Trading Tips: Introduction to Fibonacci–Part One
02/12/2009 12:01 am EST
The concepts and sentiments expressed in this lesson, though nothing new, are still very valid in today's market. For those of you who are not familiar with Fibonacci analysis, I hope this will serve as a good introduction. If you are currently using Fibonacci analysis in your trading, I hope you will find a review and/or tune-up to be beneficial.
It should be no surprise to most of you that, in addition to the tools and knowledge that you bring to trading, the mental component is equally important, if not more so. In order to act at the right time, not only must you have done the analysis, but you also must have confidence in your analysis. Novice traders will often go through a frustrating period where they act too late, and the next time act too soon, losing money both times. This is sometimes the result of faulty analysis, but more often it is because they lack the confidence to act based on their analysis. Of course, everyone is different, and some successful traders require just a minimum of analytical tools to trade successfully, while others prefer to have several confirming analytical tools before making their decisions.
Fibonacci analysis is one such technical tool, and it is based on a series of numbers developed by an Italian mathematician, Leonardo Fibonacci, in the 12th century. From a trading perspective, there are many basic, as well as 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, 0.618. In these articles, I will just cover the basics, however, if you would like a more detailed discussion of Fibonacci, I recommend Joe DiNapoli's book, Trading with DiNapoli Levels: The Practical Application of Fibonacci Analysis to Investment Markets.
There are two primary ways that I use Fibonacci analysis in my trading. One is to further 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. 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, confirming the breakout. The problem then becomes determining a favorable level at which to enter the market. Many times, the novice will wait several days for a correction, but won't have enough patience, and will end up jumping in at just the wrong time. Fibonacci analysis can help the trader to better define both their entry and exit price. For these examples, I will use long-term data of euro FX global futures, which will demonstrate that the Fibonacci relationships can repeat over and over again. The euro declined from its inception in January 1999, and in late 2000 and early 2001, it formed a double-bottom formation (see blue arrow). The euro then turned up in 2002, breaking first its short-term downtrend and then confirming the double bottom on June 1, 2001 (point 1). This chart shows a series of rallies and declines over the next four years that are labeled "a" through "i."
We will now discuss each of these phases in more detail. |pagebreak|
The rally continued for six more weeks before the euro made its high versus the dollar at 1.0185 (point b) and turned lower. The euro also declined the following week, consistent with a deeper correction. In order to determine at what level the correction might end, you take the distance from the low (point a) to the high (point b), then subtract this distance times 0.236, 0.382, 0.500, and 0.618 (Fibonacci ratios) from the high to get four different retracement levels. These are shown on the chart as 23.6%, 38.2%, 50% and 61.8%. Most software programs allow you to do this very easily. You will note that the 23.6% level was broken the sixth day after the highs. Fibonacci analysis would conclude that the next level to watch was the 38.6% support level at .9560. The euro reached this level on September 17th (point c), but then rallied to close the week higher. This became an important level of support, because if it were broken, the next Fibonacci support level was at .9367, which corresponds to the 50% retracement level. Any long positions that were established after point c should have been initially protected with a stop under the 38.6% support level. The continuation pattern was completed on October 30, 2002 at point 1, indicating that the uptrend had resumed.
The euro rallied sharply over the next four months, forming a short-term peak in early March, and then, after a four-week correction, resumed its uptrend. The euro eventually reached the 1.1950 level (point d) and moved sideways for two weeks before starting a deeper correction. At this point, the analyst would start to examine the entire rally from the low at .9571 (point c) to the high of 1.1928 (point d). Once again, we look at the difference between the high and low to determine the Fibonacci levels to watch: 1.1950 - .9571 = .2357. The 23.6% level at 1.1371 was broken on July 3, and the 38.2% level at 1.1027 held until August 21 when it was also broken. This made the next key level of support at 1.0749 the 50% support level. After the 38.2% support was broken, one was able to identify the continuation pattern (blue lines) that eventually took the euro to a low of 1.0759, just holding above the 50% Fibonacci level. The break through resistance at point 2 completed the continuation pattern.
So far, we have just been focusing on the daily rallies, but it is important to never lose track of the big picture. We have discussed the importance of looking at the weekly charts, and it is important to also keep an eye on the longer-term Fibonacci analysis. In Fig. 4, we were focusing on the euro's rally from .9571 to 1.1928, but at the same time, we should be looking at the Fibonacci analysis using the previous low of .8549 and the high at 1.1928. The 23.6% support level of this rally was at 1.1130, which was broken the week of August 23, 2003 along with the weekly uptrend. The next level from the longer-term chart was the 38.2% support at 1.0637. Therefore, you had the daily 50% support level at 1.0749 and the weekly 38.2% support level at 1.0637. The convergence of these Fibonacci levels (see circle labeled e) made this a critical level of support. The euro, as discussed earlier, made a low of 1.0759.
The euro moved sharply higher from the low at 1.0759 and quickly tested the previous highs before it underwent a two-week correction. The breakout to new highs was supported by heavier volume, and the euro continued to rally sharply, making an initial peak in early 2004. The euro managed to make further new rally highs in February at 1.2919 (point f). In little over a week, the uptrend and the 23.6% level were both broken at point 3, indicating that a correction was definitely underway. The 38.2% support level at 1.2093 was also soon broken, which made a decline to the 50% level at 1.1839 more likely. This level was also violated, so it was very important that the 61.8% support level at 1.1584 held. The euro finally made its lows at 1.1745 during the week of April 27th, 2004. The longer-term support levels of the rally from .8571 to 1.2919 (not shown on the chart) were as follows: 23.6% at 1.1871, 38.2% at 1.1249, and the 50% at 1.0734. Even though the longer-term 23.6% was broken, the decline held well above the 38.2% support at 1.1249. I mention this to demonstrate that one does not always see the convergence of long- and short-term Fibonacci targets, as was evident in the prior example.
In the next article in this series, I will continue my discussion of the Fibonacci analysis of the euro and take you up through the 2008 peak. We will also take a look at how Fibonacci analysis can be used across different time frames and in different markets.