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Trade What
You See
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Trade What
You See
How to Prot from
Pattern Recognition
LARRY PESAVENTO
LESLIE JOUFLAS
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Copyright C 2007 by Larry Pesavento and Leslie Jouas. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey
Published simultaneously in Canada.
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Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in
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Library of Congress Cataloging-in-Publication Data:
Pesavento, Larry.
Trade what you see : how to prot from pattern recognition / Larry
Pesavento, Leslie Jouas.
p. cm. (Wiley trading series)
Includes index.
ISBN 978-0-470-10676-1 (cloth)
1. Speculation. 2. Stocks. 3. Investment analysis. 4. Fibonacci numbers.
I. Jouas, Leslie, 1957 II. Title.
HG6041.P382 2008
332.63 228dc22
2007034476
Printed in the United States of America
10 9 8 7 6 5 4 3 2 1
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To all traders, past and present, who have dedicated themselves to becoming
successful at making a living in the profession of trading.
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Contents
Preface xi
Acknowledgments xv
About the Authors xvii
PART I Introduction to Trading with Pattern Recognition
CHAPTER 1 Opening Thoughts 3
How to Use This Book 3
Succeeding or Failing in Trading 4
Steps to Take for Successful Trading 7
CHAPTER 2 Geometry of the Patterns and Fibonacci Ratios 9
History of Geometry in the Markets 11
Fibonacci Ratios 13
Applying the Fibonacci Ratios 15
Summary 18
CHAPTER 3 Harmonic Numbers and How to Use Them 19
Where the Term Harmonic Numbers Originated 19
Defining a Harmonic Number 20
Vibrations in Price Swings 22
Repetition in Price Swings 24
Finding Harmonic Numbers 28
Harmonic Numbers Found in Other Markets 34
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viii CONTENTS
PART II The Price Patterns and How to Trade Them
CHAPTER 4 The AB CD Pattern 37
History of the AB CD Pattern 37
AB CD Pattern Description 39
AB CD Pattern Structure 39
Important Characteristics of the AB CD Pattern 42
CD Leg Variations 43
Slope and Time Frames 46
Psychology of the AB CD Pattern 48
Trading the AB CD Pattern 49
CHAPTER 5 The Gartley 222 Pattern 53
History of the Gartley 222 Pattern 53
Gartley 222 Pattern Description 55
Gartley 222 Pattern Structure 56
Important Characteristics of the Gartley 222 Pattern 57
Psychology of the Gartley 222 Pattern 59
Trading the Gartley 222 Pattern 60
CHAPTER 6 The Buttery Pattern 67
History of the Butterfly Pattern 67
Butterfly Pattern Description 69
Butterfly Pattern Structure 70
Important Characteristics of the Butterfly Pattern 71
Psychology of the Butterfly Pattern 72
Trading the Butterfly Pattern 73
CHAPTER 7 The Three Drives Pattern 81
History of the Three Drives Pattern 81
Three Drives Pattern Description 82
Three Drives Pattern Structure 83
Important Characteristics of the Three Drives Pattern 84
Psychology of the Three Drives Pattern 84
Trading the Three Drives Pattern 85
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Contents ix
CHAPTER 8 Retracement Entries and Multiple Time Frames 91
Fibonacci Retracement Entries 92
Fibonacci Retracement Pattern Structure 92
Trading the Fibonacci Retracement Pattern 95
Opening Price Retracement Setups 98
Market Setup for the Opening Price Retracement Trade 99
Trading the Opening Price Retracement Setup 100
Multiple Time Frames 103
CHAPTER 9 Classical Technical Analysis Patterns 113
A Brief History of Technical Analysis 114
Basics of Technical Analysis 115
Double Bottom and Top Patterns 115
Head and Shoulders Pattern 120
Broadening Top and Bottom Patterns 126
CHAPTER 10 Learning to Recognize Trend Days 131
Identifying a Trend Day 132
Patterns Found on Trend Days 135
Fibonacci Ratios on Trend Days 138
Controlling Risk on a Trend Day 140
Trading a Trend Day 141
PART III Essential Elements of Trading
CHAPTER 11 Trade Management 149
Thinking in Probabilities 150
Warning Signs and Confirmation Signs 151
Money Management 155
CHAPTER 12 Using Options with the Fibonacci
Ratios and Patterns 161
Call and Put Options Defined 161
Factors That Influence the Price of an Option 162
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x CONTENTS
Controlling Risk with Options 163
Examples of Using Options with Extension Patterns 164
CHAPTER 13 Building a Trading Plan 167
Daily Trading Plan 168
Trading as a Business 174
Disaster Plans 177
Summary 181
CHAPTER 14 Daily Routines 183
Trade Preparation 183
Mental Preparation 187
Physical Preparation 188
Appendix 191
Index 195
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Preface
Trading is a journeynot a destination.
