How to Trade the Fan Priciple - Intermediate Correction Pattern

Trying to understand whether or the market will resume the trend or reverse can be at times a difficult task, especially when the pullback or rally is deeper than expected. Many traders area caught in a dilemma not knowing if the market is only consolidating before advancing or if an actual reversal is taking place. For many, this confusion can create indecision to hold or exit. Then fan principle is a simple but effective tool to judge how the strong or weak the market and how likely it will continue or not.

Above is the typical scenario facing a trader; prices have advanced with good pace in an orderly manner. Then came the pullback, the prices stagnates and just not go up or go down. In this scenario, there are usually many bears and bulls confused about the direction of the market. Experienced traders will quickly point out that a range has been established. But they don't know truly whether or not the price will resume the trend or reverse. Many bears will exit seeing the prices are not going down immediately so they cover. As for the bulls, they will sell seeing that the pullback is taking longer than expected and will want to take their gains and move on.

In the fan principle, the market can be determined by the use of simple trendlines to view how healthy the trend still is.

The above shows the moving down hugging the first somewhat steep trendline (red trendline on the left). At this time, the pullback is considered a normal retracement. When prices break the first trendlines, the market is now moving to the next phase of the pullback: trying to move back up to retest the last high. But when there are many participants in the market, prices move sideways. With that, the second trendline was broken, giving a more healthy indication that the market is still trending. Many times, the trend is strong and will resume the direction of the trend after then second trendline is broken. Some happen on the third and last trendline. When it finally breaks the second or third trendline, this is the very positive sign that the trend is ready to resume back to the last high but still need confirmation by moving past the recent pivot high.

Where is the entry placed? When the break above the last pivot high is shown and the last pivot low is higher than the previous pivot low, that is the entry.

Note that the pullback has to be steep enough for the risk/reward ratio to be high enough to consider the entry because the first target is the last high before the pullback began. If not, then the trade may be best not taken, or another pattern must be drawn or used to trade accordingly.

If the trader pays close attention to the chart, the layout looks very similar to the bottom reversal pattern. It is in fact a similar experience but the only difference is that the trendlines are drawn from the last high and not from two bottoms drawn to make rising trendlines

This pattern applies mainly for intermediate trends and intraday pullbacks. Using this during bull and bear markets will keep the trader in line with the primary trend and not be distracted with false moves. This will help him make a better entry to get more from the trend. Recognizing this pattern will serve to avoid prematurely leaving the money on the table or worst, short when it is not the right time yet.