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RichardCox

The Death Triangle: Looking at a Variation on the Head and Shoulders Pattern

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The Death Triangle: Looking at a Variation on the Head and Shoulders Pattern

 

One of the biggest problems in the approaches generally taken by chartist traders is the tendency to over-rely on backtesting and simple probability figures at the expense of really looking at what price patterns are telling us about market sentiment. There is a reason, for example, that a Descending Triangle pattern is considered to be bearish, and there are clearly definable explanations for why short positions should be taken once the foundational support level in that pattern breaks. The same is true for flags, wedges, harmonic patterns, double or triple bottoms, etc. So what tends to get missed when we look at backtesting statistics (which give only limited information for how an asset is likely to trade in any given situation) is the underlying philosophy and rationale behind these patterns.

 

It is important to remember that the the map is not the territory, the menu is not the meal. And there are many cases where traders might see markets unfold in ways that might not exactly match the textbook criteria for a specific pattern. One pattern that should be considered here is the Death Triangle, which uses some of the same rationale that is seen in a Head and Shoulders pattern. It is valuable to have some idea of how patterns like these inter-relate because it can be helpful in avoiding missed opportunities once they are present in the market.

 

Head and Shoulders Structure

 

First, let’s take a look at the commonly accepted structure for what a head and shoulders pattern should look like. There are some differences of opinion in which rules can be broken here but most traders would agree that the structure shown below would qualify:

 

2n07p0j.png

 

These structures take place in an uptrend, form a left shoulder, rally further (creating the head), and start to lose momentum until the neckline is finally broken. Stop losses could be placed above the right shoulder, and the profit target is generally located using a pip distance that is equal to the distance between the head and the upper price point found at the head.

 

o8xiyc.png

 

Above, we can see what the pattern might look more like in actual trading practice. Overall, the head and shoulder pattern is highly effective in pinpointing the ‘topping out’ period in a uptrend and can be used to short sell an asset.

 

Structural Parameters

 

But while this pattern is great for spotting these special circumstances, the reality is that markets don’t need to fit the textbook criteria. So, what happens if the shoulders are not equal? What happens is the neckline is not level? Is the structure still valid? Can short positions still be taken?

 

The main point here is that waiting for textbook conditions will mean that you miss trading opportunities. Instead, it is much more important to look at the underlying rationale that delineates the pattern. What the head and shoulders pattern is meant to define is a topping structure, where the initially bullish momentum starts to give way until we start to see major support breaks. This means that the right and left shoulder do not need to be equal in order to be identified as a tradable scenario. In fact, there are instances where unequal shoulder levels will actually go further to match the rationale behind the pattern.

 

The Lower Right Shoulder

 

Specifically, consider the pattern with a lower right shoulder. Some traders might argue that this invalidates the pattern. But what is the real rationale that should be considered here? The main concept in the head and shoulders structure is that prices have reached a peak that they were not able to match again. A true uptrend is marked by a series of higher highs and lows. But when prices are only able to form a shoulder (and not a higher head) it essentially suggests that the market momentum is changing.

 

t7hfl0.jpg

 

But if the right shoulder is lower than the left, it is an indication of an even more forceful turn in momentum. This will only increase the probability for successful short positions as there is less of a reason to argue that the original uptrend is still in place. In a structure like this, we can see an example of how a trader that only obeys the textbook rules would have missed what is actually a much better trading opportunities. I am reminded here of the time when my football coach said that “the worst type of player is the one that never follows the coach’s rules -- but its also the one that does nothing but follow the coach’s rules.” The lesson here is that there will be plenty of instances where you will need to read the situation and identify times where the spirit of the pattern is being met even if the textbook criteria is not followed to the letter.

 

The Death Triangle

 

Another example here can be found in the Death Triangle, which is essentially a variation on the idea of the head and shoulders formation. Below, we can see the topping formation that begins after an uptrend and results in a major change in the market’s underlying momentum:

 

2dbp505.png

 

In the above example, we can see price action that would be difficult to describe as a head and shoulders formation. But most of the important parts in the structure remain, and this is another structure that could be used to establish short positions in the asset. After the uptrend starts to turn, we see a pyramid-like structure that ends the previous series of higher highs and leads to a major support break. Sound familiar? It should, and this is because it is the same rationale that supports short positions taken once a head and shoulders is spotted.

 

But if you chose to wait for three exact price levels that would fall into the commonly watched head and two equal shoulders, you would have missed out on the massive downtrend that was signaled by the ominous-sounding death triangle. In this pattern, we can see another example of how a commonly watched pattern should be viewed with some degree of flexibility. As long as you can still make a reasonable argument for lower prices, most of the same trading parameters can still be applied. Look to establish a profit target that is roughly the distance between the triangle base and the highest high in the formation. This is because prices tend to move in waves, and those waves tend to be similar (although not exactly similar) in value.

 

Conclusion: Watch For Price Patterns But Don’t Restrict Yourself To Textbook Definitions

 

In the example above, we can see that traders should not limit themselves to the textbook definitions when structuring new trades. This can lead to many missed trading opportunities and an imperfect understanding of how the market actually operates. The market will never obey the structural parameters in any pattern, as much as we would like to wish it would. Because of this, we need to allow some degree of flexibility and pay more attention to the rationale behind the pattern, rather than the pattern itself. This will open up your position to a much wider range of options and give you a better sense of what is actually happening in the market at any given time.

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