Candlesticks, Fibonacci, and Chart Pattern Trading Tools : a synergistic Strategy to Enhance Profits and Reduce Risk

Figure 4.16
Extensions out of a regular 3-wave pattern and a bear trap chart
formation.
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FIBONACCI PRICE EXTENSIONS
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In general, we calculate price extensions based on the Fibonacci
ratio 1.618. Those who want to extend the analysis to alternative ra-
tios can do so by choosing appropriate ratios from the menu bar of the
WINPHI software.
The application of Fibonacci price targets to extensions leads to
three scenarios. Market prices can:
• Come close to the precalculated target price, but miss it by a
small margin.
• Reach the exact target price.
• Overshoot the target price.
The most important variable in the analysis of extensions is
the swing size; therefore, which scenario develops will depend on the
strength of the selected impulse wave.
If the swing size is too small, the thrust of the extension may be
too big and overshoot the precalculated price target by a wide margin.
This makes the Fibonacci ratio 1.618 unreliable for calculating the
Figure 4.17
Extension in the third wave of a 3-wave pattern uptrend. Target
price level measured by the Fibonacci ration PHI
=
1.618.
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APPLICATIONS OF TRADING STRATEGIES
target price. Noise in the market can also cause underlying swings to
become unpredictable. Even more important, a swing size that is too
small can reduce prof it targets to such narrow margins that it be-
comes diff icult to execute them.
If the swing size is too big, it could take weeks, months, or even
years to reach the target price. The bigger the selected swing size, the
more long-term oriented the analysis must be, especially if the trader
is using weekly price bar charts. When long-term price targets are
reached, they will determine major turning points in the products an-
alyzed. Price extensions calculated on large swings are of little use
for average investors who invest with a short-term or mid-term time
horizon.
In addition to the size of the impulse wave, a few other parame-
ters determine a successful application of extensions.
Entry Rules, Stop-Loss Rules, and Profit Targets
The general idea behind extensions is to invest countertrend short or
long once the target price of an upward or downward extension has
been reached.
Integrating an entry rule makes it possible to f ine-tune this
countertrend investment strategy. Because we must deal with three
scenarios, an entry rule is necessary to make the early stages of a
market position more f lexible and reliable.
The application of an entry rule slightly reduces the prof it po-
tential because positions are entered with a time lag after the target
price has been reached. Trades become safer, however, because posi-
tions are protected from excessive losses if strongly rising or falling
markets do not stop at precalculated price targets.
To properly handle the three aforementioned price target sce-
narios (being missed, reach the exact target price, or exceeded by some
margin), the analysis must include small price bands above and below
the line for the price target at the end of an extension. As long as the
market price moves within the price band, the entry rule remains in
effect. Should the market price exceed the upper price band, no ac-
tion will be taken because it has to be assumed that market prices
will rise higher without a correction countertrend.
Whenever a precalculated target price is reached on daily charts,
we recommend working with an entry rule. This should be done in an
uptrend either to the previous 2-day low, or to a market on close if the
close of the last trading day is lower than the close of the highest day
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