Breakouts and Fib Numbers

TRADERS´STRATEGIES

When Does a Trend Become „Real“?

Breakouts and Fib Numbers Many years ago a Fibonacci guru I know was adamant in explaining to me that it was impossible to combine breakout trading with Fibonacci ratios. However, any “breakout” simply involves a violation of some price level, doesn’t it? A breakout violates a high, a low, support, or resistance, or even an area of Fibonacci confluence. I am not a great fan of trading Fibonacci ratios, but I am also not a breakout trader. If I had to put a name to what I do, I would call it “momentum” trading. I believe the money is made from properly managing momentum. Nevertheless, there are ways to combine breakout trading with Fibonacci ratios. Just bear in mind that the big bad sharks will be looking for you when you trade with fib numbers. This in part is because you will find yourself a fish among many when the sharks become hungry for stops. o What You Need to Know

Anyone who trades, soon finds himself asking the question „How do I know if support or resistance is really broken?”. Put another way, if you are looking at a trend line or a fib number for support or resistance, how do you know when prices break through that the breakout is real? After all, was not support or resistance supposed to hold prices? Were not prices supposed to bounce off of Fibonacci support or resistance, giving you an opportunity to trade in the opposite direction? There is indeed a way to know that support or resistances has not held, and that prices are continuing in the direction they were moving! Is the method 100% accurate? Is anything for certain in the marketplace? I think not, but there is a very old concept

26

July 2010 | www.tradersonline-mag.com

that I was taught and it remains among the best I have seen. I can show you a number of ways to use what I will describe next, but one way will do for now. Simply stated it is this: Whenever you have a breakout, you cannot consider it real until you have confirmation of the breakout. Whether it is the violation of the number 2 point of a 1-2-3 high or low formation, the violation of a trend line, or the violation of Fibonacci support/resistance, you must see confirmation before taking the risk of a trade entry. If you are using a 1-2-3 low or high, you must see an entire bar move beyond the number 2 point. If you are using a trend line, you need to see an entire bar move beyond the trend line, and if you are using a fib confluence, which is supposed to support or resist, you have to see an entire price bar move beyond

TRADERS´STRATEGIES

the area of confluence. By entire bar, I mean everything from high to low of the breakout bar.

F1) Simple Fibonacci Expansion

Confirmation Is Necessary Now, what about confirmation? So far all we have defined is the breakout bar itself, i.e., every part of the breakout bar must be in the clear, having passed the price level of a number 2 point, a trend line, or support or resistance. Confirmation is seen in that you must have a Close that moves beyond the high of the breakout bar if prices are moving up and a Close beyond the low of the breakout bar if prices are moving down. If these requirements are met, then you probably have a confirmed breakout (violation). Otherwise, what youare probably seeing is nothing more than stop running. This is especially important in keeping you from trading a false breakout, when using the lines of support or resistance, or a trend line. Also depending on your time frame it may take a while to happen, so patience for the full breakout and confirmation of the breakout will help you preserve capital. As with all violations, the larger the time frame from which the breakout occurs, the more powerful it usually is but the longer you have to wait.

Euro Example In the case of the euro chart that follows, we will be looking at a daily breakout, which will signify the potential continuation

The daily euro chart shows a simple Fibonacci expansion to an area of support. The question is, will the support hold? Source www.genesisft.com

of the trend which can be very useful for swing and position traders. Of course, this same concept can be useful for intraday trading as well. What we see is a Fibonacci expansion from 1.4585 down to 1.3666. (Figure 1) The formula is simple:

July 2010 | www.tradersonline-mag.com

27

TRADERS´STRATEGIES F2) False Breakouts

B-A+C = Fib Expansion area: (1.4223-1.5148) + 1.4585 = 1.3666

In Figure 2 we see two false breakouts being identified by a failure of prices to follow through with lower Closes following the breakout bar. Source: www.genesisft.com

F3) Ross Hook

We can expect support at that level, and indeed, a range of support was there. Following a brief correction, we would expect a violation of the low of the 1.3666 bar, and continuation of the trend. However, it never materialized. Instead, prices formed an area of consolidation. With the exception of a single bar, every bar that follows the 1.3666 bar (29 in all) has some part of itself within the price range of the 1.3666 bar (1.3754-1.3592). This is a true sign of consolidation. Note: The range of the 1.3666 bar does not defi ne the high and low of the consolidation. The high and low are defi ned by the dotted lines. Without an actual confi rmation bar in place (a Close lower than the low of the breakout bar), you should not assume that selling short would probably result in a continuation of the former trend. But as we can see from Figure 1, the word “probably” had a great deal of meaning in this case. Prices dropped down to form another area of consolidation. In Figure 2, the confi rmation method truly worked. The bar following the breakout bar did not Close lower than the low of the breakout bar. We see the same situation again on the last two bars. There was a breakout, but the bar following the breakout failed to Close lower than the low of the breakout bar.

Abandoning One Method for Another

Figure 3 demonstrates the beginning of a trend using a Ross Hook as a filter. Source: www.genesisft.com

Joe Ross Joe Ross, trader, author, and educator is one of the most eclectic traders in the business. His over five decades in the markets include position trading of shares, futures, and options. Ross day trades stock indices, currencies, and forex. He trades futures spreads and options on stocks, and futures, and has written books about it all– twelve to be exact. Ross has written countless articles for many trade journals and magazines and has appeared on TV financial programs, as well as financial programs on Radio. Moreover, he produces a trading newsletter called Chart Scan™.

28

July 2010 | www.tradersonline-mag.com

As with all methods, there comes a point at which a trader must abandon the method in favor of the reality of what is happening to prices. What we have been looking at is how to know if a violation of a key price level is real. We have been looking at support and resistance levels. But there comes a point at which prices are seen to be clearly trending. The question is “At which point can we identify a trend?”. The so-called Ross Hook™ can help us here: A Ross Hook is in place when prices fail to make a new (high) low following the breakout of any form of consolidation. A violation of the point of a Ross Hook, establishes a trend. And every failure to make a new low (in this case) becomes a subsequent Ross Hook (RH). Let’s look at that now. Following the fi rst Ross Hook we see on the chart (Figure 3), prices began to trend. At each retracement, a new Ross Hook was formed. A method for entering the market ahead of a violation of a Ross Hook is called The Traders Trick Entry™. A Ross Hook is one of the formations of the Law of Charts™. The Traders Trick Entry is one way to implement the Law of Charts formation known as The Ross Hook.

Conclusion Techniques that are used for breakouts are not the same techniques you use for trading once prices are trending. A trader needs an arsenal of tools. The breakout method discussed in this article deals with breakouts from areas of support and resistance. For this, I combined breakout trading with Fibonacci ratios. The most important thing is to wait for a confi rmation of the breakout. Only then will the breakout be real. n