everal hundred years ago, technical analysis began its journey to help investors and
S traders determine, with reasonable probability, what direction prices might take.
Technical analysis allows investors and traders to identify moments of opportu-
nity to prot in the markets. It does so by identifying and quantifying specic patterns
that form and repeat with enough regularity that trading methods and strategies can be
developed and implemented with success.
Trade What You See: How to Prot from Pattern Recognition focuses on trading pat-
terns with an underlying root structure based on simple geometric forms and Fibonacci
ratios. The patterns are easily identiable once the trader has spent some time observing
and learning the basic structures. Each of these patterns can be quantied and a sound
money management strategy applied.
Writing a book about pattern recognition based on geometric patterns and Fibonacci
ratios requires acknowledging the early scholars of geometry, including Pythagoras,
Archimedes, and of course the great mathematician Leonardo di Pisa (better known as
Fibonacci). These great scholars had all traveled to Egypt during their lifetimes and had
studied the Great Pyramids. Pythagoras, the father of modern geometry, was obsessed
by the mathematics of the pyramids. The actual mass of the structure was not as impor-
tant to him as the fact that all of the angles on all sides were within .01 percent. Part of
the mystery of the Great Pyramids is how the mathematics relates to the golden ratio,
which is also referred to as the divine proportion, or .618.
It was not so many years ago that a book of this nature, based on technical analysis,
would not have been taken seriously by many. We begin with a look at a point in time
when technical analysis had begun to take root in the academic community.
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xii PREFACE
VALIDATION FROM THE SCIENTIFIC COMMUNITY
For years technical analysis was shunned by many Wall Street professionals, looked
upon as one step above tea leaf reading. A turning point occurred on April 17, 2000,
when a paper by Dr. Andrew W. Lo of the Massachusetts Institute of Technology (MIT)
was published in BusinessWeek. The title of the article was This Alchemy Will Yield
Pure Gold. The article substantiated and veried that indeed there is an edge in tech-
nical analysis after all. This, of course, did not surprise any market technician who had
successfully been using pattern recognition.
The article did, however, bring technical analysis from the age of alchemy into the
realm of academia. Princeton University Press published a book by Dr. Lo and A. Craig
MacKinlay, A Non-Random Walk Down Wall Street, which analyzed why patterns work
and how they repeat. This could be one of the reasons that the nancial public is now
exposed to so many chart patterns in the nancial press and on television.
Long before Lo and MacKinlays book was published, there were many great techni-
cal analysts to whom today we owe a debt of gratitude. Some of these technical analysts
who have contributed groundbreaking work are H.M. Gartley, William Garrett, Edwards
and McGhee, Frank Tubbs, R.W. Schabacker, William Dunnigan, Ralph Elliott, John
Murphy, Linda Raschke, John Hill, Bryce Gilmore, Charles Lindsay, and Richard
Wyckoff. We regret if we unintentionally omitted any famous names.
What this book teaches is a simple, pragmatic approach to pattern recognition. Its
designed to be hands-on and to appeal to new students of technical analysis as well as
seasoned traders.
