Fibonacci Retracement 618 Percent and 3Point Chart Patterns

The biggest problem in trading corrections is to stay close enough to the fast-moving trend changes while waiting long enough for confirmation of the trend change.

Candlesticks have shown a positive effect on the total performance of the trading strategy. How far the integration of 3-point chart patterns leads to a similar effect can be estimated for the S&P 500 Index according to the trading signals in Figure 6.3.

Figure 6.3 S&P 500 chart from 12-01 to 04-02. Simulation of trading signals based on plain price corrections daily in combination with 3-point chart patterns (EL: entry long, ES: entry short, XL: exit long, XS: exit short, S-L: stop-loss, TS: trailing stop).

The underlying relevant trading parameters for generating entry and exit signals are:

• Swing size of 30 basis points.

• Fibonacci correction level 61.8 percent.

• Market entry on 1-day high/low backward look after the correction level is reached.

• Stop-loss point at previous swing high or low; re-entry after being stopped out.

• Daily data; slippage and commission excluded.

Nine trading signals can be found for the S&P 500 Index between December 2001 and April 2002 (as shown in Figure 6.3). They are summarized in Table 6.3.

Table 6.3 Trading Signals

Profit/ Loss in

Table 6.3 Trading Signals

Profit/ Loss in

#

Entry Rule

At

Exit Rule

At

Points

1

Sell short

1,140.00

Stop-loss

1,152.00

(12.00)

2

Re-sell short

1,163.00

Buy reverse

1,146.00

17.00

3

Buy reverse

1,146.00

Stop-loss

1,124.00

(22.00)

4

Sell short

1,118.00

Buy reverse

1,094.00

24.00

5

Buy reverse

1,094.00

Sell reverse

1,112.00

18.00

6

Sell reverse

1,112.00

Buy reverse

1,101.00

11.00

7

Buy reverse

1,101.00

Trailing stop

1,156.00

55.00

8

Re-sell short

1,161.00

Trailing stop

1,153.00

8.00

9

Sell short

1,123.00

Open

Working with an entry rule and reentry rule improves the trading results to an acceptable level. The entry rule ensures that we receive a short-term confirmation of a trend change. The reentry rule comes into effect after swing highs or swing lows are broken and the market price moves back into the trading range.

Looking back to the immediate entries on price corrections in the first example of the section (Figure 6.1 and Table 6.1), we can now reexamine the trading signals according to underlying price patterns that would have prevented us from entering the market too early:

• Signal 2 failed when the market price formed a double top.

• Signal 4 failed when the market price formed a double bottom.

• Signal 7 failed when the market price formed a triple bottom.

• Signal 8 failed based on a quadruple top.

• The low of signal 9 followed a triple top.

The integration of 3-point chart patterns and a backward look entry rule have a positive effect on the trading results in combination with Fibonacci price corrections of 61.8 percent.

The 3-point chart patterns are a stable element of trading the markets and should be watched carefully, whereas swing size and reentry rule may vary from product to product. Hardly any other investment tool can monitor the investor behavior as accurately as regular 3-point chart patterns.

Now that we have discussed the S&P 500 Futures Index on three different approaches to analyze the Fibonacci retracement level 61.8 percent, we want to add two stocks, Microsoft (member of the Dow Jones 30 Index) and Allianz (member of the Dax 30 Index).

In contrast to Microsoft, which moves in a trending pattern, Allianz is stuck in a sideward market. Not surprisingly, the number of trades is much smaller in a trending market. Microsoft shows 6 trades in 12 months, whereas Allianz comes up with 12 trades in just 6 months.

The latter finding is typical of the kind of strategy we present. Because we never know future market patterns in advance, we have to take every trade.

As discussed in Chapters 3 and 4, the most crucial parameter— in addition to the 61.8 percent retracement level—is the swing size. The swing size of a trading product can only be determined from test runs on historical data. However, conducting test runs is not difficult and can done by every trader. Knowing the price level a product is trading at is less important than knowing its most common swing size.

Every trading vehicle that we analyze has a different volatility. In contrast to the S&P 500 Index, which shows a trading range between less than 800 points and somewhat above 1,200 points over the past year, Microsoft trades at price levels between USD 40 and 70, and Allianz trades at price levels between EUR 230 and 290. Traders have to keep in mind that the smaller the swing size is, the more trades we get. If the swing size selected is too large, we might not get a trade at all. The easiest way to find a good swing size is to look at historical data on the longest lasting sideward pattern to find the best average swing size value.

Figure 6.4 contains the chart example of Microsoft over one year.

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I I Mil 12.1'I.<!1 1.30IJ2 3.1 1.02 4.18.02 5.2H.U2 / . IN- 8.13.02 9.20.02 10.29.02

Figure 6.4 Microsoft chart from 11-01 to 11-02. Simulation of trading signals based on plain price corrections daily in combination with 3-point chart patterns (EL: entry long, ES: entry short, XL: exit long, XS: exit short, S-L: stop-loss, TS: trailing stop).

I I Mil 12.1'I.<!1 1.30IJ2 3.1 1.02 4.18.02 5.2H.U2 / . IN- 8.13.02 9.20.02 10.29.02

Figure 6.4 Microsoft chart from 11-01 to 11-02. Simulation of trading signals based on plain price corrections daily in combination with 3-point chart patterns (EL: entry long, ES: entry short, XL: exit long, XS: exit short, S-L: stop-loss, TS: trailing stop).

Figure 6.5 shows the same trading approach applied to the Allianz stock late in 2001 and early in 2002.

Figure 6.5 Allianz chart from 10-01 to 04-02. Simulation of trading signals based on plain price corrections daily in combination with 3-point chart patterns (EL: entry long, ES: entry short, XL: exit long, XS: exit short, S-L: stop-loss, TS: trailing stop).

Having explained in detail the Fibonacci ratio 61.8 percent in combination with candlesticks and 3-point chart patterns, it is pertinent to mention the alternative two Fibonacci-related key ratios: 38.2 percent and 50.0 percent.

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