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Wednesday, January 23, 2008

Fibonacci Retracements

The Fibonacci (pronounced fib-eh-nah´-chee) sequence of numbers was introduced to Europe by Leonardo Fibonacci da Pisa, a thirteenth century mathematician. In the early 1200s,

Leonardo Fibonacci of Pisa, Italy published his famous Liber Abacci (Book of Calculation) which introduced Europe to the decimal system, including zero as the first digit of the number scale. This system, which included the familiar symbols 0, 1, 2, 3, 4, 5, 6, 7, 8 and 9, became known as the Hindu-Arabic system, which is now universal numeric standard used today.

This new numeric system gradually replaced the Roman numeric system used in Europe at the time. The sequence was discovered answering the seemingly unimportant question of how many pairs of rabbits placed in an enclosed area will be produced in a single year from one pair of rabbits?

We are not going to examine the rabbit family tree to discover how 144 pairs of rabbits were produced in a year, but rather examine how this discovery affects us as traders. In this work, (Liber Abacci) he developed the Fibonacci number sequence, which is historically the earliest recursive series known to date.

The sequence is simple (1+1=2) (1+2=3)(2+3=5) (3+5=8) (5+8=13) 21,34,55,89,144,233 and so on to infinity. After the eighth sequence of calculations there are constant ratio's that can be derived from the series.

These ratio's are apparent in thousands of examples in our universe, from the building of the great pyramids of Egypt, to the human form, and nature. Many traders believe that this natural rhythm of the universe is also responsible for the rhythm of the financial markets and use them to predict turning points and profit targets for trading.

Whether or not you subscribe to these theories, Fibonacci retracement(pullback) is probably the most popular trading method used today in all financial markets by large institutional traders and small day traders alike.

The sheer numbers of traders using this method could well be the cause of this method being so successful.

The key Fibonacci ratio’s of 61.8% or 1.618 are often referred to as "the Golden Ratio" or "the Golden Mean.”

Retracement Levels
The important numbers to remember from the above calculations are .382 or 38.2 % , .618 or 61.8% , .786 or 78.6 %, these we call Fibonacci retracement levels.

Extension Levels
The 1.27 or 127% 1.618 or 161.8% and 2.618 or 261.8% levels we refer to as the Fibonacci extention levels or take profit levels. Other numbers to remember are .50 or 50% and 23.6 or 23.6% and the 1.382 or 138.2% levels

In the financial markets we use these ratios to calculate a percentage of a move in the market. So if the market moves 100 points then the .786 will be 78.6% of the move from bottom to top. 127% will be 127% of the total move.

Support & Resistance
These Fibonacci levels create hidden support and resistance levels, that do not necessarily conform to normal highs and lows in the market, however when there is a confluence of traditional support and resistance, a trend line or pivot level at a fib level then this level is considered to be more impenetrable and likely to cause a reversal.

These Fib levels can be used as entry and exit points as well as profit targets and stop loss levels.

Fibonacci ratios are used by millions of traders around the world every day to trade the market. To keep it simple we will use A, B, C, D as our symbols to plot the various price swings, retracement’s (pull back)and extensions.(profit targets) A - B is the total value of the price swing. B -C is the retracement (high, low) and entry point for the trade. C - D will be the trading range with D our ultimate profit target on the trade.

Click to enlarge
If we examine today's Gbp/Usd 15 min chart the recent price swing (high to low) from point A (1.9645) to point B (1.9547) (gold shaded area) price then retraced to C (orange shaded area)1.9607 at the .618 or 61.8% retracement level.

We notice that price stalled at the .618 level. Even though there is no traditional support or resistance at the 61.8% level the Fib level warns that this could be a turning point in the market. If price fails to penetrate this level and continue up towards the high of our price swing then we can anticipate a reversal at the .618 area.

Should we decide to short the market at this point we can target the 1.618 fib extension at 1.9485 as our target for the trade with our stop loss above the swing high above point A.
Click to enlarge

This next chart is a continuation of the 1st one. As we can see price dropped to the 23.6 Fib retracement level before testing the 61.8% level again. Failure to breach the 61.8% level was the signal to short the market. Price fell steadily to the 1.27% level. The 1.27% level is a normal stalling area with the Fib Fibonacci retracement trading strategy. (lavender coloured area)

Price returned to just above the 100% area before rallying further to the 1.382% Fib ext level where it once again stalled before rallying once more to our 1.618 target at 1.9485.
Click to enlarge

This next chart shows yesterdays market move on the Gbp/Usd where we can again see the A to B Price swing.(light colour) In this instance price only retraced to the 23.6% Fib level (blue) before rallying to the 1.27% extension level. (orange) At the 1.27% level it stalled and retraced back to the 23.6% retracement level from where it once again rallied all the way to the 1.618 Fib extension target level.

The major difference between the two trades was the entry points. The 1st chart shows a .618 entry with a small stop above the swing high. The second shows a .236 entry with a much larger stop required below the swing low. As the .236 is the level that generally offers the least support or resistance for a reversal we would generally wait for a break above the 100% line before entering the trade to confirm the market direction. On the long trade I would have placed the stop loss below the .382 or .50 retracement support level to limit the risk.

Once price has hit our 1.618 target and started to retrace then then we start a new ABCD sequence where our previous point C becomes our new point A and D becomes our new point B for our high Low price swing.

