Mastering the Cipher Pattern in Trading: A Comprehensive Guide
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Chapter 1: Understanding Harmonic Patterns
Harmonic Patterns are advanced price action techniques that help identify market reactions. The effectiveness of these patterns stems from their reliance on the confluence method, which anticipates reactions at specific levels indicated by Fibonacci retracements. The rationale behind their success is not mystical; rather, it is due to the widespread use of Fibonacci levels by traders, which enhances the likelihood of market reactions and boosts the predictive capabilities of these patterns. However, relying solely on Harmonic Patterns may not be adequate. As we will explore, they are most effective when paired with contrarian indicators to improve the chances of a successful trade.
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Introduction to the Fibonacci Sequence
Leonardo Bonacci, widely known as Fibonacci, created a sequence based on the mating patterns of rabbits, which led to several mathematical insights. This sequence follows a distinct pattern where each number is the sum of the two preceding ones. For instance, the number 13 is derived from 8 + 5, represented by the formula:
The elegance of these numbers lies in their ratio, known as the golden ratio. When examining any two consecutive numbers in the sequence, their ratio (X_n / X_(n-1)) approaches approximately 1.618, which we refer to as the golden ratio.
While the journey from these patterns to trading is intriguing, our focus here is on their significance. We will analyze these ratios from a financial trading perspective, keeping 1.618 in mind as one of the two key ratios we will utilize in trading. Our task now is to uncover additional significant ratios relevant to trading, all of which are variations of 1.618 and its reciprocal, 0.618. It’s worth noting that the reciprocal of 1.618 is simply 0.618, achieved by dividing 1 by that number. The table below summarizes the remaining ratios and how they are derived:
Detecting the Cipher Pattern
The Cipher Pattern is a unique configuration that capitalizes on semi-extended moves to identify potential reversal or correction levels. It is characterized by:
- An initial move that retraces a maximum of 61.8%, ideally hitting this level precisely.
- A strong reaction that exceeds the highest/lowest point, depending on the pattern type, retracing back to 127.2%.
- The market then retraces to 78.6% of the initial leg, where the anticipated reversal zone is located.
The following figure illustrates a bullish Cipher Pattern, showcasing a strong reaction when prices reached 78.6% of the initial leg. Although it can be challenging to spot, when it does appear, it offers powerful signals.
It's important to note that a bullish Cipher resembles an "M" shape, while a bearish Cipher takes on a "W" shape. We anticipate a reaction around the D point, with the pattern consisting of five points labeled XABCD, where we execute trades based on the last point and manage our risk according to specific metrics discussed later in this article.
The first video titled "Trading the Cypher Pattern - A Common & Dangerous Mistake" delves into common pitfalls traders encounter while using the Cipher Pattern, emphasizing the importance of accuracy in pattern recognition.
Detecting the Cipher Pattern
The Cipher Pattern can begin to be identified around the midpoint of point C, providing ample time to act without the influence of hindsight bias. The following steps outline how to detect it over time:
Step One: Monitor the reversal at point C after the market exhibits initial reactions. The first step involves identifying an impulse move followed by a reactionary move that retraces to 61.8%, which is the retracement of the XA leg. Next, we must observe whether the AB leg will retrace back to a significant 127.2%. This marks our C point.
Step Two: After the C point reaction, we await the market to reach point D. This requires the market to retrace to the XA leg's 78.6% level, which will be our D point from where we expect a reaction.
Step Three: Establish a support level around point D. At this point, we can draw the Cipher Pattern, relying on the anticipated reaction at the D point defined by the 78.6% retracement of the XA leg.
Step Four: Assess the reaction from the potential reversal level. Finally, we manage the reaction based on the risk management strategies outlined later in the article.
Combining the Cipher with the RSI
Having a Cipher Pattern at its D point, along with an RSI at extreme levels or showing divergence, serves as a robust trade confirmation and enhances conviction. But what exactly is the Relative Strength Index (RSI)?
The RSI is one of the most recognized momentum indicators, particularly effective in ranging markets. It operates within a range of 0 to 100, making it easy to interpret. Its popularity contributes to its effectiveness; the more traders and portfolio managers monitor the RSI, the more likely they are to react to its signals, influencing market prices.
Calculating the RSI is straightforward. We begin by determining the price differences over one period, subtracting each closing price from the previous one. Next, we compute the smoothed average of positive differences and divide it by the smoothed average of negative differences. This calculation yields the Relative Strength, which is then used in the RSI formula to create a measure between 0 and 100.
Step Five: Integrating the Cipher with the RSI.
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Summary
In conclusion, my goal is to contribute to the realm of objective technical analysis by promoting transparent techniques and strategies that should be back-tested before implementation. This approach aims to dispel the notion that technical analysis is subjective and lacks scientific grounding.
Whenever you encounter a trading technique or strategy, I recommend following these steps:
- Maintain a critical mindset and eliminate emotional responses.
- Back-test using real-life simulations and conditions.
- If promising, optimize and conduct forward testing.
- Always factor in transaction costs and simulate slippage in your tests.
- Incorporate risk management and position sizing in your evaluations.
Finally, even after ensuring all these aspects, remain vigilant and monitor the strategy as market dynamics can shift, rendering the strategy unprofitable.
The second video titled "Trading Advanced Patterns - Cypher Pattern" provides deeper insights into advanced trading strategies related to the Cipher Pattern, enhancing understanding and application.