Table of contents:
- 1 When does a stock or product become cheap?
- 2 Profitable correction trading – high-performance approach
One of the most important trading concepts is the response after a strong price movement. A large number of professional traders swear by this pattern of success. It is mainly due to the combination of low risk and high profit opportunity. In the literature, one often finds different terms for the return. Many analysts speak of retracement, correction, consolidation or pullback. What is meant is always the same.
The following picture shows the basic principle of retracement.
Figure 1 shows a strong rising wave A with a subsequent return of wave B. The length of wave C is closely related to the force of the bulls from wave A and the force of the bears in wave B.
The art of trading is to know when wave B ends or wave C starts. The return can take many different forms. The variations are practically unlimited.
When does a stock or product become cheap?
A good question: At what price does a stock become so cheap that you would buy? Psychology helps us to answer this question. One condition is that the purchase of the share would not be a compelling necessity. Because if you were in the desert, just before dying of thirst, you would also pay 1000 Euros for a water bottle.
The extreme case is not relevant for us stockbrokers. Rather, it applies that we can buy, but do not have to. In this initial situation it always runs up to half the price. As soon as a 50% discount becomes possible, a potential buyer is greedy.
Many examples under auctions
You can observe the behavior pattern very well at Ebay auctions. For example, if a product has a new price of 60 Euros and the product is put on Ebay with a starting price of 1 Euro, you will notice that the price will quickly rise to 30 Euros. When the 30 Euros are reached, the number of offers will decrease noticeably. Only sluggishly will the auction price increase further. Only at the end of the auction can the price change drastically again. This is when the bids arrive, from those who urgently need the product. Only through emotional pressure does the price rise far above the 50% limit. And how strong an emotional compulsion can become, you can observe at art auctions. Often the art objects are unique and have a history. Top prices always result from the “unconditional desire to own”. As we know, the attraction can become incredibly high.
The Fibonacci followers and their prophecy of pullbacks
The response implies the future expectations of market participants. Meanwhile, hopes, fears and new information distort normal price formation. As a result, the price often deviates from the 50% level.
Fibonacci analysts will tell you that there are several important response levels. There is a series of numbers that was discovered by the mathematician Leonardo Fibonacci from Pisa. You will find this series of numbers particularly often within nature. Fibonacci followers transfer the laws of nature to the stock markets, and claim that price movements also work according to the laws.
My personal opinion on the Fibonacci influences is divided. On the one hand, there are many examples with price inflection points directly at a Fibonacci level. On the other hand, Fibonacci numbers are so closely spaced that a price reversal point can almost always be associated with Fibonacci. The mere wishful thinking that the Fibonacci numbers are an incontrovertible stock market law can lead to a lack of reality. And a trader must avoid this at all costs.
There should be no discussion here whether Fibonacci numbers actually influence stock market prices or not. It is much better to judge the practical side of the number series, because Fibonacci numbers sometimes offer a “self-fulfilling prophecy”. When most technical analysts use Fibonacci ratios, they also have a proven effect.
With the help of Fibonacci, there are three important response numbers: It’s 38%, 50% and 61%. Some traders also include 23% and 76%. However, the first three percentages have a much higher effect.
Interpretation possibility for pullbacks:
- The Fibonacci ratios are guidelines without mathematical accuracy.
- If a stock has a return of 38% or less, the subsequent price movement should be particularly strong.
- If a stock has a greater response of 61%, the subsequent movement is considered weaker.
- In general, 50% response is the normal case.
- The first return after a strong upward movement is often a good buying opportunity.
- A return of 38% after an upward movement allows the assumption that the next upward movement will clearly outbid the high.
- A return of 50% after a strong rise has a chance of about 50% that a new high is reached afterwards.
- If the return is 61% after an upward movement, the probability that the high will be surpassed in the subsequent movement is only 30%.