We can clearly see that by using Fibs we have an entry point, a stop loss point, and a profit target. A to B was the price swing, B to C was the retracement, C to D the rally. The 1.27, 1.618, 2.618 points we call Fibonacci extensions which became our profit targets.

We have now discovered that this natural rhythm of the universe can be applied to the financial markets. We also know that the market moves continually in three different ways but they also move at different speeds. Let’s look at how the speed affects our fib levels.

In an uptrend the market should bounce at one of these levels .236 or 23.6%.382 or 38% .50 or 50 % .618 or 62% .786 or 78.6 %. Remember these are our hidden support and resistance levels.

Market Speeds
The Market moves at varying speeds. .382 Fast and aggressive then slowing till the .786 level where it is at its slowest. Remember the .786 is the last level of support or resistance. If the market breaks above the 88% level the chances are it will continue in that direction and reverse the current trend. The .786 retracement level is also the reversal point that requires the smallest stop.

The market generally stalls at the 127 % and 138.2 before continuing the rally to the 1.618 extension. Simply put the bigger the retracement i.e. .618 or .786 the slower the next move is likely to be and the less likelihood of hitting the 1.1618 profit target. However when using the smaller time frame like the 15 min charts above, most days the price will rally to at least the 1.618 target level and often to the 2.618 target.

The smaller the retracement i.e. the .236 or .382 levels the faster the next move should be and the more likely we are to hit our 1.618 profit target.

In an uptrend, we look for a long trade when a retracement move reverses at a Fibonacci support level. Most modern trading software now has Fibonacci as a standard tool on their charting package making it easier to plot the Fib levels.

In a down Trend we look for a short trade when a retracement move reverses at a Fibonacci resistance level.

If we look carefully at at the above charts we will see that the market seems to find temporary support or resistance at each of the Fibonacci Retracements Levels. Because of this it is sometimes difficult to determine at which level price will stop.

It is at this point that some other indicator might assist with the entry. The .236 seems to offer the least support or resistance. The .382 and .618 levels seem to be the most important retracement levels.

It is not cast in stone that the market will stop at one of these levels, sometimes it goes through our support or resistance levels and reverses direction of the previous swing.

Entry Levels
Fibonacci retracements can also be very subjective when having to decide which swing (high or low) to use. There is no right or wrong answer as each trader will see the charts from their own unique perspective. My view is to concentrate on the current swing for my preferred time frame and if the market exceeds those levels or does not react at those levels then I will try to find the correct swing on a higher time frame or a larger price swing. It is only with practice and back testing that you will start to identify the correct placement.

Stop Losses
Purist Fib traders will suggest the rule is to place stop losses above or below the A - B price swings. More often than not though this will entail a higher risk than your money management plan allows for as was evident in yesterdays trade. My theory is that if each of these levels represent support or resistance then I rather use the fib retracement Support or Resistance level closest to my required risk to place my stop loss.

Lets assume the price swing is 100 Pips from top to bottom and my money management only allows me to risk a 40 pip loss. If I am entering a short trade at a .382 or 38.2% retracement level then the required stop will be 61 pips to the swing high. This is 21 pips more than I am prepared to risk so I would place my stop at the 78.6 retracement which will give me 40 pips stop. Again this is something each trader has to work out for himself.

Fibonacci retracements also offer 2 other trading tools namely, the Fibonacci Arcs and Fibonacci Fan's. Lets look at the same trade on the above charts using Fib Fans and Arcs.

On the above chart I have added a Fibonacci Fan to today's down move and we can see that the 1.618 target for todays trade coincides with the .382 retracement on a Fib Fan.

On this chart we have taken a Fib Fan from yesterdays low to this mornings high, a much larger price swing. We can see that the profit target at 1.618 today coincided with the .786 retracement of yesterdays up move on a Fib Fan . So whether we are trading long or short time frames the Fibs always seem to fit the bigger picture.

On the above chart I have used a Fibonacci Arc from yesterdays low to this mornings high. Again our 1.618 profit target of today was equivalent to a .618 retracement of yesterdays up move when measured on an arc.

There are many trading systems used in the market today based on Fibonacci ratios including Elliot Waves, Gartleys, Fib clusters, Fib channels and probbably systems I have not even heard of. To do the system justice would require writing a number of books. The retracements and extensions discussed in this article are the basics of Fib trading. The only way to master this amazing trading method is to practice and back test.

As we can see from these two trades, we can have Fibs within Fibs, yesterdays swing from low to high formed a larger fib and todays entire down move was only a retracement of yesterdays up move. Fibs work well on all time frames and can suit traders at every level of trading.

As with any indicator Fibonacci levels can be more effective when used in conjunction with another indicator as confirmation.

  • The important Fibonacci retracement levels are 0.236, 0.382, 0.500, 0.618, 0.786

  • The important Fibonacci extension levels are 1.27, 1.382, 1.618 and 2.618.

  • Since so many traders use the Fibonacci retracement levels as key support and resistance areas to buy and sell, orders placed to enter trades, place stops or take profits, make it more likely that the market will react at these levels.

  • In order to apply Fibonacci levels we need to identify the Swing High and Swing Low points on our charts.

  • Fibonacci retracements can be used on all time frames.

  • Our point C retracement level is our reversal point and entry point for a trade

1 comment:

TheWoodsmensPost said...

This are my favorite indicator.Its what jump starts my trading.Once I get all my ducks in a row, boom I pull the trigger.Subscribing to your feed, Thanks for jump starting me again. Woody