Catching big reversals is something that many new traders day-dream about but rarely ever succeed in doing. However, the 5-0 pattern offers traders the opportunity to catch these types of market moves by finding a unique entry point.
Ok so, looking at the bullish version of the pattern first then. We want to initially identify a bearish drop in price which we call the 0X leg; this is the leg that leads into the setup of the pattern. From here we then need to identify a retracement higher which is the XA leg and the start of the pattern. Price then drops down from here to put in a new low below the X0 low, giving us our AB leg.
For a clean, textbook 5-0 pattern, this low needs to be between the 1.13 - 1.618 extension of the XA leg. This gives us our AB leg. From this low, we then need to see price reverse and trade sharply higher moving back up above the XA leg high to put in a new high between the 1.618 and 2.224 extensions of the AB leg. This gives us our BC leg. From here we then need to see one final retracement lower which completes into the 50% retracement of the BC leg. This gives us our CD leg and should be equal in length to the AB leg. The completion of the CD leg gives us our buying zone.
Let's now take a look at the bearish version of the pattern which follows exactly the same structure and parameters as the bullish version but obviously this time in reverse.
So, first of all, we want to identify a bullish move in price which leads into the setup of the pattern and gives us our 0X leg. From here we then want to see price retrace lower to give us our XA leg. From this point price will then reverse and trade back up to put in a new high above the XA high, which needs to complete between the 1.13 and 1.618 of the XA leg, giving us our AB leg. From this point price then needs to retrace sharply lower to give us our BC leg, which should complete between the 1.618-2.24 extension of the AB leg.
From here the pattern should see one final retracement higher, completing into the 50% retracement of the BC leg. This final CD leg should be equal in length to the AB leg. The completion of the CD leg gives us our selling zone
Trading The Pattern
With that in mind, let's now take a look at how these patterns present themselves on the charts. I've mentioned this before, but one of the key challenges that many traders face with harmonic patterns is getting used to the different ways the patterns can present themselves in practice. Obviously, when we're looking at diagrams, we're looking at nice smooth lines whereas on the charts the patterns can sometimes be a bit harder to spot because of the way that price moves.
So let's look at some examples starting with a bearish 5 - 0.
In this example, you can see we have a classic bearish 5-0 pattern, and this example really demonstrates beautifully just how fantastic this pattern is for picking out reversals.
You can see that we have our bullish swing in price initially which gives us our X0 leg before we get small retracement lower to give us our XA leg. From here we then get another push higher where price makes a new high above the initial 0X high. This high completes ahead of the 1.618 extension of the X leg and gives us our AB leg.
From this point, we then get a sharp reversal lower with price breaking down below the XA leg low. This gives us our RB leg. From here you can see that we then get a reversal higher to gives us our CD leg. Importantly, note how this pattern completes into the 50% retracement of the BC leg but is also equal in length to AB leg.
Remember, if you want to check that two price swings are of equal lengths you can simply draw a line in to measure the first one and then clone it and apply it to the second price swing.
So, the completion of the CD leg into this area gives us our sell zone where we can look to set short orders. In terms of how we trade this pattern, we have two options. We can look to capture a short-term reaction, or alternatively, we can look to enter and hold for a larger move.
In terms of capturing a short-term reaction, we want to enter short at the 50% retracement of the BC leg with a stop above the 61.8% retracement. We then look to target a move back down into the 23.6% retracement. This gives us a roughly 2:1 return. The beauty of trading the pattern in this way is that generally the reaction will happen very quickly and we are able to achieve a positive risk:reward result in a fairly quick manner, and we don't risk running into a reversal when price hits the BC low, which is the key pivot for the pattern when we are holding for a larger move.
While trading the pattern for a larger move, we would again enter at the 50% retracement but this time place our stop above the 78.6% retracement of the BC leg. From here we are then looking to target a move from the CD high that is equal in length to the BC leg. So, to find our target we can simply draw a line in over the BC leg, clone it and apply it from the CD high point.
Doing this put our target in down here, just slightly below the 0X low and gives us a roughly 3:1 return to risk. Once price hits this target point, traders can then decide whether to bank their position or hold for a larger trending move. If traders decided to hold for longer, it is prudent to trail their stops lower to make sure they lock in some profits in case price reverses on them.
As you can see, the 5-0 pattern can be an exceptional structure for catching reversals and helps traders enter these moves in a safe and methodical way.