of support and resistance that should hold if the original trend is toresume pace.Besides acting as zones of support, Fibonacci levels also offer higherprobability trades when multiple Fibonacci retracement lines converge on asingle value. Known as Fib confluence, this dynamic occurs when Fibonacci
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FIGURE 7.4 Conﬁrming Fibonacci Support in EUR/USDSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
FIGURE 7.5 Trading the Fibonacci “Box” in GBP/USDSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
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FIGURE 7.6 Trading Support at Fib Clusters in GBP/USDSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
support or resistance lines on, say, an hourly trend, a daily trend, and aweekly trend all approach the same level. As prices reach this intersection ofsupport or resistance for multiple moves, technical analysis will consider itfar more valid as traders from all time horizons (the short-term speculators,the intermediate-term swing traders, and the long-term position traders) willall have reason to sell or buy at that point. Note how in Figure 7.6 the Fibonacci confluence puts an iron lid on the rally in GBP/USD as multiple Fibonacci retrace lines vector in on the 1.9000 level.
TRADING BREAKOUT AND RETRACEMENTWITH FIBONACCIOne of Fibonacci’s most useful properties is that it can be used effectivelyto trade both trend continuation and trend retracement (see Figures 7.7and 7.8). Because trend trading is usually a more common technique formost traders, let’s take a look at that approach first.Imagine that the EUR/USD pair makes a strong breakout on thehourly charts. Although it’s impossible to be certain that the move will follow through, a trend trader would go long in anticipation of further upside
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FIGURE 7.7 Projecting Breakout Targets with FibonacciSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
FIGURE 7.8 Scaling into Trade Using Fibonacci LevelsSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
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price movement. In fact, most breakouts will usually fail, but because it isimpossible to know which breakouts will succeed and which ones willfail, trend traders have to take every trade. As the saying goes, “You haveto be in it to win it.” Using Fibonacci, however, breakout traders can optimize their few wins while minimizing their many losses.To trade the breakout setup properly, you could use the followingtechnique: Once the breakout candle prints, enter at market but with onlyhalf your total trade size. If you are correct and the price continues tomove in your favor, you can add a quarter more at 138.2 percent of the initial breakout move. Finally, if the trade momentum persists you can addthe final 25 percent of the position at 161.8 percent of the move.This strategy is a variation of an idea presented by Josh Lukeman inhis book The Market Maker’s Edge (McGraw-Hill, 2003) and is known aspressing the trade. Using Fibonacci levels as his guideposts the tradercarefully increases his position as price action moves his way. Let’s lookat a specific example to better understand how the trade works.Imagine that the length of the breakout candle is 100 pips long and itcloses on the high at 1.3300. Your total capital budget for the trade is200,000 units or two standard lots. To properly execute this setup youwould take the following steps:1. Buy 100,000 units (one lot) at 1.3300 and place a stop-loss order at
1.3260, 40 points underneath the entry price. This is a rather tight stopjust below the first 38.2 percent Fibonacci retracement level. However, the motto of the breakout trader is “Either I am right or I amout!” If prices retrace much more than the first Fib level, the case for amomentum-based move would be greatly diluted and the probabilityfor success diminished. If prices do retrace that far, you would lose 40points but only on half of your intended position, so the net losswould be only 20 points.2. If, however, prices continue to trend, you would add another 50,000units (half lot) at 1.3338, which would be equal to the 138.2 percent Fibonacci projection of the move. Your average cost would now standat 1.3312. You could then tighten the stop to 1.3298, just below the38.2 percent retracement level, consistent with the logic that a trendmove should maintain momentum. Again, if the trade is stopped outyou would lose only 20 points.3. As the price continues to move higher you would add the final 50,000units to the position at the 162.8 percent Fib projection level, whichwould be equal to 1.3363. Having put on the full position, your average cost now stands at 1.3325. If the price reaches your target of1.3400 you will now have 75 points of reward for the maximum 25points of risk.
