When it comes to trading the contracting triangle, there are a few things that you need to know to use this strategy. First, you need to understand a contracting triangle and its formation.
Essentially, a contracting triangle is created when the price action of an asset starts to contract or ‘squeeze’ into a tighter and tighter range. This range-bound price action typically forms after a significant move higher or lower, and it signals that the market is losing momentum and that a reversal may be imminent.
The two main types of contracting triangles
There are two main types of contracting triangles:
Bullish contracting triangle
A bullish contracting triangle forms when the price action is squeezed into a tighter range following a significant move higher. This type of triangle typically forms during an uptrend, and it signals that the bulls are losing steam and that a reversal to the downside may be imminent.
Bearish contracting triangle
A bearish contracting triangle forms when the price action is squeezed into a tighter range following a significant move lower. This type of triangle typically forms during a downtrend, and it signals that the bears are losing steam and that a reversal to the upside may be imminent.
How to trade a contracting triangle
There are two ways to trade a contracting triangle: breakout and breakdown.
Breakout
A breakout is when the price action of an asset moves outside of the upper or lower boundary of the contracting triangle, which signals a continuation of the previous trend.
Breakdown
A breakdown is when the price action of an asset moves outside of the upper or lower boundary of the contracting triangle, which signals a reversal of the previous trend.
To trade a contracting triangle, you need to wait for the price action to break out or break down from the triangle. Once the breakout or breakdown has occurred, you can then enter a trade in the direction of the move.
It is also imperative to always remember that you should not enter a trade until the candlestick has closed outside the contracting triangle because there is a chance that the candlestick could retrace back into the triangle, which would invalidate the breakout or breakdown.
When trading a contracting triangle, you should also set your stop loss and take profit levels. For a breakout, you should place your stop loss just below the lower boundary of the contracting triangle.
For a breakdown, you should place your stop loss just above the upper boundary of the contracting triangle. Your take profit level will depend on the size of the contracting triangle. The larger the contracting triangle, the further away your take profit level should be. Conversely, the smaller the contracting triangle, the closer your take profit level should be.
Risks associated with using contracting triangles
A few risks are associated with using contracting triangles to trade the markets. These include, but are not limited to:
Market condition
Contracting triangles typically form during periods of high volatility and uncertainty, leading to unpredictable market conditions. For this reason, it is crucial to practice good risk management and carefully consider your entry and exit points when trading a contracting triangle.
False breakouts
As mentioned earlier, there is always the potential for a false breakout when trading a contracting triangle. You may enter into a trade prematurely only for the price action to retrace back into the triangle and minimise your chances of being affected by false breakouts. It is best to wait for a close candlestick outside the triangle before entering into a trade.
Limited profit potential
The profit potential for contracting triangle trades is typically limited compared to other trading strategies, and this is because the price action is confined to a tight range, which can make it difficult to make large profits. However, traders can offset this risk by using a smaller timeframe when trading contracting triangles.
Conclusion
Contracting triangles can be an excellent tool for traders looking to capitalise on reversals in the market. By following the trading tips outlined above and using a reputable online broker such as Saxo Bank, you can help reduce your chances of losses when trading.