Triangles in general and contracting triangles in special are one of the most common patterns to be found on the markets in general and on the currency markets in special.
The reason for that is the fact that price has the tendency to consolidate in more than 60% of the time and one of the favored ways to do that is by forming a triangle.
Expanding and Contracting Triangles
Triangles can be either contracting or expanding but expanding ones are quite rare and for this reason we are covering here only the contracting ones and what to do and when to buy the options based on such patterns.
The recordings in this article are showing the USDCAD chart and we do have to contracting triangles there and one of them acts as a continuation pattern (meaning price is breaking in the same direction like the previous trend was moving) and one acts as a reversal patterns (meaning price is breaking in the opposite direction than the previous trend prior to the triangular formation).
Importance of the B-D Trendline
In both cases and in all instances price is forming a contracting triangle the all-important line is the b-d trend line as when this line is broken the pattern should be considered completed and all we should look for is to buy call options if the triangle is a continuation pattern after a prior bullish trend or put options if the triangle is reversal pattern after a prior bearish trend.
It is important to note that a triangle has five legs, no more, no less, and they are always being labeled with letters, namely a-b-c-d-e. If you see a triangle that seems to have more subdivisions than five, it means that one of the legs of the triangle is subdividing into a lower degree. Usually this is happening when wave e is forming a triangle of its own, but of a lower degree. This is not changing the five original legs and it is helping a great deal when trading binary options.
Choosing the Expiration Time Based on Contracting Triangle
Choosing the expiration date of an option based on a possible contracting triangle is a tricky thing and depends a lot on the stage the triangle is and the time frame the triangle is forming. Besides the expiration date, one should take into account the striking price and this is tricky as well but with a bit of basic technical analysis this impediment should be overcome.
Using Fibonacci to Get perfect Strike Price
One way to find the perfect striking price is to take a Fibonacci tool and measure the length of the longest leg of the triangle. Usually it is either wave a or b in any contracting triangle.
Next thing to do is to find the 50% retracement level and draw a horizontal line.
If the triangle is a bullish one, meaning it appears after a rising trend, then chances for it to break higher are bigger than for it to act as a reversal pattern. Therefore, split the 50% distance that results into two equal parts and buy call options by the time price is moving into the lower part of the newly created channel.
The expiration date should be adjusted based on the time frame the triangle appears as, for example, if it is forming on the daily chart, choosing end of day expiration date may not be enough, so looking for one week or even for end of month expirations may be appropriate.
Triangles According to Elliott Waves
There are many types of contracting triangles and they appear in different places according to Elliott Waves Theory, but what is important to remember is the fact that any triangle is travelling between two trend lines: the a-c trend line and the b-d one. By far, the most important one is the b-d trend line as by the time it is broken it means the triangular formation is completed and price already started to form the next pattern.
The break out of a contracting triangle, regardless if it is a continuation or a reversal one, is really powerful as the market finds a reason to move higher/lower after a period of consolidation. Such a break can be the outcome of an economic news that is released or simply supply and demand rules that are governing trade balance in such a way that the triangle is breaking.
Triangles appear as simple corrections, like b waves in a zigzag for example or 4th waves in an impulsive move, but also as part of complex corrections. In the last case, a triangle is either ending a complex correction, or it is acting like a connecting wave, a so called x wave. Nevertheless, in all situations, the key to finding out the break of a triangle is the b-d trend line, as when it is broken, then market effectively moves on to the next pattern.
Expect contracting triangles to form in the trading sessions that are not that liquid as when the market is not really moving the triangle is the favorite way of consolidation.