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This approach has several advantages. First and foremost, it minimizes risk by committing only half your capital at the beginning of thetrade. Using Fibonacci levels as your guideposts you are then able to add50 percent more capital to the trade without materially increasing your average cost. Instead of costing 1.3300, the trade cost rises to only 1.3325and only after the price action confirms the breakout bias, making thetrade much more likely to become profitable. The net result is that thetrade now posseses very favorable risk/reward characteristics of 3:1,which are crucial for long-term success of breakout-based traders sincethe strategy is generally fraught with failure and fakeouts, even in a highlytrending market like FX. Therefore, even if the trader is successful only 40times out of 100, given such favorable payoff he would have a positive expectancy and should be able to generate a profit in the long run.Now let’s take a look at a reverse situation and see how Fib ratios canhelp the trader to properly position himself for a retracement trade. Imagine the same breakout scenario where prices rise from 1.3200 to 1.3300 except you are less confident in believing that prices will immediatelycontinue forward but are still convinced that they will ultimately rise.Again you budget 200,000 units of the EUR/USD for the trade, but here ishow you would set up the trade to maximize your chances of success.1. Buy 50,000 units (25 percent of total position) at 1.3300 (initial entry
level). If you are wrong and the price continues its upward directionright away you would at least participate in the move with a partialposition targeting the 1.3400 exit.2. Buy another 50,000 units (you will now have fully 50 percent of yourposition) at 1.3262 (38.2 percent Fib retracement of the candle). If theprice now bounces off the Fib support you will have 50 percent ofyour position with a better blended price of 1.3281 instead of 1.3300and will still be able to target 1.3400.3. Buy 100,000 units (now completing 100 percent total position) at1.3236 (61.8 percent retracement of the candle). Your cost for thetrade now declines to 1.3259 from your original entry of 1.3300. Ifprices simply rally back to your original entry point your trade wouldalready be materially profitable!4. Put a stop for the whole trade at 1.3220, just below the 76.1 percent Fibonacci level, reasoning that if price has retreated so much, mostlikely you are wrong on the trade. Furthermore, with such a favorableprice average you could shorten your target to 1.3338—the first 138.2percent Fib projection level—and still enjoy a very attractive 2:1 reward-to-risk ratio on the trade. (Total risk would be 39 points, whilepotential reward at 1.3338—fully 62 points less than your original target—would be 78 points.
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In the second scenario you, the trader, could also afford to lose morethan 50 percent of the time and still be profitable on the strategy. Even ifyou decided to stick to your original target of 1.3400, the lower probabilityof the trade would be offset by the substantially higher profit gains of thewinning trades. At 1.3400 your profit potential would rise to 140 pointswhile your risk remains at 39 points.Which scenario is best? They both have their drawbacks. In the firstexample, the trader is vulnerable to a quick reversal if the price justreaches the 161.8 percent target level and then suddenly falls backthrough the original entry level taking the trader out of the trade and thenjust as quickly rallying to 1.3400. In that case the trader would be bestserved if he had simply entered the position all at once at 1.3300 with ahard stop at 1.3280. In the second example the trader is at risk of being underinvested as price moves in his favor right away and overinvested in alosing position if it doesn’t.Ultimately, however, these strategies can help the FX trader to bettermanage positions by adjusting to market action. As Josh Lukeman contends in his book, professionals understand prices are always fluid andthey never make the mistake of committing all their speculative capital toa single price point. By utilizing Fibonacci levels as malleable markers forsupport and resistance price zones rather than exact price points, technically oriented traders can put Fibonacci levels to practical use, even if thequasi-mystical emphasis on their relevance is somewhat suspect.
CHAPTER 8
Patterns andAntipatterns:Know Your Mark
I
n the movie Rounders the climactic scene takes place between MattDamon as a young card shark and a menacing Russian mobster calledTeddy KGB, played with slouching malevolence by John Malkovich.Damon and Malkovich are playing high-stakes poker in a garishly lit NewYork private club and Damon is about to call when he sees Malkovichtwist open an Oreo cookie and calmly lick out the middle in a casual gesture of self-satisfaction. Damon hesitates and then quickly folds.Stunned, Malkovich’s character blurts out angrily, “No! you were supposed to bet!” Damon of course goes on to win the game, recover all hismoney, and head to California to reunite with the girl of his dreams andlive happily ever after. Why did Damon withdraw his bet at the last moment? Because the exact same dynamic occurred at the beginning of themovie when Teddy KGB devoured the Oreo cookie in the same mannerjust prior to setting Damon up and winning all of Damon’s life savings.This time the Damon character caught the move before falling intoMalkovich’s trap.In poker this practice of looking for key patterns of behavior is called“reading a tell,” and world-class poker players are masters at not onlyplaying the cards but also observing their opponents’ physical moves forany potential clues to the strength of their hands. So, for that matter, aremaster con men and master magicians. There once was a wonderful NewYorker article on Ricky Jay, a virtuoso magician who in recent years hasbecome a solid character actor in movies and television, including HBO’sWildwood. Another magician, an expert at his craft, was stunned at howMr. Jay was able to pull a complex magic trick on him. “He must have113
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marked me,” he says of Mr. Jay, meaning that Ricky had carefully observed the man’s behavior and then taken advantage of his habits to set upthe magic trick.In every life situation where only imperfect information exists, observation and pattern recognition are critical to successful decision making.Technical analysis is no different. Common price patterns exist and repeatthemselves endlessly. In fact, as I once wrote in an article, “For anyonewho has ever actually watched price flow on a tick-by-tick basis formonths on end, what soon becomes strikingly clear is not the wild randomness of price patterns, but their mundane repetitiveness.” Indeed, thecommon technical formations are all well known and have long ago beenclassified. This chapter focuses on not only the basic trading patterns thatall technicians look for in the FX market, but also their “antipattern” counterparts, because in order to trade patterns successfully, the well-versedtechnical trader must also understand how these price patterns can failand often morph into completely different technical setups.
