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winning approach, to add that “looks like” component to your personal results, is to enter positions on 50% retracements.
I want to make one thing abundantly clear: 50% retracements are notFibonacci study, projections, or retracements. Fibonacci was a Re- naissance mathematician. He was interested in uncovering the grand harmony and design of the universe. He wanted to find the all-pervad- ing, bedrock component to the nature of physical reality—what you and I would call the essence of the physical universe. He lived in a time when money was a very unsophisticated concept. The general level of ignorance in which people existed at the time just before he lived was profound. Fibonacci’s discoveries would have been seen as dramatic leaps forward, so much so that they looked like magic and bordered on heresy.
Still, Fibonacci believed things about the nature of reality that you and I know today are completely erroneous. For example, Fibonacci was an alchemist. He believed with all his heart that he would discover, through mathematical design and prayer, the very nature of reality. When he did, he would exploit this knowledge to turn lead into gold, thereby ending his money problems. If I told you that as a trained trader I will trade for you, and that I will execute for your account by studying the flights of bees, you would be no worse off than if you followed Fibonacci through his day as he tried to turn lead into gold.
Fibonacci never applied the golden ratio or the Fibonacci Progres- sion to markets or trading. None of that existed yet. Fibonacci discov- ered a part of nature that is accurate for the study of nature, nothing else.
He didn’t know that at the time. He himself lived under a cultural illusion and wasted his knowledge pursuing something that couldn’t physically be done.
Why am I telling you this? Because Fibonacci retracement study is an accepted method of simple technical analysis. All successful traders use some form of retracement analysis in their simple methodology. But Fi- bonacci never intended his discoveries to be developed or applied to trading.
That was W. D. Gann’s idea, so your best bet in understanding retracements is to study W. D. Gann, not Fibonacci.
Gann discovered a unique relationship between time and price that is still considered accurate today. That relationship is apparent across all markets in all time frames; no successful trader should ignore it. The rela- tionship is very simple and actually was initially discovered by Fibonacci, except Fibonacci had no use for this knowledge—he was busy going broke trying to turn lead into gold.
The time/price relationship follows the rule of 72 and 50% ratios.
Some of this is also covered in Elliot Wave analysis but I want to make this simple. Any time pundits of Elliot Wave, W. D. Gann, or Fibonacci start
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talking they complicate this whole retracement issue so dramatically that you would think the sun rotated around the earth just prior to the moon eating it. People need to just relax and focus on the main issues.
Fifty percent retracements are important because they balance the net inequality between the competing net order flows. That’s it. Retrace- ments do not predict price action or portend new highs or lows. Retrace- ments are not predictive. They are historical. The reason Gann, Elliot, and Fibonacci are all included in this discussion is because they happened to notice the relationships first—though they didn’t necessarily understand what it might be saying. Fibonacci noticed that a mathematical ratio ex- isted in nature. He assumed that lead and gold would also be subject to this natural ratio but, as we know now, this is not true. This ratio is appar- ent in nature and in the way things grow; it is not apparent in crowd be- haviors, and markets are about crowd behaviors.
Gann asked the question, “What if the market has a ratio and rhythm in and of itself?” Gann thought he had found an answer to that question when he and Elliot noticed that markets appear to have waves that occur with regular frequency and repetition. By combining these two assump- tions into a larger assumption, we now have a supposedly “verified” math- ematical model to follow in pursuing our trading success.
But the apparentrelationship is not the same thing as the realrela- tionship. The real relationship is what we want to discuss.
Fifty percent retracements happen because once enough buyers square off against enough sellers, only half of those contracts will be prof- itable. At the 50% number, exactly half the bulls have a profit and half the bears have a profit. When I say this, it is important to note that this is a net perspective. The actual result to any one trading account isn’t the issue. If you could find a way to look into the total number of open trades, you would see that of the sum total of the open longs, about half of that total number of open contracts will have an open-trade profit—the others will have losses. In other words, if there were 10,000 open longs, around 5,000 of them will have some open-trade gain and the other 5,000 will have some open-trade loss. The exact same situation will be accurate for the shorts.
The market is now temporarily balanced from the net perspective.
This situation won’t last long; it will only take a short time for new buying or selling pressure to come in. Whoever has the net advantageat that point will tip the balance. Most of the time it is in the original direc- tion back toward the previous high or low because from the net perspec- tive the late loser entered from the short-term trend—that is, the few days or so just before the 50% level is reached.
