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Both Sides of a Triangle


What patterns will mean in uptrends or downtrends.


There's been a lot written about the triangle pattern in the major indices, and how it typically leads to a break in the direction of the trend. That is one of those textbook nuggets of wisdom that I rarely see tested. I'm sure it's been done, but I have not seen any tests of this pattern either. So let's do it.

A triangle pattern can be very difficult to program, since some creative leeway is needed in order to define the pattern. Like other, less savory aspects in life, the pattern is one of those things that we know we're seeing it only when we're seeing it. It's tough to define mathematically.

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.
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