The motto that we trade by is Trade what you see, not what you believe. A true
technician is interested only in price bars and the summation of these price barsthe
only truth in trading. Traders must learn to believe in what the market is telling them
based on price. This is best accomplished by studying price behavior through pattern
recognition.
OVERVIEW OF THE BOOK
This book was written to give the reader a comprehensive view of the specic patterns
presented. We use a variety of stocks and markets in the chart examples throughout
the book to illustrate that these particular patterns do form in all markets, and in all
time frames. We present patterns derived from some of the classic technical analysis
patterns as well as the geometry and Fibonacci-based patterns. Here is an overview of
each chapter:
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Preface xiii
Chapter 1: Opening ThoughtsWe give the reader some of our observations on what
is needed to successfully use the information in this book. We also offer our insights
after dealing with hundreds of traders on what can make a successful trader and also
what leads to failure.
Chapter 2: Geometry of the Markets and Fibonacci RatiosThis chapter covers
the simple geometry of the markets and how the x-axis and y-axis provide just an-
other way of illustrating triangles. We also cover the history of Fibonacci ratios and
present the ones we apply to our trading.
Chapter 3: Harmonic Numbers and How to Use ThemThis chapter shows that all
nancial markets have what we refer to as harmonic and repetitive swings that are
inherent in each particular market. This chapter begins to outline the basic structure
of each pattern.
Chapter 4: The AB=CD PatternThe AB=CD pattern is one of the simplest to identify
in any market, on any time frame, and is the basis of several other patterns presented.
Chapter 5: The Gartley 222 PatternDerived from Gartleys work in the 1930s,
this pattern is a classic retracement pattern.
Chapter 6: The Buttery PatternThe Buttery pattern is seen at extreme turning
points in tops and bottoms; it is ideal for options trades and allows low-risk entries.
Chapter 7: Three Drives PatternThis pattern can signal either a major turning point
or a more complex correction in a trend. It is very easy to see on a price chart when
it forms.
Chapter 8: Retracement Entries and Multiple Time FramesWe cover simple re-
tracement patterns with Fibonacci ratios that we use to enter in the direction of a
trend. We also look at how to combine multiple time frames.
Chapter 9: Classical Technical Analysis PatternsPatterns such as Head and Shoul-
ders, Double Tops and Bottoms, and Broadening Tops and Bottoms are discussed
using Fibonacci ratios.
Chapter 10: Learning to Recognize Trend DaysThis chapter could pay for the
book many times over. It teaches traders how to identify trending conditions and
offers techniques for entering in the direction of the trend. We also show how to use
Fibonacci ratios as support and resistance in trends. We emphasize the importance
of staying out of countertrend trades when a strong trend is in progress.
Chapter 11: Trade ManagementThe secret to trade management is in understand-
ing that risk is the most important element in trading. We look at position sizes
and methods for determining total risk. This chapter covers which warning signs
we use and the conrmation signals for trade entry or for passing on a trade
altogether.
Chapter 12: Using Options with the Fibonacci Ratios and PatternsOptions are
available on nearly every liquid trading vehicle. Pattern recognition, because it is a
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xiv PREFACE
leading indicator, is applicable to options. We present some basic option strategies
that minimize risk and allow for substantial prots.
Chapter 13: Building a Trading PlanOnce readers have studied the patterns, they
can then move on to a trading plan. This chapter gives a solid foundation to build a
plan that can be expanded upon as the trader gains experience. Over half a century
of trading experience was used to describe the formulation of a trading plan.
Chapter 14: Daily RoutinesRoutines and rituals are a necessary part of the trading
profession. The difference between successful traders and unsuccessful traders is in
the thought process and the preparation. The successful trader does the same things
every day to prepare for trading. This chapter gives suggestions for daily routines.
The appendix includes our lists of recommended books, magazines, and web site
resources.