In the picture above, three different returns are highlighted. In the first example there is an upward movement which ends with a return of about 62%. The following upward wave does not manage to outbid the previous high. In the second example there is a strong downward wave. The corresponding countermovement reaches about 50%. The subsequent downward wave is strong, but it cannot push the price far below the previous low. The third example is the direct reaction to the significant low. The upward movement is dynamic. Afterwards there is a rebound of about 35% and another strong upward movement.
Practical trading tips for trading
- Always keep an eye out for returns between 38 and 61%.
- If the return is about 38%, you should not take profits too early. An upward movement often clearly surpasses the previous high.
- If the return is 50%, you should study the market movement well. If there is no momentum, you should take a partial profit at the high of the previous upward movement.
- With returns of 61%, profit taking below the previous high is often advisable.
- If the return is more than 61%, one should refrain from entering the market.
- You should also observe the duration of the reflux. For example, if an upward movement lasted 10 days, then 5 days (50%) of backtracking is a good time to start a reverse movement.
Profitable correction trading – high-performance approach
In a bull market it is a good idea to buy corrections. Under what conditions can gigantic returns be achieved?
Buying corrections can be worthwhile, as I pointed out in the article “This is how they trade equity profitably! In this article, a short-term combination of stop-loss and price target was presented, with which a hit rate of more than 50% could be achieved. The approach was aimed at traders and investors who place relatively high value on being right. Please read this article again to remember the logic of our strategy.
If you want to take it to the top in terms of hit rate, take a look at the following chart. In it you can see the top 5 combinations with the highest hit rate. It is easy to see that these are approaches in which very small CRVs are traded. The top combination even has a CRV of only 0.5.
Blessed are those who can live with small hit rates!
In the next step we want to turn the tables and focus on profitability. We are interested in which combination of target price and stoploss can achieve the best performance. The answer to this question can be found in Figure 2:
The best performance is achieved if a price target of 28% is targeted with a stoploss of 9%. This turns the originally presented short-term approach into a medium-term trading strategy. At the same time, this leads to a significant reduction in trading frequency and thus also in trading costs. Only 1,000 of the original 2,200 trades are now left. At the same time, we are able to generate a profit almost three times as high. The risk profile also made a significant leap forward. The ratio of profit to the now maximum drawdown has risen from 285 % to 578 %. This more than clearly outperforms the benchmark index (182 %). Further statistical figures can be seen in Figure 3, where the performance curve before costs is also shown on the left-hand side.
We have already seen in the basic article (see here) that it is worth buying corrections. We have been able to deepen our findings today, shifting the focus away from the hit rate and towards profitability. This has shown that trading large CRVs is advantageous. Profitability has increased significantly, but at the expense of the hit rate.
With this overview, the question naturally also arises as to whether the approach can be traded directly in the form in which it is presented here. Ultimately, the decision is of course up to you, but I would not like to end the article without a few critical words.
It must be clear to everyone that this test is an analysis of the past. There is absolutely no guarantee that it will be repeated. This aspect is all the more important as we continued to look at a period (2008 to the present day) in which markets in general were extremely bullish. Multi-year bear markets are likely to weigh heavily on performance. So if you want to trade the approach, you should be aware of the “bull market” filter. Investors and traders should therefore first ask themselves the fundamental question of whether there is currently a bull market and whether it can continue for some time.
With the combination of stoploss and price target presented here, the trading frequency could be significantly reduced. Of course, this also means lower trading costs, but they are not zero. All statistics shown here ignored the trading costs, not least because these can vary greatly from broker to broker.
Finally, it should be mentioned that one should be careful when choosing optimal test results. Always taking the best setting is risky. With these settings, you might run into the over-optimization trap. What becomes clear from the optimization, however, is the tendency that trading larger CRVs is worthwhile. Whether one should really choose the perfect setting of 9 to 28%, on the other hand, should be treated with caution.
In the end, you as a trader have to decide whether and to what extent you use this information. There are many opportunities for you to do so. For example, you can systematically implement the strategy with the reservations already mentioned. However, you can also use the insights you have gained to incorporate them into your existing trading. Regardless of how you decide, I wish you every success.