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Trading the Arrow Pattern
Presenting and Trading the Arrow Harmonic Pattern
Harmonic Patterns are one of the powerful advanced price action techniques that are used to detect reactions. The thing that works about Harmonic Patterns is that they use the confluence method, meaning that they expect reactions from clusters of certain levels defined by Fibonacci retracements. The reason they work has nothing to do with mystic or magic whatsoever, it is simply the fact that Fibonacci retracements are used by many traders and their visibility makes reactions more likely, thus increasing the predictive power of the patterns. However, only using Harmonic Patterns on their own might not be sufficient as we will see below, they are best combined with contrarian indicators to increase the chances of a profitable trade.
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Introduction to the Fibonacci Sequence
Leonardo Bonacci, known as Leonardo Fibonacci has developed a sequence out of rabbit mating which formed the basis for many mathematical observations. The sequence follows this distinct pattern:
The numbers are found by adding the previous two numbers behind them. In the case of 13, it is calculated as 8 + 5, hence the formula is:
The beauty of these numbers is a certain ratio, called the golden ratio. If we take any two successive numbers in the sequence, their ratio (Xn / Xn-1) gets closer to 1.618 which is what we call the golden ratio:
It is not important how we got to trading from these patterns as much as how important they are, therefore, we will discuss the ratios from a financial trading perspective. Let us keep the 1.618 in mind as for the moment it is one of the two most important ratios that we will use in trading. Our job now is to find the rest of the significant ratios useful to us in trading. They are all variations of 1.618 and its reciprocal 0.618. Notice how the reciprocal of 1.618 is simply 0.618. A reciprocal is when you divide 1 by the number. The below table summarizes the rest of the ratios and how we got them:
We will now proceed to define the Pattern and how to detect and trade it.
The Arrow Pattern
I have found this pattern after searching for extended moves that occur after extreme reversals. The pattern is fairly easy and comes from the ABCD family. The ABCD is simply a symmetrical configuration where the AB leg equals the CD leg. The Arrow harmonic pattern is when the CD leg equals 2.24x of the AB leg and thus it captures distant reversals.
The Arrow pattern is an interesting configuration that takes advantage of extended moves to detect an imminent reversal level. It is defined as:
An impulsive move followed by a reaction with no preferable retracement level.
An extended move of a magnitude of 2.24x of the impulsive move starting off where the market has reacted. This can be calculated using the Fibonacci Expansion Tool.
The figure above shows a powerful reaction after prices reached 224.0%. The Arrow pattern benefits from the time factor as extended moves are bound to correct sometime. It is not that easy to detect nor is it common but when it occurs, it definitely adds value to our trading.
The pattern is always composed of four points in time ABCD where we trade the last point and manage our risk according to specific measure discussed in the last part of the article.
Detecting the Arrow Pattern
The Arrow Pattern can start to be detected around the middle of point C. Therefore, we have enough time to act on it without any hindsight bias or delay. The below plots show how to detect one across time:
The first step above is simply detecting an impulse move following by a reactionary move. After that we have to wait whether the move will continue in the direction of the initial impulsive move.
Having retraced back of the new leg, we are now looking for a 224.0% retracement of the new leg and the break of the B point.
Now, we can even draw the Arrow. All we need is the expected reaction from the D point. As opposed to a retracement method, the Arrow uses a projection through the Fibonacci Expansion Tool. This means that if we replica the AB move starting from the C point, we need the CD move to be 2.24x of the AB move.
And finally, we should manage the reaction according to the risk management measures outlined in the last part of the article.
Combining the Arrow with the RSI
Having an Arrow Pattern at its D point (pending reaction) and an RSI around extremes or in divergence is a good confirmation of the trade and is a conviction enhancer. But what is the Relative Strength Index?
The RSI is without a doubt the most famous momentum indicator out there, and this is to be expected as it has many strengths especially in ranging markets. It is also bounded between 0 and 100 which makes it easier to interpret. Also, the fact that it is famous, contributes to its potential.
This is because the more traders and portfolio managers look at the RSI, the more people will react based on its signals and this in turn can push market prices. Of course, we cannot prove this idea, but it is intuitive as one of the basis of Technical Analysis is that it is self-fulfilling.
The RSI is calculated using a rather simple way. We first start by taking price differences of one period. This means that we have to subtract every closing price from the one before it. Then, we will calculate the smoothed average of the positive differences and divide it by the smoothed average of the negative differences. The last calculation gives us the Relative Strength which is then used in the RSI formula to be transformed into a measure between 0 and 100.
To sum up, what I am trying to do is to simply contribute to the world of objective technical analysis which is promoting more transparent techniques and strategies that need to be back-tested before being implemented. This way, technical analysis will get rid of the bad reputation of being subjective and scientifically unfounded.
I recommend you always follow the the below steps whenever you come across a trading technique or strategy:
Have a critical mindset and get rid of any emotions.
Back-test it using real life simulation and conditions.
If you find potential, try optimizing it and running a forward test.
Always include transaction costs and any slippage simulation in your tests.
Always include risk management and position sizing in your tests.
Finally, even after making sure of the above, stay careful and monitor the strategy because market dynamics may shift and make the strategy unprofitable.