A simple program that scans for triangle patterns can be a valuable tool for creating a map of where the market is headed. It is more of an art than a science, but science does play a part. The examples below are charts of the S&P 500 Index and Goldman Sachs.
S&P 500 Index(click to enlarge)
GS - Goldman Sachs(click to enlarge)
The first step is to identify triangles. Triangles are basically converging trend-lines showing a series of lower highs accompanied by a series of higher lows. Once the triangle is defined, the next step is to find the midpoint of the triangle to determine the triangle width. This width is key to determining extensions and secondary targets once prices break free from the triangle pattern.
Taking the width of the triangle and multiplying by 1.618 gives the value to be added to the high value of the triangle width. This same value is subtracted from the low. To obtain the secondary price targets, the width of the triangle is simply add to the top of the width and then subtracted from the bottom width value of the triangle. Secondary targets have a very high value of being reached, the extensions usually take time to attain.
In the examples above, the width of the triangle in the S&P 500 Index is roughly 80pts(1390-1310). This number multiplied by 1.618 give us a value of 129.44. Taking this value and adding it to 1390(1519.44) and then subtracting it from 1310(1180.56), gives the values to the extension targets. Taking the width of the triangle, 80pts, and then adding it to 1390(1470) and subtracting it from 1310(1230), then gives us the secondary targets of 1470 and 1230. These two values also happen to coincide with price targets developed using the opening range system for estimating swings in the market(red-dashed lines in the chart).
In the chart of Goldman Sachs, the width of the triangle is 25.40 points. This value gives us extensions of 274.75(233.65+(25.40 * 1.618) and 167.15(208.25-(25.40 * 1.618). The secondary targets are 259.05(233.65+25.40) and 182.85(208.25-25.40). This lower secondary target has already been reached. This example of Goldman Sachs shows a great example of the breaking down out of the triangle followed by a test to the original lower trend-line of the triangle. This is a great place to short if one missed the original break. The placing of a stop at the midpoint of the triangle is one method, however using a stop at the top of the midpoint of the triangle is another. Determining your stop depends mostly on your appetite for risk and the amount of time you can devote to following a specific trade. If you are willing to enter a trade and be stopped out multiple times, and not afraid to go back in, tighter stops can work. It varies greatly depending upon your trading personality.