While I sit and do not much of anything, I'll attempt explaining some geometry, probabilities, and characteristics of market extensions and their counter parts.
First, let's identify the labeled areas. A. Is the launch of the extension, this is where the price of the underlying increases at a point where compensation can not keep up. B. Is the extension top, this changes each time a higher high is made in an upward extension, or a lower low in a downward extension. C. Is the counter-trend, or retracement target. There are two targets, or two stages of C. One is the deleveraging retracement, and the second is the compensatory retracement. D. is where we would extend to to make another demarkation of C (a higher high) if the C compensatory objective was not met (the extension did not fully compensate).
The AB segment rules the trade, everything that happens within the trade, or until compensation occurs, is dependent upon the maon extension (primary extension). The AB segment is somewhat dependent upon historical study, but not entirely. The historical max, average, and mean value of this percentage number can be a good gauge of basing your trade. You can always default to the general market numerical values when in question. Just calculate the loss at stop, and re-initialize the trade if you miscalculated. The AB segment has a few interesting characteristics. The smaller the percentage of extension, the greater the chance a deflection will occur from area C in the same direction as the primary extension. The larger the AB segment, the greater the probability a full reset, or compensation, will occur at area C. The market needs regulation, and this is the basis behind the rules followed. So, a quick conclusion, the smaller the percentage extension of the AB segment, the greater the probability a momentum play will work when area C1 (deleverage point) or area C2 (compensation point (or reset point)) is hit. The greater the percentage extension of the AB segment, the better the %ROI offered on a fade trade with averaging down concepts.
While I am at this point, let me mention something concerning averaging in a trade, and my number of tiers I use on posted trades. When averaging down a trade, the further the extension moves, the less impact your additions have to affecting your overall rolling average. You can compensate this effect by A. Increasing additions with smaller price movements of the underlying. B. Increase overall size of the addition (non-static lot sizes), or C. Use fewer tiers, stop out and re-initiate more frequently.
The third option has some very good merit. This is why... Let's look at the effect, or impact, on cost average using symetrical lot sizes. This example is entering at 50.00 covering a possible extension up to 60.00 using a constant lot size of 1. I am only listing the first six entries and calculated rolling averages:
Here are the entries:
50.00
51.30
52.43
53.41
54.27
55.02
Here are the calculated rolling cost averages:
50.00
50.65
51.24
51.79
52.28
52.74
You will see, in this example, the rolling cost average is impacted less as we accumulate more shares/contracts. The first addition has the most impact upon cost average. When adding one share at 51.30, we increased our cost average (which is a good thing, this is a short!) by 0.65. Adding another lot at 52.43 increase the ACB (average cost basis) by 0.59. This number increasingly gets smaller. Until, when you are very deep into a high tiered trade, it impacts your ACB very little. You have the option of stopping out, calculate the position size required to keep the deleverage point at break even, and use a tiered matrix with less numbers of tiers. This works fine, but, as I say.... there is ALWAYS a trade-off.
The trade-off, when using less tiers is there is less consistency to the calculated %ROI of utilized capital. The resulting gains of the trade become wider in their range of return. Let me attempt to explain. Averaging in frequently gives you a smoother curve to your ACB, resulting in a more consistent return percentage-wise throughout the duration of the trade. Using less entries makes the percentage gain a little more sporadic. An example would be as such: If you had a three tier set-up, and price of the underlying came up 0.01 short of the third entry trigger, your return would be much less than if that last cent where achieved before turning and heading to the reset price. More entries makes this increment smaller, thus having a more smoothing effect. Each tier has a worse and best exit point. If the trigger was hit and not exceeded by even 0.01, this is the best exit for that tier range. If you came up 0.01 short of the next tier entry, it is worse case exit for the current tier (which is still a positive return if you calculated correctly).
Ok, back to the extension geometry. The BC segment, or BC1/BC2 to break it down further, is the counter trend retracement depth. The point C is a compound target, first is the delevage, second the reset. The smaller the AB segment, the greater a continuation from C1, or a new extension beginning from C2 in the same direction of the last primary extension. C1, the deleverage point, allows the fade trader a point to re-calculate his/her trade matrix and adjust the position, for this is the "break-even" point, where the total P/L is a wash. C2, the reset point, is the point of exit, this is the profitable exit and will return your calculated ROI when the trade was initiated. C1, and C2, is a percentage related movement which corresponds with the AB segment. The market standard is the C1 level is about 23.6% and the C2 area is 38.2%. Different traders, depending on capital and agressiveness, may use values that are less than these percentages, but these are the deepest "guaranteed" areas of retracement. Bear in mind, you will find this rule is adhered to ONLY if you have calculated your launch point correctly. The launch is the key to the entire process!!!
The CD segment is actually a continuation of the AB segment if the extension has NOT reset, or starts a new AB segment if a new extension (a new launch) occurs. An extension, which remains within an issues frequent oscillation trade range is noise. It keeps resetting and no playable extension materializes. This "noise" area depicts that the issue is in a neutral state, and has no biases in any direction. Entering any type of trade within the confines of an issues neutral state is EXTREMELY dangerous. An issue can violently launch from a state of neutrality at any time and its lack of limitations at that point will crush many a trader. An issue may make hundreds, or thousands, of 3% extensions (just a number, each issue has its own value) and reset very quickly, not allowing us to exploit this movement. This is the threshold level which anything less is considered "noise".
