Size of Corrections

The most common approach for working with corrections in research and practical trading is to relate the size of the corrections to a percentage of the prior impulse move.

In our analysis, we concentrate on 61.8 percent, which is directly related to a ratio out of the Fibonacci summation series. A price correction of 61.8 percent is the result of division (1.000 + 1.618).

Forecasting the exact size of a correction is an empirical problem. Investing after a correction of just 38.2 percent might be too early, whereas waiting for a correction of 61.8 percent might mean missing a strong trend completely. We concentrate on 61.8 percent and keep the investment risk very small by placing a well-defined close stop-loss.

The best way to work with corrections is to combine the percentage of corrections with the swing size as a second parameter. Each product has a typical swing pattern that traders can identify with a computer simulation. This pattern should be part of the investment strategy. To get the best real-time results, the investor needs to identify and test it on historical data.

The swing size depends on the product. The swing sizes between daily data and intraday data on the same product can be very different. The smaller the swing sizes are, the more noise there is in the price data and the more difficult it will be to filter out the product's typical swing size.

For example, if 150 basis points cover the swing size in the cash currency Japanese Yen every day, correction levels of 38.2 percent, 50.0 percent, or 61.8 percent might be too small to work with. On the other hand, a correction level of 38.2 percent might be the best to work with if, in the same product, we measure a price swing of 1,000 points over a longer period. It might take weeks before the market price has a correction of 382 basis points.

Entry Rules

The main reason to work with an entry rule is to get an additional confirmation of trend changes. Working with entry rules also means working with a compromise because we always invest a little later than if we had entered the market as soon as a correction price target was reached. By giving up a little bit of the profit potential, we gain a safety net to avoid getting stopped out and whipsawed so often.

Because we work only with a 61.8 percent correction level in our strategy, we need just one entry rule. We buy or sell—after the correction level of 61.8 percent has been reached—when the previous day's high or low is broken.

Figure 4.7 shows market entries to the long and short side.

Figure 4.7 Entry signals long and short after price corrections of 61.8 percent on 1-day high and low breakouts.

As mentioned, we always have to expect false breakouts. We can integrate this into our investment strategy with a more conservative entry rule. We buy and sell after a false breakout as soon as the previous 2-day high or the previous 2-day low is broken (see Figure 4.8).

Figure 4.8 Entry signals long and short after false breakouts on 2-day high and low breakouts.

Immediately after establishing market positions, traders need to protect them with stop-loss rules.

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