24 February 2008

Triangles On the Dow Charts - Is There Any Significance To This?

Recently, I noticed two triangle patterns appeared on charts of the Dow Jones Industrial Average. Apparently, others noticed as well, from Daily Options Report:

Three of my favorite chart gurus, Trader Mike, Alpha Trends, and Afraid to Trade are all over the triangles about to bust out. Yes, the tightening range noose we have in the market is likely to end pretty imminently. And given that we classically bust out the same direction we entered (down), it doesn't bode well if you buy into the pattern and theory.

Jason Roney on Minyanville agrees, noting the S&P futures have traded at a price within 10 pts. of 1350 in 24 of the past 27 days. He's expecting a 3-5 day trend move to commence shortly.

The posting from the Afraid to Trade blog grabbed my attention:

Market Still in Triangulation Zone

The US Stock Market still has failed to break its recent symmetrical triangle or coil pattern, and the pattern is still forming on the major indexes.

Let's peek:

Most triangles resolve 66% to 75% of the way to the apex, and that is approximately where we are. Volatility has narrowed and typically price will eject into a trend move following these consolidation periods.

Triangles are mostly continuation patterns, meaning that the odds slightly favor resolution to the downside, but no pattern and no market prediction is ever 100% accurate, and this triangle could break to the upside as well.

Volume has also been declining as the triangle formed, which further confirms the pattern.

I drew the most recent triangle pattern, which occurred throughout the month of December. That particular triangle consolidation resolved to the downside. What will February's consolidation do?

We're currently in "wait and see" mode.

Before we go any further, I would like to point out that I try to maintain some skepticism when it comes to chart reading and technical analysis. Some of that skepticism I derived from reading Evidence Based Technical Analysis. The first reviewer over at Amazon gets the gist of the book for me. The gist is in bold:

5.0 out of 5 stars Great book, November 12, 2006
By Mike Carr, CMT (Cheyenne WY) - See all my reviews
In this thought-provoking work, David Aronson tests more than 6,400 technical analysis rules and finds that none of them offer statistically significant returns when applied to trading the S&P 500. This result, presented at the end of his work, is not disappointing to dedicated students of technical analysis who draw from the book not a new trading technique but instead take away a new, and more effective, approach to system development and trading. Those seeking the single best indicator or day trading pattern will be disappointed after reading Evidence-Based Technical Analysis, just as they will be disappointed in their trading until they advance beyond seeking the Holy Grail of Trading.

With that seed of doubt firmly planted, let's see how Investopedia defines triangles:

Symmetrical Patterns
So far we have seen two triangle patterns. One, from an uptrend and bullish market move and one from a downtrend with a decidedly bearish look. Symmetrical triangles, on the other hand, are thought of as continuation patterns developed in markets that are, for the most part, aimless in direction. The market seems listless in its direction. The supply and demand therefore seem to be one and the same.

During this period of indecision, the highs and the lows seem to come together in the point of the triangle with virtually no significant volume. Investors just don't know what position to take. However, when the investors do figure out which way to take the issue, it heads north or south with big volume in comparison to that of the indecisive days and or weeks leading up to the breakout. Nine times out of ten, the breakout will occur in the direction of the existing trend. But, if you are looking for an entry point following a symmetrical triangle, jump into the fray at the breakout point.

These patterns, both the symmetrical triangles on the bullish as well as the bearish side are known to experience early breakouts that give investors a "head fake". Hold off for a day or two after the breakout and determine whether or not the breakout is for real. Experts tend to look for a one-day closing price above the trendline in a bullish pattern and below the trendline in bearish chart pattern.

Remember, look for volume at the breakout and confirm your entry signal with a closing price outside the trendline.

Wow, Investopedia asserts that 9 out of 10 triangles will break out in the same direction of the existing trend. The December 2007 triangle resolved in a significant downward trend in January. Going into December 2007, the overall market trend was indeed bearish. The current February 2008 triangle is also occurring during a bearish trend, so according to the Investopedia entry, we have a roughly 90% chance of seeing another bearish result from the current triangle.

Are you convinced of what the future holds?

Me either.

Daily Options Report followed up his original post on triangles with some research from Minyanville:

A good start is just to look for multiple inside weeks, which is what we're getting now in the cash S&P 500 index. An inside week has a lower high than the prior week, and a higher low.

If we don't see a big move through Friday, then we'll have had two consecutive inside weeks in the S&P. That should work for the definition of a triangle pattern, in so much as it defines a contraction in volatility. I looked for any other double inside weeks since 1950, in the context of both a rising trend (upward sloping 50-day moving average) and declining trend.

In uptrends, the "triangle" led to positive one-month returns 4 times out of 6 occurrences, with an average return of +0.3%. The average winning trade was +2.7% while the average loser was -4.6%. Not impressive in the least.

In downtrends, the pattern led to positive one-month returns 3 times out of 5 occurrences, with an average return of +0.6%. The average winning trade was +2.7% while the average loser was -2.5%.

The interesting take-away from the test is that future returns after volatility contractions in downtrends was not all that great, but it was better than returns during uptrends. Whichever way the triangle breaks, it should give a little juice to the short-term movement simply because so many folks are focused on it. But as for a harbinger of returns in the intermediate-term, I wouldn't count on the pattern to give us any clues whatsoever.

I thought I would do some of my own chart analysis, using an artful technique that is pooh-poohed in Evidence-Based Technical Analysis. I eschewed attempting to come up with a mathematical definition, and looked over daily charts from 1-1-80 to 2-22-08, with my own eyes.

I rustled up seven triangle formations, spotted visually by me. I have annotated them, so click on them to fill your screen with shapes, lines, candlesticks, and more data than Star Trek:TNG.

Let's find out if the Investopedia thesis holds, namely that as a triangle formation comes to its point, the price breakout nearly always continues with the greater market trend prior to entering the triangle.

Here's the Dow chart for the last six months, ending with last Friday's data, featuring two, yes TWO triangles:

Below is the triangle from November-December 2007:

Now we have to travel back to May-July 1999 for the previous triangle formation that I could find on the Dow:

April-May 1998:

February 1994:

October-November 1990:

October-November 1987:

The Investopedia thesis on triangles held in December 2007, May-July 1999, and in October-November 1987.

The thesis did not seem to hold in April-May 1998, February 1994 (admittedly, a questionable example of a triangle), and October-November 1990.

These results from a very small sample size look 50/50 to me. Perhaps if one were to look at a broader sample of charts from a slew of individual stocks, as opposed to 28 years of Dow index charts, then we'd discover that triangle formations are more predictive than a coin toss. Considering the outcome of this data, I think I'll leave that to someone else.

1 comment:

Anonymous said...

Looks like DOW is forming a triangle now. Might want write a update entry on this. Newbie, so I'm interested in what you have to say.