Pinpointing Key Turning Points in ETFs
01/28/2014 6:00 am EST
With ETFs available for almost every financial niche imaginable, more and more traders are looking to technical analysis tools to help them trade the ETF universe, writes Cory Mitchell of ETFdb.com and VantagePointTrading.com.
The Fibonacci extension tool is available on most trading platforms and can help ETF traders establish profit targets and isolate potential price reversal areas. Like any indicator, it shouldn’t be used in isolation, but is a valuable tool for providing an overall context of where an ETF may be going.
Fibonacci Extension Tool
There is often a mathematical relationship between one price wave and the waves that follow it. This relationship is based on the ”golden ratio” and related Fibonacci numbers that are found throughout the natural world including galaxy formations, plant growth, and even man-made financial markets. The Fibonacci extension indicator plots the most common mathematical relationships, producing a predictive technical indicator.
The Fibonacci extension tool is drawn over one wave of price to provide estimates on where the next price wave will go. The most watched Fibonacci extension levels are: 61.8%, 100%, 138.2%, 161.8%, 200%, 238.2%, 261.8%.
The tool utilizes three price points. In an uptrend, the first point is placed at the former swing low, the second point at the recent swing high, and the third point goes at the most recent swing low. The recent swing low may need to be adjusted several times in real-time until the price begins to move higher and the low is established.
The tool then plots the levels based on the prices used. Notice how the SPDR S&P 500 (SPY) comes very close to the 61.8% level in Figure 1 and then begins a pullback. In this case, a profit target could have been placed at 61.8% to avoid holding through another pullback.
By default, most trading platforms show additional Fibonacci extension levels, such as 78.6% and 178.6%. You may opt to keep these levels, as the price will occasionally stall at these levels as well, but the chart will become cluttered. Add Fibonacci levels, or delete less important Fibonacci levels, by entering the tools properties, making the adjustments and then saving the changes made.
Interpreting Fibonacci Extensions
Typically, the price of an ETF will move to one of the extension levels, and then experience a consolidation or pullback. A pullback doesn’t indicate an overall trend reversal, just that a short-term consolidation or move against the trend is occurring. Only price and trend analysis can determine if the trend is reversing, as explained here: How to Take Profits and Cut Losses.
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The Fibonacci area where the price stops will depend on the strength of the trend. During a weak uptrend the price will barely make it past the former high, so the price is likely to stop near the 61.8% or 100% level. If the trend is very strong and surging past the former high, it’s more likely to run to the 161.8% or even 200% level.
Once a reversal occurs, another Fibonacci extension tool can be drawn to project the next price wave. Figure 2 is the same chart as Figure 1, except a Fibonacci tool has been applied to the wave prior as well.
Notice how the first wave drawn respects the 100% level, and the latter wave higher respects its own 61.8% level, and the 100% level of the former wave. When two Fibonacci levels from different waves are very close to each other, this is called a cluster, and is likely to be an important area [see 5 Most Important Chart Patterns For ETF Traders].
Figure 3 shows the Fibonacci Extension tool applied to a downtrend in the ProShares Short Russell 2000 (RWM). The price consolidates or pulls back when it reaches a Fibonacci cluster – price areas where two or more Fibonacci extension levels occur.
If the chart becomes too cluttered, delete older Fibonacci extension levels that occurred more than two waves ago.
Ideally, Fibonacci extensions are used to trade with the trend, with the levels used as potential exit points or to indicate where a consolidation or pullback is likely to occur. Avoid trading against the trend, assuming these levels will stop the trend. For example, during a downtrend—such as in Figure 3—going long at one of the Fibonacci levels expecting a move higher is a low probability trade. There is no assurance price will stop at a Fibonacci level and reverse; the price could also very well continue to run through one level toward the next.
The Bottom Line
Fibonacci extensions can be applied to any timeframe, from monthly charts down to one-minute charts. Apply the tool to price waves in order to project where future price waves could go and recognize that clusters of Fibonacci levels indicate a price area that is especially significant. Most importantly, investors need to remember that there is no assurance that the price will make it to a target level or that the price will stop there. Therefore, it would be most prudent not to rely on the Fibonacci extensions in isolation, but rather as part of a complete trading plan.