Great Examples of Fibonacci Analysis-Part One
01/06/2009 11:17 am EST
What in the world is Fibonacci analysis? This is a technical tool available to new or experienced investors regardless of your trading time horizon or market of choice. Fibonacci analysis is a way to forecast levels of support and resistance and project price targets. It can be used to set stops as well as to time entries, however, the most valuable information is what it can tell us about risk. In this lesson, we will be introducing a few of the tactical concepts and tips you will need to know.
What Are the Ratios and How Are They Used?
I will spare you the long, historical (and mostly erroneous) explanation of where the Fibonacci ratios come from and how they appear in the natural world. If you are really interested, here is an article to learn more. In the forex essentials course, we introduced Fibonacci retracements and the Fibonacci number series. From that number series we get the Fibonacci ratios, which are applied to price charts. While there are many Fibonacci ratios, in our experience, it is sufficient to stick with the standard levels of 23.6%, 38.2%, 50%, 61.8%, 100% and 161.8%. Slicing these levels into thinner segments results in a crowded chart and probably won't improve your analysis.
Where Do the Lines Go?
The sticky part of fundamental and technical analysis is that they are both very subjective, which means that they allow for a great deal of interpretation and individual preference. However, with Fibonacci analysis that subjectivity is easy to handle, and I have a good example to show you why.
In the chart below, you can see a Fibonacci retracement drawn from the "top" of the market in June to the "bottom" of that trend in August, where prices started to move back up. Once prices started to move back against the trend in late August, we could anchor our Fibonacci retracement lines to that bottom. That analysis may seem a little subjective, but I can show that as long as you are picking extremes in the trend, it really won't matter. I have simplified the chart to just show the 23.6% retracement level.
In the next chart (below), you will see that this level continued to be fairly important with consolidations in September and late October, but then the market broke below the Fib retracement anchor in November and started to form another bottom later that month. Your analysis should probably change to account for the lower bottom in the market, but should we move the top anchor down to the top of the rally in October? What if we left it where it is?
In the next chart (below), you see that leaving the top of the retracement where it was and moving the bottom line down to the new low placed the 38.2% retracement level within the same range (about 4%) as the previous 23.6% level, which subsequently was a significant level for a risk of reversal in December.
And in chart number four below, you see that I did move the top anchor down to the top of the rally in October, which then placed the 61.8% retracement level within that same price range. This is not a coincidence; it's the way this analysis works and how price trends frequently move relative to Fibonacci ratios. Not all levels will be repeated like this as you move your retracement anchors, but experience has shown that critical levels will remain clear. The key factor that separates good Fibonacci analysts from bad ones is not where the anchors are, but what they do when prices are at those levels.
Bodies or Shadows?
There is always a minor debate about whether you should anchor your Fibonacci retracement to the body of a candle or the shadows. I prefer to use the shadows so that the study includes the extremes of market sentiment. Most of the time, the difference is insignificant, but sometimes it can be critical. In the examples above, you can see that I anchored the Fibonacci retracement to the shadows of the candles at the top and bottom of the trend.
Support and Resistance Lines or Areas?
We feel that support and resistance is more often an area around the Fibonacci lines than a specific to-the-pip point in the charts. You will find that prices move around a support or resistance line, especially during a consolidation. Discounting that level because of a temporary break may lead you to ignore a valid signal in the future. In the examples I will use in the course, I will show how to evaluate that support and resistance area and how to use it to be aware of risk as well as opportunities.