In the contemporary marketplace, chart patterns are a favorite tool for legions of participants. In the study of Japanese candlestick or open-high-low-close (OHLC) pricing charts, patterns are often used to evaluate market state or to craft trading decisions. Whether you're trading futures, forex, bonds or equities, chart patterns may be implemented on any product and time frame.
One of the most popular formations is the ABCD pattern. A readily discernible appearance and user-friendly interpretation make the ABCD an attractive indicator for active market technicians.
What Is The ABCD Pattern?
The ABCD pattern is among the most simple formations found on a pricing chart. Classified as a harmonic chart pattern, the ABCD is a geometric shape that signals either trend extension or reversal. The formation consists of three phases: an initial directional move, a pullback and a subsequent continuation.
As a rule, valid ABCD patterns occur within trending markets. In doing so, the pattern has two primary components:
A directional move in pricing represents a significant bullish or bearish change in asset valuations. Directional moves are commonly referred to as "legs" and may be quantified on any duration chart, from one minute to yearly. As a general rule, a directional market is in the midst of a trend.
A retracement in price is a pullback from a periodic high or low. Also referred to as a correction, a retracement is viewed relative to a prevailing trend and can occur on any time frame. In terms of the ABCD pattern, corrections are frequently measured in terms of Fibonacci retracements. The most commonly applied Fibonacci retracement levels in the ABCD pattern are 38.2% (0.382), 50.0% (0.50) and 61.8% (0.618).
Uptrends And Downtrends
From a practical standpoint, ABCD patterns occur during uptrends and downtrends. Here is a look at each type's constitution:
- Uptrend: Within the context of an uptrend, the ABCD pattern consists of an initial bullish leg (A to B), a retracement (B to C) and a second bullish leg (C to D).
- Downtrend: As it pertains to a downtrend, the ABCD is made up of an initial bearish leg (A to B), a retracement (B to C) and a second bearish leg (C to D).
Visually, the ABCD is routine to spot. The pattern's appearance is similar to a lightning bolt or sloped zig-zag . Although the formation's structure may be a bit convoluted on candlestick and OHLC charts, you can streamline the presentation by drawing simple trendlines connecting higher highs or lower lows.
Trading The ABCD
For all intents and purposes, the ABCD pattern may be used to trade trend and reversal strategies. Generally, reversals are the favoured methodology. However, many active traders choose to utilise the ABCD within the context of a trend-following gameplan.
In live market conditions, the ABCD chart pattern is a powerful indicator for spotting and trading market reversals. The formation is applicable to both uptrends and downtrends with the aim of capitalising on bullish or bearish reversals:
- Bearish: A bearish market reversal occurs at the top of a periodic uptrend. To execute a bearish reversal strategy with the ABCD pattern, the trader sells an asset following completion of the C-D leg. At this point, the market is trading at periodic highs as the C-D leg has eclipsed the initial bullish move of the A-B leg.
- Bullish: A bullish market reversal takes place at the bottom of a periodic downtrend. To execute a bullish reversal strategy using the ABCD pattern, the trader places a buy order at the completion of the C-D leg. At this point, the market is trading at periodic lows as the C-D leg has fallen well beneath the A-B leg.
When trading reversals with the ABCD, its standing as a harmonic indicator requires that guidelines for completion of retracements and legs be established. A common way of doing this is by using Fibonacci retracement levels to validate B-C pullbacks (38.2%, 50%, 61.8%), and Fibonacci extensions for determining C-D leg completion (127.2%, 161.8%).
In contrast to reversals, trend-following strategies use the ABCD to seek profits in concert with a directional move in price. This may be done via buying or selling pullbacks in a prevailing bullish or bearish trend.
- Bullish: To join an existing uptrend, the trader uses the ABCD pattern to identify a buying opportunity. Accordingly, buy orders are sent to market when the B-C retracement completes. In doing so, profits may be realised from the bullish price extension of the C-D leg.
- Bearish: To join an existing downtrend, the trader uses the ABCD pattern to identify a selling opportunity. Accordingly, sell orders are placed when the B-C retracement is deemed complete. Upon doing so, profits are realised from the bearish price extension of the C-D leg.
Once again, Fibonacci tools may be used to determine when the B-C retracement and C-D legs are complete.
Tips For Trading The ABCD
It's important to remember that the ABCD isn't infallible. Below are a few tips that may help improve the pattern's efficacy and promote long-run profitability:
Beware Of Market State
Periods of low trading volumes and consolidating ranges are not ideal for the ABCD. This pattern functions best in trending market conditions.
The ABCD works well on multiple time frames or in concert with other technical indicators. As mentioned earlier, Fibonacci retracements/extensions are common; others are single or multi-candlestick chart patterns, moving averages or momentum oscillators (stochastics, RSI). Through combining the ABCD with other facets of technical analysis, you may be able to confirm the validity of the formation.
Apply Prudent Risk Management
With the ABCD pattern, false buy/sell signals are possible. A prudent use of leverage is advised when trading ABCD trend-following or reversal strategies. Also, positive risk vs reward ratios may be applied by aligning stop losses and profit targets according to the periodic highs or lows included in the pattern.
The ABCD chart pattern is a readily discernible, user-friendly technical indicator. It may be applied in a variety of trading strategies facing any time frame and market. However, like all other technical tools, the ABCD is not infallible. For best active trading results, be aware of market state, seek confirmation and always practice sound risk management.
FXCM Research Team
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