Trading Tips: Introduction to Fibonacci—Part 2

02/26/2009 12:01 am EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

In the previous article, I introduced how the Fibonacci ratios of 0.236, 0.382, 0.500, and 0.618 could be used in a strongly rising market to determine good levels of support where new positions could be considered. These are noted in the charts that follow as percent levels: 23.6%, 38.2%, 50%, and 61.8%. In this article, I will continue the discussion of the Euro FX Composite through July 2006 and then look at some examples of how Fibonacci analysis can be applied to stocks and intraday data.

Previously, we looked at the euro from the lows in 2001-2002 up through the correction, which ended in April-May of 2004. The Euro FX, after rallying from the lows at point g, moved sideways for the next five months with support at 1.1944 and resistance at 1.2449. The resistance was overcome on October 15, 2004 (point 1), and the euro quickly surpassed the previous highs, reaching the 1.3687 level on December 30, 2004 (point h). The initial correction from these highs was quite sharp as the 23.6% support level was broken, followed four weeks later by the 38.2% support at 1.2930. The euro was finally able to reach the 50% support level on February 2, 2005 (point 2), and then turned higher. At this point it became important to look at the long-term Fibonacci support levels as well.

The weekly chart above shows the entire rally from the euro's late-2000 lows at .8245 up through the latter part of July 2006. I have outlined the euro's first three major corrections: the first labeled b-c, which retraced 38.2%, the second labeled d-e, which retraced 50%, and the third labeled f-g, which resulted in a 61.8% correction. This illustrates the Fibonacci symmetry that is often seen in a major rally or decline. The major Fibonacci support levels of the rally from .8245 to 1.3687 were calculated as follows: 23.6% (1.2402), 38.2% (1.1608), 50% (1.0966), and 61.8% (1.032). The euro, after attempting to rally from the daily 50% support level (Fig. 1), again turned lower, breaking back below the daily 50% support (1.2716) at point 2, and then the 61.8% support level (1.2486). You will note on the weekly chart above that the major 23.6% support at 1.2402 was also broken. The euro did attempt another rally in the middle of 2005, but then turned lower late in the year, declining to a low of 1.1661 and holding just above the weekly 38.2% support level at 1.1608 (point 3). The euro formed a classical falling wedge formation in 2005 (lines B and C), which was resolved on January 7, 2006 at point 4. This indicated that the euro would move higher in 2006, which we will see when we look at the rebound in terms of Fibonacci ratios.

On May 12, 2006, the euro's rally from the November 2005 lows exceeded the 61.8% retracement resistance of the decline from the highs of December 2004 (Fig. 3a, point 1). This indicated that the euro's uptrend had resumed, which is consistent with the completion of the falling wedge formation that was shown in Fig. 2.

Now, let's look more closely at the rally from the November lows at 1.1661 to the May highs at 1.3003. |pagebreak|

So far, the euro has held above the 38.2% support level at 1.2500 with next support at 1.2330, the 50% retracement level. The daily chart does show a flag formation at lines a and b. The completion of this formation will indicate that the euro's uptrend has resumed.

As noted above, the move above the 61.8% level (point 1) and break above the weekly resistance at line a suggested that the major uptrend had resumed. The euro tested the Fibonacci support below 1.2500 three times before completing the flag formation in November 2006. This confirmed a major new leg to the upside. The euro reached a high of 1.5941 in July 2008 before undergoing a very sharp decline. The euro broke below the 38.2% support at 1.3180, but is still holding above the major 50% support at 1.2150 considering the lows so far have been at 1.2330. A break of the 50% support would imply a decline to the 61.8% support, which is just above 1.1200. On the upside, there is Fibonacci resistance first at 1.3210 (23.6%) and then at 1.3750 (38.2%). The 50% retracement resistance stands at 1.4200, and it would take a close above the 61.8% resistance at 1.4630 (line b) to indicate that the euro's uptrend has resumed.

