Every trade yields a winner and loser. Successful traders seek out ways to build profit and manage risk by strategizing how to win and, when their strategy fails, how to profit from the unanticipated.
As CEO and portfolio manager of Vision Capital Management, a Commodity Trading Advisor that invests in global commodity futures, I attempt to identify and employ trading techniques that can anticipate more than mere price action in commodity futures. We consider market behavior an extension of human emotion; and within these emotions, there are patterns that reflect the polar forces of greed and fear.
I have found that one of the best ways to trade common patterns like "head and shoulders", "double tops", "Elliott Waves", "cycles" and an infinite number of other familiar names is to look for opportunities when they fail. This is because, when faced with the fear of tremendous loss, many investors will be on the wrong side and seek to exit or reverse positions.
This leads me to what Vision Capital Management calls the "Failed A-B-C" pattern. An A-B-C formation is a fancy way to say "correction". It can be applied to both "bullish" and "bearish" situations; below is an illustration of an A-B-C bullish pattern.
In this illustration, many traders would buy at the Fibonacci support zone of .786 / .886 retracements of the impulse move (from X to (1-A)). In other words the market has moved impulsively higher and is now correcting and investors are looking at this as a second change to get on board at a bargain price. Of course many times this pattern does offer a nice bullish entry but we are going to explore here the opportunity that this pattern offers when it fails to move higher from this Fibonacci support zone.
Most traders/investors looking at this situation will jump in as price touches the Fibonacci zone but many times price goes through this area of support and this is what we are looking for to go the other way and short this market. In order to maximize this opportunity we must follow a number of rules to improve probabilities and be able to create a profitable reward to risk ratio of at least 3 to 1 or greater.
So first thing we look for is an A-B-C pattern that is developing, mainly we are looking for a well defined low or what we like to call the X point (the beginning of the pattern), next an advance in price and then a zig-zag move down for the correction. We then wait and see if price will continue through the Fibonacci support zone, if price penetrates the low of X we are on the alert for a possible failed A-B-C pattern forming.
Now at this juncture it is very important that price does not go beyond the 1.128 Fibonacci retracement of the impulsive move (The distance from X to (1-A)). To calculate this level we take the distance of X to (1-A) multiply it by 1.128 and subtract this number from the high of (1-A.). Soon after price breaks below X we want price to come back up to test the Fibonacci support zone from underneath and if we get a bar to close inside this zone and then a bar to close below this would give us a green light to go short, stops would be placed above the Fibonacci support zone and target would be equal to the distance of X to (1-A) subtracted from X.
In the example above the S&P 500 failed to hold and move higher from the Fibonacci support zone with a confirmation close below X or beyond 1.00 retracement (arrow #1)and also not closing below the 1.128 retracement. A few bars later price closes inside support zone (arrow #2) followed by a close below (arrow #3) giving us all the confirmation we need in order to enter at market.
We are now short the index and we must follow strict guidelines in order to protect capital and maximize the potential opportunity. The chart below shows our entry, stop and target points.
Once we are short, stops should placed just above the Fibonacci support zone and in the example above the difference between entry and our stop is 35 points, the target is the distance from X to (1-A) subtracted at the X point and this gave us a target of 1286 or 122 points below entry and a nice 3.5 to 1 reward to risk ratio.
Other things that can improve probabilities of success trading this pattern are:
1.Looking for a zig-zag in the move up from X to (1-A).
2.Ideally we should not see a close above the Fibonacci support zone before entry.
3.Once price has reached 50% of target objective stops should be moved to break even.
The financial markets provide many opportunities in the form of patterns, but most traders fail to look at the opportunities available when a pattern does just the opposite of what it's expected. Few invest enough time exploring the other side and this can give an edge for those willing to take a path less travelled by.
To truly succeed one must have confidence and discipline in his investment methodology and a strong grasp of risk management.
I hope that this gave you some ideas as to how one should be thinking when trading patterns and in seeing both sides of coin. Should you have any questions feel free to visit forwardthinking.vc - Good trading to all!
Dario Michalek is President and CEO of Vision Capital Management (www.forwardthinking.vc), a global investment firm. Michalek began his career in 1999 developing trading systems for Mapleton Capital Management. He has also served as head analyst for Vision Investing Group, a financial newsletter publisher that provides trading education, training and research.
