The Power of Fibonacci Overlaps

02/25/2014 6:00 am EST

Focus: STRATEGIES

The plotting of Fibonacci retracements is one of the most commonly used methods in technical analysis trading, says Richard Cox of TradersLaboratory.

In most cases, traders will use Fibonacci levels in conjunction with moving averages or indicators that give overbought/oversold readings since a retracement essentially marks a "pause" or correction within a broader trend. These types of readings can give traders a strong signal that the correction has run its course and that markets are now ready to begin resuming the broader trend. This tends to be an effective way to base trading positions but it should be remembered that there are other ways of using Fibonacci levels, as well. Fibonacci retracements can be placed in more than one location (tracking more than one price move). In instances where these multiple plots show agreement, you can gain access to support and resistance levels that are made more valid (from the additional confirmation), and this can lead to higher probability trades.

Brief Overview
Derived from numbers in the Fibonacci sequence, Fibonacci retracements refer to support (in an uptrend) and resistance levels (in a downtrend) that are based on percentage corrections of the broader trend. Commonly watched retracement levels include: 23.6%, 38.2%, 50%, 61.8% and 100%. Retracement activity is important because prices can never rise or fall indefinitely, and Fibonacci levels allow traders to spot areas where those corrective moves might stall and reverse. Below, we have examples of the general structure for how Fibonacci retracement activity might unfold:

Bull Trend Fibonacci Retracement

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Bear Trend Fibonacci Retracement

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Improving Probabilities
But one concept that many technical traders fail to grasp is that these retracements do not need to be plotted in isolation. Furthermore, viewing these moves singularly can even be called a mistake, given the fact that the plotting a price move is highly subjective. That is to say, two traders might look at the same chart and see two completely different price moves as being most important. This, of course, would lead to different price levels (for support or resistance), and then these traders would be entering into positions at two different values. Which trader is right? Which trade has the highest probability of generating gains?

The answers to these questions is, of course, difficult to quantify. But the answer can be found with the trader that is able to capture the best sense of what the rest of the market is watching. Let's say hypothetically that Trader A is plotting a retracement using a move in the EUR/USD from 1.3250 to 1.3375, while Trader B is plotting a retracement using a move from 1.32 to 1.3375. If a larger section of the market is using 1.32 as a starting point, then Trader B is more likely to complete a successful trade.

Fibonacci Overlaps: Plotted Examples
But what about using multiple price moves? This is best done when using more than one time frame, and a common approach is to combine hourly and daily charts for short-term strategies or daily and weekly charts for those that prefer to enter into longer-term positions. Below, we can see a bullish and bearish example of this type of occurrence:

Gold Chart with Multiple Fibonacci Overlays

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The bullish example above shows two plotted moves on gold (GLD). The short-term move is drawn from around 700 to 1900. The longer-term move is drawn from below 300 but the same peak is used at 1900. This is often the case when two separate moves are plotted, as it is often easy to find a major top or bottom that is clearly defined. But this does not have to be the case, you could use completely different tops and bottoms in your analysis, as well.

NEXT PAGE: Capitalize on Multiple Sections of the Market

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In the chart above, we next consider the most important question: Do we have enough evidence to establish a trade in the direction of the bullish trend? In order to establish a long position, we need a solid level of support and at least one indicator reading that suggests the potential for more upside. A 50% retracement means that prices have risen or fallen in an amount equal to have of the originally plotted price move. For the short-term charted move, this would mean that prices will drop back into the 1300 region. Does this 1300 level have a corresponding area in the longer-term move as well (the move from below 300 to 1900)? In the Fibonacci measurements shown above, we can see that 1300 is also the 38.2% Fib retracement of the longer-term move.

This suggests that the 1300 area is a dual support level, and is likely to contain prices from falling further to the downside. In addition to this, we have an indicator reading that suggests oversold prices. Since we are seeing agreement in multiple areas, we can come to the conclusion that high-probability long positions can be taken near the 1300 level, with stops just below.

Copper Chart with Multiple Fibonacci Overlays

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Next, we look at a bearish example of the Fibonacci overlap on the copper (JJC) chart above. In order to establish a short position, we need a solid level of resistance and at least one indicator reading that suggests the potential for more downside. In this example, we again have two plotted price moves that are used to make our Fibonacci calculations. The longer-term move begins near 4.00 and extends downward to 3.00. The short-term move begins at 3.8 and then extends back down to the same range low at 3.00. This creates a tiered structure of Fibonacci resistance zones that can be used to establish short trades. Of course, the strongest levels will be seen at instances of agreement between the two moves.

One such area can be found just above 3.4, which is shown as an orange bar in the chart above . In this example, however, the zone really marks a range—as the 50% retracement of the longer-term move can be found at 3.45, while the 50% retracement of the shorter-term move can be found at 3.42. This suggests that short trades can be taken anywhere inside this range. In addition to this, we have a bearish indicator reading (trending downwards), and the agreement of all these factors suggests that high-probability short trades can be taken while prices hold below 3.45. Stop losses would be placed just above this level, as any upside violation here would render the resistance zone invalid.

Conclusion: Capitalize on Multiple Sections of the Market
Fibonacci support and resistance levels are used by a majority of technical traders, at least sometimes. But in most cases, these levels are not as "solid" as they could be. This is because Fibonacci calculations are generally made in isolation. Wouldn't it make more sense to use these levels in combination? The fact remains that you will receive fewer trading signals and be out of the market for longer periods of time. But this also means that the trades you actually to take will have much higher probabilities for gains, as there will be more validity to the support or resistance levels you choose.

One of the central benefits of this approach can be seen in the fact that not all traders operate on the same time frame—but this does not mean that traders with different perspectives will necessarily be trading off of different price levels. There will always be cases where a trader using a daily chart will be watching the same price zone as the trader that is watching an hourly chart, but neither will know this is happening. When we combine larger and smaller price moves within a trend, there is a greater chance that we will be able to capitalize on these occurrences when they do happen. For these reasons, it makes sense to look for Fibonacci overlaps and place your trades if you have at least one added indicator reading that agrees with your analysis.

By Richard Cox of TradersLaboratory

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