This is a factor of the rule of 72. Most market participants operate on a time frame of 72 hours or less. That means that in all the various ways of creating a market timing signal that now is the time to initiate a position,
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most traders have gotten at least one signal in a 72-hour period and have executed, creating net order-flow. Once they have initiated, they must liqui- date to accept their open-trade profit or loss. Most methodologies will have given the exit signal within that time frame as well, with the net result that almost everybody has gotten in and out at least once within a 72-hour pe- riod. If this process happens at a 50% balance point, the net result is usually a resumption of he previous trend. See Figure 25.1.
HOW TO USE THE RULE
First you must select a significant high or low price previous to the price the market is currently retreating from. When I say significant price I mean a price that is around 72 bars back in time; also they are usually weekly, monthly, or daily price points. If we use a bullish scenario, you are looking for a previous important low price andthe market is retreating from the most recent high. If you use a daily chart, as used in Figure 25.1, your previous low price must be about 72 days/bars back or so, I find that on longer time frames anything substantially less is not as accurate, and anything significantly more is usually ignored by traders as “old data.”
Place a 50% retracement study between the old low and the new
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FIGURE 25.1 Buying and Selling 50% Retracements—Cash Euro/USD. FOREX, April 2005 to April 2006.
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high—that would be your best buy point. That point will be some time in the future that approximately reflects the 72-bar ratio. This is why a price could trade to a high and Gann would say, “By this time next week, the market will trade at _____ (price).” He would be merely projecting his ra- tios and computations forwardsome amount of that ratio as a price/time relationship. Of course, the opposite would be a sell point if you were tracking a rally in a bear market. But the underlying psychology behind the 50% retracement is not about resumption of a previous trend or a failed reversal; it is about the late trader who entered in the last 72 hours.
Most people who initiate a position—about 80% of the total warm bodies sitting in front of a trading screen—are going to do at least one full round turn in the market just prior to the market reaching the 50% price area. The vast majority of those traders are looking to make money right now. If they follow standard technical analysis or use any of the most common methodologies, because the market was trending lower for more than 30 bars from the rejected high to the 50% point, they are looking to sell into the market and join the apparent downtrend currently in progress, from their point of view. Their focus is to get positioned on the short side because “the trend is your friend.”
But the market has just become balanced momentarily. That means only one thing. The shorts from above the market will cover; they have the most recent 72-hour open-trade profit. The late shorts cover, adding to the buy order imbalance as they take their loss. Last, the old longs on the greater-than-72-bar time frame (the 20% of long-term traders, the ones who know how to follow this rule—the professionals who know you need more than 72 hours to beat the loser) add to net winning open positions, many of which they have owned since the turn under the market. They know that the retracement is coming and it will draw in late blood. So they gladly sit through the 50% retracement with at least part of their orig- inal position. Of course, the exact opposite scenario develops when a de- clining market rallies 50%.
Now obviously, markets don’t always turn on a dime once they re- trace 50%. Sometimes they take more time to balance temporarily; some- times they need several more or fewer bars than 72; sometimes they sit at the 50% level for a bit and then retrace farther before moving back in the original trend. None of that is the point. The point is, if you want to make a lot of winning trades and keep it simple, enter your position at the 50 per- cent retracement point and wait. More often than not you will get at least something you can work with.
When you combine this rule with Rules #11, #14, #16, and #17, you have a huge potential to take a lot of money when a market still has more to go and you are willing to wait for it. In fact, you only need a handful of trades a year if you are willing to think ahead more than 72 bars when you
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are developing a trade hypothesis. Traders who have hit the home run, traders who have been long a bull market when an honest-to-goodness shortage is developing or short an hysterical bull market when the hedgers finally cap the rally, will tell you that when the 50% retracement happened, it was truly a thing of beauty and the money rolled in.
One last thing before we close out this rule: In fairness to all the peo- ple out there who are legitimate experts on the theories of Gann, Elliot, and Fibonacci (which I am not), I really don’t intend to discredit anyone or their theories. I just think that the essential part of what these men can teach us is best found when we use some simple common sense. No one has a secret method, and there is no perfect technical approach. These great men of history and of the markets found pieces of the deeper truth and expressed it the best they could. Only they could know how to use the sum total of their knowledge in today’s markets; the rest is conjecture and opinion by people who never knew them personally.
I think it is important to remember that the essential part of market knowledge is simplicity. Remember, Livermore was a contemporary of Gann and Elliot and made more winnings then they did combined. Liver- more never used these kinds of analysis. He understood people and how they behave, so well that he could read a market better than others could analyze a market. I think the best traders are those who read the markets first; I don’t think the analysts are thinking along the same lines. Studying Gann, Elliot, or Fibonacci by reading their books is similar to saying you understand Beethoven well because you can read his music scores.
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