurs at $174.20.

• Checklist:
  1. The pattern is well-formed with two touches on each trendline.
  2. Volume has been declining for the past 2 hours and surges on the breakout candle.
  3. The breakout candle is a strong green candle that closes at $174.50, well above the trendline.
  4. The daily chart of AAPL is in an uptrend.
  5. The height of the triangle is $3. The target is $174.20 + $3 = $177.20. The stop is placed at $173, below the last swing low. The risk is $1.20. The reward is $3. The R:R is 2.5.
• Entry: The checklist is satisfied. A trader buys 100 shares at $174.50.
• Stop: The stop loss is placed at $173.
• Target: The target is $177.20.

The Role of Market Internals

Market internals can provide valuable information about the health of a breakout. The NYSE TICK is a short-term indicator that measures the number of stocks trading on an uptick versus a downtick. A strong breakout to the upside should be accompanied by a high TICK reading, such as +800 or higher. This indicates broad market participation in the rally. A breakout on a low or negative TICK reading is suspect and may be more likely to fail.

The Advance/Decline Line (A/D Line) is another useful market internal. The A/D Line measures the net number of advancing stocks versus declining stocks. In a healthy uptrend, the A/D Line should be making new highs along with the market. If the market is making a new high but the A/D Line is not, this is a bearish divergence and can be a warning sign that the trend is losing momentum. A breakout from a triangle is more likely to succeed if the A/D Line is confirming the move.

Key Takeaways:

• Accurate trendline drawing is crucial for successful triangle trading.
• A breakout confirmation checklist can help to filter out low-probability trades.
• A worked example on AAPL demonstrates the use of the checklist.
• Market internals like the NYSE TICK and the A/D Line can provide confirmation of a breakout.