Trading Lessons
By Tom Aspray, Senior Editor, MoneyShow.com
Traders and investors in all markets can benefit from this timeless analysis technique, which is highly useful in determining entry and stop levels in multiple time frames and all market conditions.
One tool that many traders and a majority of investors do not include in their investment or trading decisions is Fibonacci analysis. Though some have not been exposed to this type of analysis, many others dismiss it when they find that it is based on the work of a 12th century mathematician or because they think it is too complex.
Both traders and investors have trouble finding good price levels to enter the market and determining where to place their stops. A mistake in either area can ruin the chances of a profitable outcome, and most fail because they do not have an objective way to determine either price level.
This is where the most basic level of Fibonacci analysis can be very helpful, whether you are investing in stocks or ETFs, or even daytrading the forex market.
Without diving too heavily into the math, Fibonacci analysis is based on a series of numbers developed by Italian mathematician Leonardo Fibonacci in the 12th century.
From a trading perspective, there are many basic and advanced ways that Fibonacci numbers can be beneficial to the trader. Suffice it to say that this series of numbers and the relationship of one number to another in the series have been found throughout nature. The most notable relationship can be found by dividing one Fibonacci number by the next one in the series, which will give you the "Golden Ratio" of 0.618.
There are two primary ways that I use Fibonacci analysis in my trading. One is to identify or confirm support or resistance levels, and the other is to help identify price targets. In this article, I will concentrate on identifying levels of support and resistance.
Often times, a trader will look at a market and realize that when they were not paying attention, a significant level of support or resistance was broken and the market has already moved significantly. Fibonacci analysis can be very helpful in this situation.
Figure 1
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The first example is NetFlix, Inc. (NFLX) from late 2008 and early 2009, however, similar Fibonacci relationships can be found in any liquid market. I have used it on commodities, stocks, mutual funds, and the forex market for many years and have found it to be quite valuable.
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Figure 1
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As you see above, NFLX was in a downtrend in 2008 and made a closing low of $17.94 in October. A month later, it made a higher low of $18.60 (line c). On December 8, NFLX surpassed the previous peaks (line b), suggesting that a bottom might be in place. Given the gloomy outlook for the economy and the plunging stock prices at the time, however, buying anything may have been tough.
A stronger signal was given at the end of December when the downtrend from the April highs, line a, was broken at point 1. NFLX opened the following day at $28.27. Traders who went long on the opening may have used a stop under the recent lows at $26.82, while investors could have used Fibonacci analysis to determine their stop.
The rally from the lowest low ($17.94) to the close on the day the downtrend was broken ($28.66) was a difference of $10.72 ($28.66-$17.94). The most common Fibonacci ratios are 0.382, 0.50 and 0.618, which allows us to calculate the key Fibonacci support levels.
- 38.2% Support: $28.66 - (0.382 x $10.72) = $24.56
- 50% Support: $28.66 - (0.50 x $10.72) = $23.30
- 61.8% Support: $28.66 - (0.618 x $10.72) = $22.03
As a result, those who went long on the trend line break could have used a stop either under the 38.2% support at $24.56, or under the 50% support at $23.30. Because of the trend line break, a stop under the 38.2% support would have been wide enough so that if the breakout was legitimate, any pullbacks should be shallow.
I always give the stop some room under the Fibonacci level because others are also watching these levels. As a rule of thumb, you could use 0.5% of the stock price under the support, which in this example would be $28.66 x .005 = $.14. Thus, a stop at $24.42 ($24.56 - $.14) would have been fine.
Of course, buyers would have had to be watching NFLX very closely to observe this breakout, which might be unrealistic. Three days later, NFLX closed at $31.94 as it had gained over 10% in just three days, which was more likely to get your attention.
The rally stalled in early January when NFLX traded sideways after testing the upper Starc band. This suggested a pullback was likely. The insert on the chart shows the rally from point 2 ($26.82) to point 3 ($33.15) and the ensuing decline more closely. The 38.2%, 50%, and 61.8% levels are each labeled on the chart. The 61.8% retracement (on a closing basis) (point 4) was at $29.44, which was exceeded intraday, but not on a closing basis, on both January 14 and 15.
Typically, I would look to buy just above the 50% support or possibly between the 50% and 61.8% support levels. This would have been between $30.15 and $29.44 in this case. An initial stop under the December swing lows at $26.82 would have been good, as this was also under the 38.2% retracement support calculated from the October lows.
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Figure 2
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The above chart shows the next year of trading in NFLX, as the pullback I noted previously occurred at point 2. NFLX rallied from the mid-January intraday low at $28.78 to reach a high of $38.83 in February (point 3).
The ten-day correction from this high held the 50% retracement support at point 4 before NFX once again turned higher. Investors could have raised their stop to just below the low at point 2 after NFLX peaked at point 3.
NFLX then accelerated to the upside, forming a double top just below the $50 level in April. By early May, the exponential moving average (EMA) had flattened out, suggesting that a deeper correction was possible.