As a trader using pattern recognition, it is your job to learn these repetitive patterns
and discover the underlying price ratios that lead to a predictive nature. We hope that
you nd this book a valuable guide and reference as you progress. We wish you a long
and prosperous trading journey.
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Acknowledgments
e would like to thank Robin Farina and Rich Crane for their patience, time, and
W outstanding help with this book. We also would like to thank our friends John
Arrington and Howard Arrington at Ensign Software; all the chart examples in
this book were generated from their software, which is user friendly to our methodology.
Wed like to thank Shelli Simon for her efforts and time. Thanks to John Hill from Futures
Truth for his willingness to share some of the information obtained and some of the rare
books mentioned. Thank you to Mark Douglas and Linda Raschke for their reviews and
comments. Thanks to Jon and Liz Maresca for their support in everything.
Special thanks to Gary Porter, who patiently read each word and chapter as
though he were a student of this methodology. His comments and insights are greatly
appreciated.
A grateful thank-you to all those at John Wiley & Sons, Inc., who gave us the oppor-
tunity to write this book. Thank you, Emilie Herman, for all of your timeit is greatly
appreciated.
It would be impossible to list all the great masters who have since passed on to that
big trading room, but some of the more important ones to us do have their names men-
tioned in the book, as well as the ones still with us. The contributions of those mentioned
in this book cannot be underestimated in the development of technical analysis of spec-
ulative markets.
SPECIAL THANKS AND ACKNOWLEDGMENT
I would like to give special thanks and gratitude to Larry Pesavento. You introduced me
to seeing the fascinating, harmonic world of Fibonacci ratios in the markets. Thank you
for inspiring me and helping me develop my enthusiasm into a solid trading methodology.
Thank you for starting me on that journey.
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xvi ACKNOWLEDGMENTS
I am especially thankful to my familymy Mom and Dad, my brothers Marty and
Toddfor their support throughout my trading career. I am especially grateful to Gary,
my husband, for his never-ending support.
Leslie Jouas
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About the Authors
arry Pesavento is registered with the Commodity Futures Trading Commission,
L National Futures Association, and Securities and Exchange Commission, and is
a former member of the Chicago Mercantile Exchange (19811983). He has a BS
in Pharmaceutical Chemistry (Indiana State University, 1963) and an MBA in Finance
from Indiana State University (1970). Books he has written on the subject of trading
include: Astro-cycles: The Traders Viewpoint (Traders Press, 1987); Planetary Har-
monics for Speculative Markets (Traders Press, 1990); Harmonic Vibrations: A Meta-
morphosis from Traditional Cycle Theory to Astro-Harmonics (Traders Press, 1990);
Fibonacci Ratios with Pattern Recognition (Traders Press, 1997); Protable Patterns
for Stock Trading (Traders Press, 1999); The Opening Price Principle, with Peggy
MacKay (Traders Press, 2000); Private Thoughts from a Traders Diary, with Peggy
MacKay (Traders Press, 2002); Essentials of Trading: Its Not WHAT You Think, Its
HOW You Think, with Leslie Jouas (Traders Press, 2006). Larry can be contacted at
larry@tradingtutor.com.
Leslie Jouas began trading in 1996 and left a 17-year airline career in 2000 to pur-
sue a full-time trading career. She has studied many trading methodologies, including
Elliott Wave, options strategies, momentum trading, classical technical analysis, and
Fibonacci ratios and patterns. After trading stocks and options on stocks, she now trades
futures and commodities with an emphasis on the S&P 500 market. She manages private
accounts as well as trading her own private account. Leslie has written several articles
for such publications as Traders Journal, Active Trader, and Technical Analysis of
Stocks & Commodities. She co-authored Essentials of Trading: Its Not WHAT You
Think, Its HOW You Think (Traders Press, 2006). Leslie teaches workshops and is avail-
able for speaking engagements. She also coaches and tutors students in pattern recogni-
tion trading with an emphasis on improving and rening execution skills. Leslie can be
contacted at ljouas@msn.com or at www.tradingliveonline.com.
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