Make Money With the Fibonacci ABC Pattern

Understand that most problems are a good sign. Problems indicate that progress is being made, wheels are turning, you are moving toward your goals. Beware when you have no problems. Then you've really got a problem ... Problems are like landmarks of progress. —Scott Alexander

Most traders have heard about Fibonacci levels. Many traders have tried to use them, but like many technical indicators that work well in theory, Fibonacci levels pose a challenge when you're actually trying to make money with them.

Manually creating Fibonacci levels presents two problems. The first is created by the series of Fibonacci lines that can be drawn at each significant turn or pivot point: After a stock has zigged and zagged a few times, the resulting pivot points create a cacophony of levels that can render a chart unreadable.

The second reveals that the intraday trader often uses more than one time frame – such as a one-minute, three-minute, five-minute, 10-minute and 30-minute chart – in making trading decisions. The end-of-day trader may also use 60- and 90-minute time frames as well as daily and weekly data. By the time either of these types of traders have drawn Fibonacci levels for each pivot point in each time frame, both often have a real mess on their hands.

The Nexgen Solution

John Novak made it a personal goal to solve this problem and to see how effective Fib levels could be in trading. It was a major challenge that he and business partner (and wife) Melinda of Nexgen Software Systems sought to overcome. More than six years and a number of different program versions later, they finalized the solution. It was the program they called the T-3 Fibs Accumulator that automatically identified and plotted significant Fibonacci levels using 40 different time frames and major pivot points from each (see Figure 1). These confluence levels allowed traders to see where a stock, future, commodity or currency had the greatest probability of pausing or reversing on intraday charts.

Chart provided by TradeStation.com. Signal provided by Nexgen Software Systems.

Figure 1: Intraday chart of the S&P 500 e-minis (ES) showing computer T-3 Fibs Protrader generated confluence levels. The greater the number of lines appearing on the chart, the more significant the level is.

After spending literally thousands of hours observing equity movements, especially at confluence levels, the Novaks began to notice a regular price configuration. John called it the ABC pattern, which he defines in simple terms: "It's a stop run of the first pullback after an aggressive move to the upside that signifies more potential in the direction of the larger move."

Chart provided by TradeStation.com. Signal provided by Nexgen Software Systems.

Figure 2: An ABC pattern A pivot long signal. Confluence zones not shown.

At the beginning of an uptrend, for example, the equity would make an aggressive move to an extreme pivot point (marked "Ext" in Figure 2) outside its trend channel. This type of action was often a signal that a new short-term trend was being established. After putting in an extreme pivot point outside the trend bands, the price would then backtrack a little and put in a pivot that he labeled "A." Often, the price would then resume the original uptrend to put in another extreme pivot outside the bands. Again, the equity would backtrack to put in another A before the uptrend resumed. Novak developed his own trend bands, but Keltner Channel bands also work quite well.

When pivot A occurred at or near a Fibonacci confluence generated by their T-3 Fibs Protrader indicator, it was a good place to make a conservative long trade with the trend (see Figure 2). If the A occurred at a midtrend band support level (magenta line), it was further confirmation. The position would be exited when either another extreme pivot appeared outside the trend bands, another pivot formed inside the bands or the price collapsed through support, triggering the stop loss set just below the midtrend band or supporting confluence level.

As long as the trend continued, a conservative long trade would be placed each time an A and/or C formed, especially if they occurred at or near a Fib confluence level. At the next pivot or confluence level, the trade would be exited, and the trader would wait for the next extreme pivot to form to begin a new ABC sequence. Stop losses in an uptrend would be set on pivots A and C, 1% to 5% below the support confluence level (depending on the equity being traded and trading plan of each specific trader). (See also: Ten Steps to Building a Winning Trading Plan.)

If you want a complete demonstration, you can log on to the Nexgen website and watch the free instructional ABC videos.

Figure 3: Another combination showing A, B and C as well as an ABC failure when the equity failed to put in a higher high pivot to confirm the uptrend.

There are a number of combinations and permutations of the ABC pattern. Another configuration is shown in Figure 3. In this case, the equity put in an extreme followed by an A from which a conservative long trade (first green arrow) could have been made. At B, the long would be exited and then re-entered at C (second green arrow). In this example, the equity failed to reach a higher high than B, so the pattern failed. The trade is immediately exited once an ABC failure occurs.

More aggressive traders could take counter-trend trades dictated by their experience and size of trading accounts. In the above example, a short from the B pivot (red arrow) at a Fib confluence level would be considered counter-trend and therefore higher risk.

It is relatively easy to see a trading pattern, but the challenge comes in trying to fully automate the process. Nexgen undertook the task. Not only did ABCs and extremes have to be programed, but a trend confirmation signal had to be integrated. That way there was little chance of a trader inadvertently entering a counter-trend and therefore a riskier trade. To accomplish this task, a green vertical bar appeared under the price bar once a new uptrend was confirmed, and a magenta bar over the price bar when a downtrend was confirmed. To make the signal clearer, trend and counter-trend trades were labeled on the chart (see Figure 4).

Chart provided by TradeStation.com and signals by Nexgen Software Systems.

Figure 4: Chart showing Nexgen signals, confluence lines, MACD, cycles and major trend signals.

"One of the things that most traders do not realize is that you will have an opportunity to not only trade the entire ABC pattern but a vast majority of the time you will be as or more profitable when you trade all the combinations of the A pivot, the B pivot and the C pivot with the overall trend," says Novak.

No. 1 in Figure 4 shows the previous ABC pattern failure. Those who entered the counter-trend C short to the right would exit the trade at this point at No. 1. A new extreme forms and an A-long potential trade signal generated (No. 2) near confluence (horizontal white line). This trade would be exited at No. 3 on the next B pivot. Aggressive traders who took this counter-trend trade and did not get stopped out or exit would have enjoyed a very profitable trade to the next extreme point that started the next ABC sequence. The next counter-trend C trade would have also been very profitable (No. 4).

Novak may not be the first person to observe that trading an ABC pattern could be profitable. Others have discussed this type of trading strategy in the literature. What makes Novak a true trading pioneer is that he has integrated this pattern with trend channels and automated Fibonacci confluence zones to make them far more reliable and therefore lower-risk trade signals.

Computerized KISS

Trading doesn't have to be complicated. In fact, the best traders have all learned how to KISS—to keep it straightforward and simple—before they truly succeed in the trading game.

But who says traders can't use effective (albeit complicated) formulas if their computers do most of the grunt work for them behind the scenes? Even when there are thousands or even hundreds of thousands of calculations occurring with each new price movement, signals are as easy as ABC for the trader with the right tools and know-how.