DOUBLE TOPS AND DOUBLE BOTTOMSNo chart pattern is more common in trading than the double bottom ordouble top. This pattern appears so often that it alone may serve as proofpositive that price action is not as wildly random as many academicsclaim. If you believe, as I do, that at their core price charts simply expresstrader sentiment, then double tops and double bottoms represent a retesting of temporary price extremes. If prices were truly random, why do theypause so frequently at just those points? To technically oriented tradersthe explanation lies in the fact that many market participants are keenlyaware of these levels and they serve as clear demarcation lines betweenthe bulls and the bears.Double tops are characterized by their M shape on the price charts,while double bottoms simply flip the pattern and form a W (see Figures 8.1and 8.2). The classic double bottom pattern forms when prices finally findsome support and begin to bounce. At this point traders who were luckyenough to be short and rode the price action all the way down may begin tocover their positions. The shorts will do so because they want to make surethey lock in their substantial profits. As their buying proceeds, pushingprices up, they will encounter selling from the lucky bottom-fishing longswho are looking to flip their positions for quick gains. Additionally, asprices rise all of the trapped longs who got caught in the downdraft maynow find themselves at or near their break-even points and may join theselling spree to liquidate their positions at a minimal loss.
Patterns and Antipatterns: Know Your Mark
FIGURE 8.1 Double Top in GBP/USDSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
FIGURE 8.2 Double Bottom in GBP/USDSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
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The net effect of this tug-of-war between the short-covering bears andthe liquidating bulls is that the price rarely makes it back up to the originalpoint of its decline. Frequently it may peter out at the 38.2 or 50 or 61.8 Fiblevels of the amplitude of the original impulse move (see Figure 8.3).Prices will then turn back down and may once again find support atthe prior low. This time, however, the longs who purchase at these levelstypically tend to be longer-term, more value-oriented players who, havingobserved the initial bottom, will now view it as a solid reference point forsupport and will likely make a powerful stand at that level. Furthermore,the scared longs who liquidated their positions on the first counterrally upwill no longer add selling pressure to the currency, as they are now sidelined in cash. In fact, in watching the price action a few of them may evenreenter the market on the long side as they see their initial bias becomecorroborated by the price action. Buying pressure will also build up fromthe long-standing shorts, who will realize that directional power has inexorably returned to the longs and will now want to get out for fear of seeingtheir winning positions turn into losers. Finally, as prices clear the pointfrom which the decline originated, the last few profitable shorts will capitulate and price will break above, completing the double bottom formation(see Figure 8.4).
FIGURE 8.3 Double Bottom with Fib Retracement in EUR/CHFSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
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FIGURE 8.4 Double Bottom Breakout in EUR/CADSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
The process of course works the exact same way in reverse for double tops. In that case directional power moves to the bears instead of thebulls as long directional momentum eventually wanes. In both examples itis very clear to see how the interplay between the longer-term, more valueoriented players and the shorter-term speculators on both the long sideand the short side creates a dynamic that carves out these patterns on aregular basis.
