The basic strategy for trading the markets using PHI-ellipses is, first, to wait for a price move to develop inside the borders of a PHI-ellipse; and, second, to act counter to the main trend direction as soon as the end of the PHI-ellipse has been reached and market pricing leaves the PHI-ellipse.
Catching the rhythm of market moves by attaching PHI-ellipses and adding countertrend trades to each other is illustrated in Figure 5.10.
We recommend selling at the end of a PHI-ellipse when it has an upward slope and buying at the end of a PHI-ellipse when it has a downward slope.
An entry rule confirms trend reversals to the upside or to the downside at the end of a PHI-ellipse. The rule is set to the lowest low of the previous one, two, three, or four days for sell signals, and the highest high of the previous one, two, three, or four days for buy signals (see Figure 5.11). The choice of entry rule depends on the investor's risk preference and time frame for entry.
As soon as we are invested on a short position, we define a stop or a stop-reverse point at the highest high of a price bar within the previous PHI-ellipse. If we are invested long, we protect our position with a stop-loss set to the lowest low of a price bar within the previous PHI-ellipse.
Figure 5.12 illustrates a stop-loss protection on a short position.
For an alternative entry point, we may consider the trend channel that touches the relevant PHI-ellipse on either side (see Figure 5.13).
By choosing the conservative option of a double confirmation by PHI-ellipse and trend channel, we accept that we may sacrifice some of the profit potential that could have been realized with a more sensitive entry rule. On the other hand, we may avoid a number of losing trades in strong trending market conditions by staying in the trend channel as long as it lasts.
If the market price leaves the PHI-ellipse at the very end and immediately rises to new highs, we get a buy signal at the level of the highest high made within the PHI-ellipse. Figure 5.14 illustrates our strategy for dealing with runaway markets. For sell signals, the correct entry point runs vice versa.
The stop-loss or stop-reverse level on this buy signal is set to the lowest low of the previous three days, starting on the day when the market price reached the end of the PHI-ellipse (see Figure 5.15). On sell signals on runaway markets, the stop-loss or stop-reverse level is the opposite; it is set to the highest high of the last three trading days inside the PHI-ellipse.
If a market position is established and the market price moves in the anticipated direction, the investor must decide when to take profits. Several options are available to the investor: trailing stop exits, profit target exits, exits on extensions, time exits based on the Fibonacci summation series, and exits on the end of a PHI-ellipse.
The most conservative strategy is to work with a trailing stop set to the high of the previous four days on sells (vice versa on buy signals). In most cases, this option protects at least part of the profits, but it also means giving away open profits already accumulated (see Figure 5.16).
If we do not want to give up any of our accumulated profits, we can take the risk that the market might move in the direction of our signal after we get stopped out in a profit. In this case, we should predefine a fixed profit target level to cover a position.
We select profit target levels that can be derived from the PHI series (introduced in Chapter 4). The levels we work with are 38.2 percent, 50.0 percent, and 61.8 percent of the total preceding market move, which is the distance from bottom to top of the PHI-ellipse that generated our entry (see Figure 5.17).
The profit target level that an investor favors depends not only on the risk preference of the investor, but also on the amplitude of the preceding PHI-ellipse.
If the initial move inside the PHI-ellipse is smaller than a sample 200 ticks in the Japanese Yen cash currency (e.g., from 110.00 to 112.00), a larger profit target level of 61.8 percent is preferable; otherwise, the profit potential is too small. On the other hand, if the total amplitude of the underlying move is 10 full points (e.g., from 110.00 to 120.00) in the Japanese Yen cash currency, a profit target level of 38.2 percent might be good enough for an investor to minimize risk.
In addition to trailing stop exits and profit target exits, we can wait for a 3-wave swing in the direction of our signal and an extension out of this 3-wave swing.
As explained in Chapter 4, we precalculate the size of an extension by multiplying the amplitude of wave 1 by the Fibonacci ratio 1.618. We liquidate a position as soon as the profit target level in the direction of our signal has been reached at 1.618 times the amplitude of wave 1 (see Figure 5.18).
Price targets are a solid way of exiting positions, but we can also define targets in time to protect accumulated gains.
To establish the average standard length of PHI-ellipses on any product based on numbers of the Fibonacci summation series, we can use historical data, along with a constant scale supplied by the WINPHI software and conduct test runs. If we then find out, for a certain product, that the average length of PHI-ellipses is 21 days, we can exit positions that have not been stopped out after 21 days (given that they trade in a profit). The total move in the direction of our signal might continue, but we are content with the profit that we have realized with the Fibonacci count. Two additional conditions are that there has to be at least one 3-wave move within the 21 days and that the price move must stay within the shape of a PHI-ellipse (see Figure 5.19).
If the price move on our established position follows the shape of a PHI-ellipse, a fifth exit rule must be considered. We can wait until the market price reaches the end of the new PHI-ellipse and exit the position at the end of the PHI-ellipse. This exit rule requires the most patience and the strongest discipline, but it has the biggest profit potential of all five exit rules in our analysis of PHI-ellipses.
Figure 5.20 illustrates how to exit a position on the end of a PHI-ellipse.
Attaching PHI-ellipses, as explained in the final exit rule, is the perfect approach for catching the rhythm of markets, but of course, market rhythms are not always ideal and perfect.
The following section explains how to work with PHI-ellipses as geometrical Fibonacci trading tools.
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