From the May 01, 2010 issue of Futures Magazine • Subscribe!

Predicting price targets with the Rule of Seven

Fear and greed are always poised to derail an otherwise viable trading plan. You are most vulnerable to these dangerous emotions, however, when you’re already in a position and it comes time to exit. To combat their effect, technical traders employ an array of tools, most designed to determine some form of trading stop.

It’s useful in these situations to have an idea of how far a move will go. A price target helps abate fear and greed. If a trade is entered and the trader determines there is a 95% probability price will achieve a certain target, this will help the trader hang on and get out when necessary.

A robust heuristic tool for this process is the Rule of Seven. It has been uncannily accurate at predicting price targets and is extremely simple for any trader to calculate. The strategy gets its name from the method of calculation. It projects four price targets based upon the first leg of a price move. And, because it is robust, it works on one-minute bars and one-month bars equally well. The only decision a trader must make to apply the rule is determining which move to designate as the first leg. This decision will depend upon the trader’s time horizon.

“Leg up in copper” depicts opportunities in copper following its late 2008 low. The low price was $1.2550 per lb. on Dec. 8, 2008. Copper completed a minor first leg up to $1.6550 on Feb. 9, 2009 (the high of the sideways phase begun in early January). It completed a major first leg up on April 14, 2009, at $2.2340. For the Rule of Seven example, a position trader could have got long based on various trend indicators once the move started.

Let’s analyze both first legs, starting with the minor one. Because it is only a minor leg, we don’t expect much precision from the result, but we do expect at least two or three of the four possible targets to be achieved with 95% probability. The major leg will be more precise, but we will expect to see only the first target with 95% probability and the second with 90%.

The probability of a price failure short of the target increases with the third and fourth targets. Price surpassing a target by 3% activates the next target. Although the Rule of Seven is solely about price and not time, experience shows the first target usually is achieved in roughly the same time frame as the initial leg – that is, two time periods. The second target will be achieved within three time periods from the initial low. The third, if at all, will be achieved within five, and the final within eight from the first bottom. As you may have noticed, this is a Fibonacci series.

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