TRIPLE TOPS AND BOTTOMS AND THE ANTIPATTERNTriple tops and triple bottoms are simply extensions of the double bottom/top price action. Though far rarer, triple tops and bottoms connoteuncertainty and a sense of equilibrium between the bulls and the bears asneither party is strong enough to dominate directions. What makes tripletops and bottoms interesting and at the same time dangerous for the technically oriented trader is the possibility that these reversal patterns canmorph into consolidation patterns that will provide further fuel for continuation of the trend. This is why traders must be keenly aware of how adouble or triple top can turn into a consolidation and a possible further
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breakout. Note in Figure 8.5 how what initially appeared to be a doublebottom slowly turned into range, which eventually broke to the downsideas support gave way and the initial downward impulse move resumed itsdirection.Because the double top/double bottom pattern that foreshadows a reversal in price can easily turn on the trader and instead become a continuation pattern it is vital to a implement a logical plan of action to deal withall the possible contingencies before putting on a trade. There are a varietyof approaches to how to trade the double top or bottom, each with its ownadvantages and drawbacks. Choosing which approach works best is farmore a function of trader personality than of the validity of the setup. Thecritical factor that one must remember is that regardless of which tradingstyle one adopts, the trader must respect the logical assumptions of thescenario and immediately liquidate the position once those assumptionsare violated. Traders can be either anticipatory or reactive when tradingdouble tops or double bottoms.An anticipatory trader would simply assume that the price will findsupport on the second foray lower and will place his buy order as close aspossible to the original bottom and expect that buyers will materialize andwill rally the currency pair higher. This is akin to standing in front of an
FIGURE 8.5 Double Bottom Becomes Range in USD/CHFSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
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oncoming train and hoping that the engineer will hit the brakes fastenough for the train to stop before running you over. Needless to say, thisis a very low-probability setup. However, when successful this type oftrade can be very profitable as the risk-to-reward ratio is very favorable. Ifthe trader is correct, then he has essentially picked the bottom and hisfirst technical level of resistance is the midpoint of the W as seen in Figure8.6. His next level is the original point of decline. On the daily charts, aswe can see in this GBP/USD formation, the move can be as strong as 1,000points, while the risk is only about 100 points below the first low. Withsuch favorable odds the trader can be wrong as many as nine times in arow and still make a profit over the long run. However, anticipatorytraders must be highly disciplined with their stops. Because this type oftrade frequently fails, they cannot afford to lose a large amount on anygiven attempt. The logic behind this setup is that the trader anticipates abounce. If no bounce materializes, then the trade is no longer valid and fortraders who insist on staying in the trade only rationalizations remain.One of the more frustrating aspects of this approach is that prices willfrequently slide below the trader’s tight stop only to quickly recover andresume the reversal. Sometimes this process will happen more than once,triggering multiple stops as the anticipatory trader struggles to establish a
FIGURE 8.6 Double Bottom with Tight StopSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
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position. This occurs because many other players in the FX market, including dealers and hedge funds, are perfectly aware of these levels andwill gladly go on stop-hunting expeditions to shake out the weaker hands.Nevertheless, traders who decide to relax their stops in response to thisprice action will pay dearly as it takes only one serious break of supportto catch the trader unawares and quickly generate losses of 4, 5, even 10times his original risk.Because the anticipatory strategy can be both financially difficult andpsychologically draining, some traders prefer the reactive method. Reactive traders, as the name implies, will not “front-run” the price action. Instead they will observe how the price behaves at the key support points indouble bottoms and at the key resistance levels in double tops. Only afterthe price stabilizes at the original lows and then proceeds to make a seriesof higher lows will the reactive trader enter the trade. Granted, his entrywill be inferior to that of the anticipatory trader and his risk-to-reward ratio will not be nearly as favorable, but the probability of success will behigher. Furthermore, the reactive trader will now have a logical referencepoint in terms of where he should place his stop. Again there are severalchoices depending on the price action and the temperament of the trader(see Figure 8.7). If price makes a higher double bottom, a trader with low
FIGURE 8.7 Double Bottom with Variable StopSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
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risk tolerance can use the most recent low as his stop. The risk will besmaller but the possibility of stop-outs is far higher since price can easilytrade down to the original low to truly test support. More aggressivetraders may therefore choose to set their stops at the original low of thedouble bottom rather than the most recent low. This in fact is the mostlogical stop point. If price breaks support, the double bottom has nowchanged into a consolation range with high probability of continuationlower. The pattern has become the antipattern.A more unusual version of the double bottom occurs when the secondbottom is lower than the first. This type of pattern actually occurs withrelative frequency in FX and again shows the subtle power of former support and resistance levels. The “lower low” double bottom and its opposite, the “higher high” double top, simply demonstrate the fact that thedominant directional group had enough momentum to break the originalsupport or smash original resistance but then quickly ran out of gas. Thispattern also shows the particular advantages of a reactive approach,which would simply observe the action and act only when support appeared to have been set. The anticipatory trader would of course bestopped out shortly after prices collapsed through the original bottom.One difficult task for reactive traders is to determine exactly whatconstitutes support and to know when a second bottom has been put intoplace. Some traders suggest using a 7 percent retracement rule. The traderwould simply measure the full amplitude of the downtrend from its peakto its lowest low, and if price bounced up by 7 percent or greater of thelength of the downtrend, the reactive trader would assume that a doublebottom had been made at the lowest low. Figure 8.8 shows how thatmethod would work.The 7 percent rule is of course arbitrary, since it is impossible to determine with great accuracy the exact point of support. One can onlyspeculate and make intelligent assessments of probabilities, which iswhat trading is really all about. Nevertheless, the 7 percent approach offers the reactive trader a reasonable method for quickly identifying a bottom. Another way to identify the same possibility and one that Ipersonally prefer is to wait for price to make at least three higher periodiclows to confirm that a second bottom has been put in place. That type ofentry may position the reactive trader a bit later relative to the turn but itwill also provide a more accurate reading of the price flow. Regardless ofhow one chooses to enter this trade, the clear stop behind this setup is thelowest low of the second bottom. If that low is broken, more selling islikely and the lower double bottom has simply turned into a creeperdowntrend. Again, the pattern is now the antipattern, and woe to thetrader who refuses to acknowledge that fact. Refer to Figure 8.9 for a viewof that dynamic.
