The Money Triangle
Making the Most Out of a Classic Formation
Markets remain in the balance but not well balanced. Stock indices are within the volatile range set in the first six weeks of the year. The Dollar continues to correct the 2017 downtrend as are commodities (including Bitcoin). And yields? They are pushing the upside in what we believe is the last fateful leg of the uptrend. If we are right they are lagging the Dollar but leading stocks into what promises to be the biggest market shake out in a long time.
Such inflection is exemplified by very clear triangles in many stock indices. Triangles are very powerful formations. Such narrowing markets often produce sharp but ultimately shortlived thrust.
This week’s newsletter explains how triangles really work and why they are the perfect TECHnical formation for what we are seeking.
Elliott Wave Formation
The triangle is a classic technical correction to a trend that comes in three forms in any time frame. Symmetrical where resistance and support lines converge and asymmetrical ascending triangle where only the support line converges into a flat resistance and a descending triangle where only the resistance converges into a flat support line.
According to many textbooks they should be seen as continuation patterns that serve as a holding pattern before the trend resumes. However, experience shows this is not so clear cut and that they can and often flatter to deceive and reverse the trend.
In essence triangles are probability formations that can break either way. The reason is that triangles are not often driven by fundamentals or intermarket factors.
Rather they are a creature of sentiment and positions. As the preceding trend and sentiment becomes extreme and subject to an initial reversal, the market then enters an equilibrium range – effectively a debate about the next major move.
As the trend and reversal tend to be relatively sharp the debate is heightened and attracts positions both ways. The weighting and timing of those trades helps determine the shape of the triangle. Textbooks would have you believe that structure reflects the distribution of trades and which way it will break, ie flat lines are weak converging lines are strong. But that doesn’t have to be the case as it implies consistency and uniformity of position taking that is too perfect. For example, If one trader continues to buy at a particular level eg 10 x 10 at 100 and 100 traders sell 1 on smaller rallies, if that one trader doesn’t liquidate his position, in reality leaves the market short and the converging line vulnerable as we have seen recently on SPX.
Indeed when the triangle lines break and a supposed resolution either way is found, traders will often turn around and join the break out with relatively weak positions at relatively poor levels. It doesn’t much then later to take them out as and when the triangle thrust is reversed. Regardless of which way the triangle breaks, what appear stable equilibrium ranges more often thanK now give rise to unstable that is volatile two-way price movement. Exactly what we are seeking on global indices which begs the question of exactly where should triangle thrusts stop.
Traditional triangle targets are a variable feast. Many take it to be the distance of the widest part of the triangle from the high or the break out although we generally take 50% of the widest point from the apex for the most conservative objective and on the top of the high for the most aggressive target. This approach is consistent for all three types of a triangle and is currently in play on the longer term Indian Nifty market.
Elliott Wave Formation
The Elliott wave analysis of triangles (as shown above) provides a clear framework through the consolidation and the subsequent break out and reversal. Traditional analysis does not prescribe the number of times the instrument should touch the line before it breaks. This often leads to under-definition; that is many will prematurely treat a correction as a triangle on the basis of 3 or 4 touches of both support and resistance lines and get caught out when it develops into another pattern. Triangles are periods of market indecision and therefore should reflect this leading many to sit out the consolidation.
However, the Elliott Wave triangle with its 5 legs (ABCDE) circumvents this. It is a very useful tool in three respects. Firstly it helps manage expectations with standard percentages. Secondly it provides supporting evidence through the shifts in sentiment and change of character in what is typically an awkward market.
Thirdly it importantly helps time the break out once the five legs are complete. Clearly in the case of a (fourth wave) triangular correction, the third downleg (E) represents the optimal and last buying opportunity before the break out continuation with the trend. But that begs the question whether it is a (fourth wave) triangular correction.
Context is significant to successful triangle analysis.
Firsly context is important not just to determining whether the triangle is a correction to the uptrend (downtrend) as opposed to an internal correction within a larger retracement that produces a spike lower before the uptrend resumes. As the first (Surprise) leg of a continuation triangle is the largest move then it should normally retrace more than 38.2% of the preceding trend sequence, although knowing what that particular instrument likes to retrace in triangles or other corrections is useful. Also the scale of (Hope) leg helps define the shape of the triangle for a continuation triangle should be more than 76.4%. Anything less runs the risk of being a continuation (B wave) triangle of the first sell off.
Secondly, triangles rarely occur as corrections in the early stages of trend sequences (ie not second wave corrections). Intuitively it makes sense as triangles are generally not fundamentally driven formations. Also the momentum loss and indecision are normally more associated with established trends that are tiring and losing their fundamental drivers.
The simple (ie traditional) triangle in Starbucks in 2004-2005 reflects this well and shows the subsequent triangle thrust and reversal. Perhaps more importantly it also provides a stunning template for the DJIA over the next few months.
Textbook descriptions of technical formation can misleading because they cannot address the underlying conditions and drivers of the market (context) but also what that market tends to do at the juncture in the cycle or trend. Some markets form perfect triangles in one time frame but abortive triangles in other. Some rarely triangulate others frequently and often with percentage retracements typical for that instrument. In other words there are probabilities about probabilities (contingent probability). This may seem to reduce the general effectiveness of triangles but that can change dramatically if a similar triangle is found previously in that instrument in similar conditions. For much of this year we have relied on the 1987 SPX flat bottom triangle inflection to guide us through what has been a volatile but erratic market.
We fully expect it to continue guiding us for the rest of the year. The current 1987 triangle may be TECHnical and driven by sentiment rather than fundamental or intermarket influences. It may be the top but we doubt it. But either way we will continue to follow the TECH in the confident expectation it will produce more than nickels. Slowly but surely the US triangle is being blown up into a very hot market.
Here’s to making the very best.
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