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The AOL Triangle

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I noticed that the AOL Point and Figure chart seems to be forming a perfect triangle. How can I tell if it is Bullish or Bearish? Looking at the past high pole reversal sometime in August end, we have already reached the bottom (13 x 2 - 54 = 28) and does that mean that now we are going to have a bullish triangle? - Thanks, Rustom

A lot of my time and energy is spent in search of fulfillment. It's why I fly fish. And it's also the reason I trade stocks and write about trading.

My buddy, Jeff Bailey, and I spent a day on the river over the weekend, fishing and talking shop. In between back casts, we talked about the above e-mail we received late last week. We talked about the e-mail because it was so fulfilling. Bailey and I very much care for our work and try to provide the best education and trading ideas possible. And it was such a treat to the both of us to receive an e-mail from a reader who'd been using the techniques we write about to find a thoughtful, intelligent, and potentially profitable trade. Thanks again, Rustom!

With Rustom's permission, I'm going to elaborate on his findings.

America Online (NYSE:AOL) gave a sell signal in early July, which ultimately generated a bearish price objective of $28. The stock reversed into a column of 'Os' at $54, gave a sell signal with its breakdown below $48, and traded as low as $42. The 13 'Os' that AOL traced in its column gives us the reference to calculate the bearish price objective. As Rustom pointed out in his e-mail, all we need to do is multiply the number of 'Os' in the sell signal column (13) by 2 and subtract that total from the value of the first 'O' in the column. The formula looks like this: 13 x 2 = 26; 54 - 26 = 28.

Guess what? After AOL gave that bearish price objective in July, the stock hit $28 on September 21. Coincidence? I think not!

Since hitting its bearish price objective, AOL has traced the beginnings of a triangle. Will the triangle ultimately be a bearish or a bullish triangle? That depends on which way the stock breaks from its triangle. But before the triangle can be bullish or bearish, it needs to become a triangle first. Yes, AOL has traced the beginnings of a triangle, but, by definition, the triangle needs to be at least five columns wide. As it stands now, AOL's consolidation pattern is four columns wide. At this point, AOL needs to reverse into one more column of 'Os' before the triangle is complete. Why the talk about triangles? Recall what Bailey wrote last week:

The "bullish triangle" and the "bearish triangle" are two patterns that point and figure aficionados look for. Why is that? You may ask. A Purdue University study by Professor Earl Davis found that on average, the "bullish triangle" was profitable 71.4% of the time with an average gain of 30.9% in a 5.4 month time frame. The "bearish triangle" was profitable 87.5% of the time, with an average gain of 33.3% in a 2.5 month time frame.

The point & figure triangle is, in essence, a price pattern that is generally a prelude to a larger move. In other words, the triangle reveals consolidation after a big move and ahead of another big move. The triangle is known as such because of the shape that the consolidation takes on the chart. Notably, lower relative highs and higher relative lows move towards an apex of what appears as a triangle on the chart.

Back to AOL. Ideally, the stock will reverse into one more column of 'Os' so that its triangle is completed. Rustom brought up an important point in his question, asking that since AOL reached its bearish price objective if that means the stock is going to breakout in a bullish triangle. That's not necessarily the case. Just because a stock reaches a bearish price objective that doesn't mean that it's going to reverse and start trading in a bullish fashion. It could simply mean that the stock reached an interim bottom before resuming its bearish trend.

As for AOL, the stock does need one more column of 'Os' before the triangle is complete. If AOL does do that, traders can begin to watch for a breakout or breakdown from the triangle, at which time it can be called either a bullish or bearish triangle. At this point, if AOL reversed into another column of 'Os,' the buy signal would be generated with a breakout past $34, while the sell signal would be generated with a breakdown below $29.

In the current set-up, AOL will need to trade back down to $30.00 for another column of 'Os' to be completed. From there, traders can watch for the breakout or breakdown from the triangle, which should portend AOL's trend over the intermediate-term and provide a potentially excellent trade.

A couple of points:

1) AOL hasn't given a buy signal since late June.

2) Ideally, AOL, if it completes its triangle and when it breaks, should be confirmed with the Internet Sector Index (INX.X).

3) If you're going to watch for the triangle to be completed and trade the break, stay flexible and don't have a bias going into the trade. Wait for the break. AOL could rally to $43 or it could slide below $20.

4) Rustom is very cool for sharing his findings!

5) For another example of a point & figure triangle, see the following: Option Investor

Point & Figure charts created using www.StockCharts.com

Eric Utley
Option Investor

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