Anyone who has traded forex knows the highs and lows that this market can generate in a short period of time. I was first exposed to the forex markets in the mid-1980's, before the famed Plaza Accord in September 1985. Back in those days, all of the cash trading was done through banks, so many individuals traded futures. I, however, favored the cash markets because of cross rates like the GBP/JPY, which were tough to trade in the futures. This cross between the British pound and the Japanese yen is one of the more volatile cross rates as a 1% move in 20-30 minutes is not unusual. For those of you who have traded the GBP/JPY, I am sure you know both the elation of seeing quick 1%-2% gains as well as the pain of having those profits evaporate just as quickly. Therefore, trying to refine both entry and exit points using Fibonacci analysis has always been appealing, because when I have ignored these numbers, I have often regretted it! 

In part two of this series (click here for part one), I would like to further demonstrate how Fibonacci analysis can help traders improve their entries and exits in this cross rate as well as in others. First of all, many of you may be familiar with some of the basic Fibonacci relationships, but not some of the more esoteric relationships, so we'll begin with a brief refresher.

Most of you know that the Fibonacci numbers start with 1, and then adding 1 to 1 gives us 2, then you add the prior number to the current number (1 + 2) to get 3,  (2+ 3) then to get 5, and so on. In the financial markets, the golden mean is especially important, and it is obtained by dividing one Fibonacci number by the previous number, say, 55 divided by 24 = 1.618. Just as important is the reciprocal of 1.618, which is .618. There are some other relationships that many have found to be important in the financial markets and will be used in our discussion as well. They are:

  .382 = .618 squared
  .500 = 1 ? 2, the second and third numbers in the series
  .786 = square root of .618
1.000 = 1.618 x .618
1.272 = square root of 1.618
2.618 = 1.618 squared

Figure 1 - Click to Enlarge

This hourly chart covers the period from early January through early February 2009. The cross had hit a low of 13000 on December 30th and reached a high of 14140 on January 7  (point a). The cross then reversed from these highs and dropped to the 13700 area, where it consolidated for two days before accelerating to the downside. By January 13, the cross bottomed at 12880 as the late-2008 lows were broken. After just two days of basing action, the cross started to rebound. In light of the prior decline, this was a rally that appeared to be a selling opportunity. The 50% retracement of the decline from point a to point b came in at 13520, with the 61.8% resistance at 13670. The rebound was very sharp as the cross quickly reached 13570 (point c) and then, after a sharp setback, made marginal new highs at 13586 (point d), which was 84 ticks below the 61.8% resistance.

The violation of the low between point c and point d at 132 confirmed that the decline had indeed resumed. Using the decline from point a to point b, you can project down from the high at point d (these targets are in blue) to find the 61.8% target at 12795 and the 100% at 12390. Alternative downside targets can be determined using the distance from point b to point d and then calculating the 127.2% and 161.8% retracement levels, giving you 12660 and 12420, respectively. When combining the two methods, you get downside targets ranging from 12790 to 12390. Personally, if I am fortunate enough to be in such a trade, I take one-third to one-half off at the 127.2% retracement level and try to stay with the remainder. Looking at the hourly chart, the lower highs are obvious, but if you were watching a five-minute chart, the wide swings would likely have made you close out your short position well above the eventual low at 11933 (point e).

NEXT: Analysis Continues Using 15-Minute GBP/JPY Chart