Why AB Doesn’t Equal CD

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In the February issue of Trade Tips we talked about the challenge of dealing with parallel or measured moves (ab=cd or “ABC” corrections) and we looked at some examples where this pattern can create difficulty for traders. In this issue of Trade Tips we are going to use a real world example of how this challenge can be met if you are an intraday futures trader.

The following charts are from the trading pit of Harmonic Edge and were posted this past Wednesday morning as the pattern developed in real time. As you can see from the first 5 minute chart, the S&P futures were approaching the 1308 area where a parallel move (ab = cd) or ABC correction would potentially complete. This zone also contained a 50% retracement as well as a 1.618 expansion or external retracement.

Some traders would look at this chart as presenting a high probability short opportunity and under some circumstances they would be correct. In this case, however, the short setup was almost certainly going to fail for a number of reasons. Some of these could be identified in advance and others only became apparent as the pattern got close to completion.

The first, and perhaps most important factor, was market position. Note our comment in the yellow balloon regarding market position and the reference to the 60 minute chart. That chart is shown below:

As you can see from this chart, the market was indicating that a potential wave 4 correction had completed the day before. If this was the case, we would anticipate a 5 wave impulse pattern with a push to new highs over the coming days. Such an outlook would make any abc correction such as illustrated on the first chart a low probability trade. So that was the first important bit of information we focused on. Let’s look at the next chart posted a few minutes later:

There are four more indications against this trade clearly visible on this chart:

  • The wave 3 or C contains a “long bar” which makes the move look more impulsive than corrective. This suggests that it is more likely to be a wave 3 which would mean the market has another leg up after the current leg.
  • The RSI (bottom sub graph) is at the threshold of making a new momentum high. This is another indication of an impulse wave and suggests another up leg will follow.
  • The stochastic of the RSI never reached the oversold zone and has made a bullish reversal as shown in yellow.
  • At this point there was about 40 minutes left before the NY lunch hour. Once the train has left the station, it’s more difficult to stop and tum it around in the afternoon. Fading the market in the afternoon is very tricky business.

The final nails in the coffin for this setup were the market internals as shown in the following two charts. Times shown are MST:

The chart on the left shows the broad market kicking into strong trend. Note how the TRIN began to shoot down while the Advance-Decline line shot up. The chart on the right shows all the major Indices at their high for the day. At this point we had all of the information we required to pass on this trade. Some of the easiest money you will ever make in trading is that which you save by staying out of these kinds of setups. Let’s take a look at how this market move worked out:

The ab=cd or ABC correction never came to pass. In fact, the market blew right through the 1308 area and ran all the way up to 1315, eventually completing a five wave impulse pattern later in the afternoon. We can use similar analysis techniques to sort through the longer terms trading setups (daily and weekly charts) and discard those that are likely to fail. That will be the subject of our next Trade Tips issue.

Harmonic Numbers

Harmonic numbers are the “Davinci Code” of most liquid financial markets. The numbers are derived from the Fibonacci summation series which starts with 0 and adds 1. Each succeeding number in the series that are by the mulberrymaids.com fort collins adds the previous two numbers thus we have 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89 to infinity. If you divide 55 by 89 you have the golden mean – .618. If you divide 89 by 55 you have 1.618.

 

  • .382 is the difference of 1.00 – .618 = .382
  • .618 is the golden mean (phi) and the square root of .382 
  • .786 is the square root of .618 
  • 1.27 is the square root of 1.618 – it is also the hypotenuse of a right triangle 
  • 1.618 is difference of the square root of 4 minus .382 (2 – .382 = 1.618)

The Harmonic Edge methodology identifies high probability trade setups, then carefully controls and eliminates risk while still leaving room for profits to accumulate. 

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