This is when Fibonacci analysis can be very helpful in either determining a stop that would allow you to stay with a major trend, or in finding an entry level for new positions. If you take the rally from the lows at point 1 to the high at point 5, a stop under the 50% support level at $33.90 would have been appropriate.
NFLX slightly exceeded the 38.2% support on May 14 and then formed a series of higher lows. By late June, it was becoming more likely that the 38.2% support (point 6) would hold, and therefore, buying on pullbacks towards the 38.2% support level was warranted.
NFLX completed its flag formation (dashed lines), a classic continuation pattern, in September. The stock retested the breakout level on October 1 (point 7). This pullback held above the minor 50% support calculated from the early-September low to the late-September high.
NFLX made a convincing new closing high at $61.13 on November 18 (point 8) before starting a 20% correction that lasted until January 22, 2010. This correction held the 50% support (point 9) of the rally from the low at point 6 to the high at point 8. The 61.8% support was at $46.16 and a stop under this level would have been fine for either existing or new long positions established around the 50% support level.
Using Fibonacci Analysis in a Down Market
Figure 3
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The same type of Fibonacci analysis can also be very helpful in a declining market. Bank of America (BAC) rallied from a low in 2009 of $2.53 to a high of $19.86 in April 2010. If you were long BAC near the lows, the break of nine-month support (line a) at $14.46 in June 2010 may not have initially troubled you. However, BAC continued to drop and plunged more sharply in the fall of 2010, which must have made any longs quite uncomfortable. The eventual low of $10.91 was made on November 30.
At that point, anyone who had ridden out the decline was clearly looking for a level to get out of their long positions. Those who were comfortable buying puts or selling short would then be looking for a level to establish a short position in BAC.
Using the decline from the high at point 1 to the low at point 2, you get a difference of $8.95 ($19.86 - $10.91). To get the 50% retracement resistance level, you add $4.47 (50% of $8.95) to the low at $10.94 to get a target of $15.41. The rebound high on January 14, 2011 was $15.31.
This rally was a good opportunity to get out of any longs, and those who bought puts or sold short on the rally could have used a stop above the 61.8% resistance level at $16.47. As BAC dropped below the lows at $10.94, new Fibonacci resistance levels could be calculated from the high at $16.31. It had a low this week of $6.31.
Basic Fibonacci analysis can be used on any time frame and by any style of trader or investor. It is critical, however, to do your analysis on overlapping rallies or declines. I will often look at a daily chart to determine what I call the "minor" Fibonacci targets and then look at a weekly chart to determine the "major" Fibonacci levels to watch.
NEXT: Important Fibonacci Levels for Apple (AAPL)
Figure 4
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Let's now take a look at a weekly chart of Apple Inc. (AAPL) from the August low at $235.56 (point 1) to the high of $364.90 during the week of February 19 (point 2). The ensuing decline to the low at point 3 just slightly exceeded the 38.2% support at $316.30, though it held well above the 50% support at $300.
The correction took 18 weeks, and the fact that it held well above the 38.2% support for so long implied that a correction would be shallow. Those who did buy near the 38.2% support should have used a stop at least under the 50% support at $300.
AAPL hit a high of $404.50 at the end of July 2011 (point 4), therefore, the major 38.2% retracement support level, as calculated from the rally from point 1 to point 4, was at $340. The 50% support lies at $320 with the key 61.8% retracement support level now at $300.
Looking at the daily chart, we can examine more closely the rally from the June lows at $310.50 (point 3) to the recent highs (point 4). The minor 38.2%, 50%, and 61.8% support levels are identified on the chart. The low so far this week in AAPL is $353.02, which was just below the 50% retracement support at $357.20. The minor 61.8% support is now at $346.30.
By combining the major and minor levels, you can determine that an important level of support lies between $340 (major 38.2% support) and $346.33 (minor 61.8% support). The weekly uptrend is now at $324, so a stop under the major 50% retracement support at $320 could be used.
The minor 61.8% support may not be tested before AAPL turns higher, so I would be watching the $354- $347 area for new buying. A violation of the major 61.8% support at $300 would be a sign that the intermediate-term uptrend has been broken.
There are much more advanced ways that the Fibonacci number series can be applied to the financial markets, and I will discuss them in future articles. It is not necessary to have advanced software systems to do this type of Fibonacci analysis, as price history is available for free on many Web sites, and then you just need a calculator or spreadsheet program.
If you are not currently using Fibonacci analysis, I hope you will be encouraged to give it a try and determine for yourself whether it can be useful in your investing or trading.
Figure 5
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The best free online charting system that I have found that allows basic Fibonacci analysis is at FreeStockCharts.com, which is by Worden Brothers. The above chart of Freeport McMoran (FCX) is from the site and shows that FCX is just testing the 61.8% support as calculated from the July 2010 lows. Peter and Don Worden are both excellent technicians and have a wide array of more specialized analytical products as well.
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