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FIGURE 8.8 Seven Percent Bounceback RuleSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
FIGURE 8.9 Three Consecutive Higher LowsSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
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FIGURE 8.10 Double Top FakeoutSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
Perhaps the most interesting lesson of the fakeout double bottomsand double tops (the ones that have lower lows and higher highs) is thattraders should never quit on possible patterns. Even if prices blowthrough the initial support or resistance levels they may foreshadow atrade setup in the near future. Just like gravity, these original levels mayact as brakes on any forward momentum, and even if they don’t stop theprice action at the original support or resistance point the turn may occurin the near future (see Figure 8.10). That is why it is critical to follow theprice action of the currency closely even if the original point of support orresistance is broken. The true reversal may be near at hand.
FLAGS AND PENNANTSIf double tops and double bottoms are the most popular reversal patterns,then surely bear and bull flags are the most popular continuation patterns.Both of these patterns occur after a sharp directional move and generallyconnote that price is entering a consolidation stage before pushing higheror lower. The directional move is known as the flagpole and must precede
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the price action in order for the pattern to be valid. Note the examples ofboth bull and bear flags in Figure 8.11 and Figure 8.12 with their concomitant extensions.It is interesting to see flag formations in different contexts. Note forexample how in Figure 8.13 when we apply our Bollinger band “bands”the flag is nothing more than a retracement within a channel or in Figure8.14 it is simply the V of the W bottom. It is quite helpful to break up thesepatterns into their component pieces to understand how each pattern cantransform into another one. Note, for example, that a pattern that beginsas a bear flag, then fails to penetrate the bottom of the flagpole and becomes a double bottom, turns in the process from a continuation patterninto a reversal move.Like the flag, the pennant shares the flagpole, but unlike the flag,which is a small rectangular pattern that slopes against the previoustrend, the pennant is comprised of an asymmetrical triangle that openswide and eventually compresses to a conelike shape. The easiest way todistinguish the two is that in the case of the bear flag the lows of the rectangle will be progressively higher whereas in the case of a bear pennantthe lows will be relatively equal, forming the perfect base of the triangle(see Figure 8.15).
FIGURE 8.11 Bull Flag in EUR/CADSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
Patterns and Antipatterns: Know Your Mark
FIGURE 8.12 Bear Flag in NZD/USDSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
FIGURE 8.13 Bear Flag Retracement to Bollinger Band “Band” in AUD/USDSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
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FIGURE 8.14 Bear Flag in the Double Bottom of GBP/CHFSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
FIGURE 8.15 Bear Pennant and Bear Flag in USD/CHFSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
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Both patterns are confirmed when their respective flagpole tops orbottoms are penetrated and the price resumes its original direction. Basically flags and pennants demonstrate a pause in market action. Just as wesometimes must sit quietly and digest the main course before we cantackle dessert, so must the market absorb new price levels and test the resolve of both the bulls and the bears before making further moves.Because of their subtle differences, flags and pennants offer some different setups. While the classic way to trade them is by waiting for thebreakout to occur and follow the continuation of price flow, the flag pattern, unlike the more constrained pennant, offers another opportunity forprofit. Because the flag produces a much sharper retracement path thanthe pennant, we can participate in the trade not only at the point of breakof the flagpole but also at the moment of flag failure. Here we can use Fibonacci levels to help us gauge the possible extent of the flag formationand its turning point. Figure 8.16 shows how in a bear flag the price retraces up to the 38.2 percent Fibonacci level and then proceeds to pulldownward toward the initial downtrend. A trader could enter the setupwhen price falls below the 38.2 percent zone, indicating that most of theshort covering and countertrend strength is gone, and set the stop at themost recent swing high. If the price reaches the bottom of the flagpole, the
FIGURE 8.16 Bear Flag Capture in USD/CHFSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
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trader can cover half the position, move the stop to the break-even point,and await the possible break and continuation move.One of the more attractive aspects of the flag pattern is that it can