​The Value of Trading Contracting Triangles and Wave Corrections

April 16, 2017 06:45

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Dear Traders,

Many traders appreciated last month's article with my most favourite wave patterns. Being able to recognise wave 3 and "end of the trend" scenarios makes sense even for non-Elliott Wave traders.

This article adds another two patterns, which I think are relatively simple to identify. That is a win-win for both wave and non-wave traders.

Today we review the contracting triangle chart pattern and the end of the wave 4 correction.

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Trading triangle chart patterns

The Elliott Wave Theory explains how and why price moves as it does — with momentum and correction besides up, down and sideways. There are many variations of corrective patterns, but one particular pattern is my favourite — the contracting triangle.

The contracting triangle has many advantages because it is relatively simple to spot and trade. Why?

They key feature of the contracting triangle is that the tops and bottoms do not break. Or in other words, there are several lower highs and higher lows in a row.

The triangle usually offers 5 support and resistance (S&R) points in the pattern, although sometimes the pattern is extended with 9 S&R points.

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Price can break both above and below the triangle, but there is higher chance that the breakout will occur in the same direction as the previous momentum, which means:

  1. Bullish momentum before the formation of the triangle typically sees a bullish breakout above the triangle.
  2. Bearish momentum before the formation of the triangle typically sees a bearish breakout below the triangle.

This pattern, therefore, offers interesting trade possibilities and entry setups for traders because the tops and bottoms represent natural and strong support and resistance (S&R) points.

The S&R levels can be used in various ways:

  • For bounce entries:
    • Long entry near support.
    • Short entry near resistance.
  • For breakout entries:
    • Long entry as price breaks above resistance.
    • Short entry as price breaks below support.
  • For stop loss (SL):
    • Long entries should have SL below support.
    • Short entries should have SL above resistance.
  • For targets (take profits):
    • Bounce trades can target the opposite S&R of triangle, S&R from a higher time frame or a Fibonacci level.
    • Breakout trades can target S&R from a higher time frame or a Fibonacci level.

Basically, the triangle can be used to trade bounces within the triangle and breakouts away from the triangle.

I myself use candlesticks to measure whether a breakout or bounce trade setup has been properly formed. For more details on how I read the price action in general and how I interpret the candlestick itself, please check out the video below.

It will explain why the size of the candle is important and why percentage of the candle wick compared to the candlestick body is also vital.

Wave 4-5 patterns

Contracting triangles often occurs in wave 4s, but it can also apply to other moments. Generally speaking, wave 3 and even wave 1 are often more interesting to trade than wave 4 and 5.

However, there is an aspect of this formation that I appreciate — the price will typically retrace to the 38.2% Fibonacci retracement level. These patterns take their time to develop, so there is no rush.

  1. Time — there is plenty of time to wait for a corrective pattern to emerge. Wave 4s are typically the longest wave structure, so you can measure candles in wave 2 and assume that wave 4 will have more (as a guideline, not a rule).
  2. Fibonacci levels — if price retraces too quickly and breaks through the 38.2-50% Fibonacci zone, the pattern could hint at the reversal structure rather than a continuation pattern.

Typical patterns for a wave 4 are bull and bear flags, ranges, consolidation zones, contracting triangles, and ascending and descending triangles.

My favourite method of trading wave 4s is by anticipating a bounce at the 38.2% Fibonacci retracement level. Most often, I want to see a candlestick reaction to the Fibonacci level as a confirmation that a bounce is indeed occurring.

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Here are more details regarding the entry, stop loss and take profits:

  1. My entry is taken when the candlestick reaction confirms that the bearish or bullish bounce takes place at the 38.2% Fibonacci level.
    1. If price is retracing down to the Fib, then the Fib is support and I am looking for a long.
    2. If price is retracing up to the Fib, then the Fib is resistance and I am looking for a short.
  2. The stop loss can go below the recent candle low (when long) or candle high (when short). Other options for stop loss are placing the exit behind the 50% or 61.% Fibonacci level, which invalidates the wave 4 structure.
  3. Targets could aim for the previous top or bottom, Fibonacci target, Admiral Pivot Points and other indicators.

See the video below for more information on Fibonacci.

Cheers and safe trading,

Chris

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