These Fibonacci relationships, as discussed earlier, can also be applied to declining markets. The ratios are used to calculate retracement resistance instead of support. This can be very helpful, both for exiting a long position if you miss the completion of a top, and for identifying entry levels to establish short positions. In Fig. 4 we can see the top formation that occurred in Advanced Micro Devices (AMD) in June-July 2000 (red circle). Though the major stock market indices like the NASDAQ Composite topped in March 2000, some sectors, like the semiconductors, topped out later. If you still held a long position in AMD after it completed its top formation and dropped from its high of $48.50 to $27.00 in August, you were probably praying for a rally to sell your long positions. Of course, you may also have been looking for a good level to establish a short position. The rally in August 2000 exceeded the 38.2% resistance level at $35.21. This made the next likely target for a further rally the 50% level, which stood at $37.75, a value that was also exceeded the week of August 28th with AMD's high of $38.25 (point a). This made the 61.8% resistance at $40.28 very important, but the next week, AMD reversed to close lower, indicating that the downtrend had resumed. AMD eventually dropped to a low of $13.56 on December 22, 2000, a 73% plunge from the year's highs that made AMD very oversold and ready for a rebound.

The extent of the decline implied that, in terms of both time and price, a reasonable rally was possibly underway, but after the technical damage of the decline, it was not likely that the long-term downtrend had been completed. Therefore, a rally should provide a good opportunity to establish short positions. Once again, Fibonacci analysis, especially when used with other methods, can be very useful. The rally from the 2000 lows was impressive, as AMD quickly surpassed the 23.6% resistance at $21.80 and reached the 38.2% resistance at $26.90 before pausing. By March 23, the 38.2% level was overcome, and on April 30, the 50% resistance at $31.03 (point a) was also exceeded. This made the 61.8% resistance at $35.15 a very critical level to watch. AMD made a high of $34.45 the week of May 25 (point 3) but closed the week lower. Any short positions established in the $31.03-$34.45 area should have used a protective stop initially above $35.15.

The daily chart of AMD's decline from the May 2001 highs is shown on Fig. 5b. As you can see, the decline was extremely sharp, as AMD plunged from its high of $34.45 to a low of $7.76 on October 5, 2001. AMD had not been that low since November 1999, before it started its rally to the 2000 high of $48.50. The rebound from these lows also followed a fairly common Fibonacci pattern. First, we notice a rally to the 23.6% resistance at $14.05, where the rally stalled for a couple of weeks before AMD rallied to just above the 38.2% resistance at $17.95 in December 2001. Because AMD was able to move above this level, it was expected that the 50% resistance at $21.10 would be tested, but the rally peaked on January 7, 2002 at $20.60. Once again, the lower weekly close suggested that the rebound was over.  For those establishing short positions on this second rally, a stop above the 50% resistance level at $21.10 would have worked well.

Though we have looked at examples so far using daily or weekly data, let's now look at how the same methods can easily be applied to intraday data. |pagebreak|

The decline in the US stock market in May was quite sharp as evident on the hourly chart of the June S&P 500 futures chart. The June futures peaked at 1331.30 on May 5, 2006, and 12 days later, they had dropped to 1247. Those looking to establish short positions or to hedge their portfolio may have been watching both the S&P and the NASDAQ futures to find a favorable level to sell. In fact, the Fibonacci analysis can also assist you in picking the best market to trade. In an uptrend, the market that has the smaller correction will usually be the strongest one on the next rally. Conversely, in a downtrend, the market that rebounds the least will often decline more once the downtrend resumes. The June S&P futures rallied quickly through the 23.6% resistance at 1267.10, and also above the 38.2% resistance at 1279.35, before pulling back. The next rally took the S&P futures above the 50% resistance at 1289.25, peaking at 1293.70. At this point, a flag formation (lines A and B) was clearly evident, with important resistance at 1299.15, the 61.8% resistance level. The flag formation was completed on June 6 (point 1), indicating that the decline had resumed.

One gets a slightly different picture when looking at the June NASDAQ futures as they made their high on April 7th at 1766.00 and formed a series of lower highs for the next month (line A). The completion of the top formation came on May 11, as key support, (line B) was broken at point 1. The decline in the NASDAQ took it to a low of 1557.50 on May 23. The first rally from the lows slightly exceeded the 23.6% resistance level of the decline from 1766.00 to 1557.50, which was at 1606.45. After a sharp pullback, the next rally took the NASDAQ futures to 1634, falling just short of the 38.2% resistance at 1636.90. The completion of the continuation pattern, lines A and B, at point 2, confirmed that the correction was over. In comparing the trading in the S&P with that of the NASDAQ futures, the fact that the NASDAQ futures did not even retrace 38.2% of its decline, while the S&P retraced over 50%, indicates that the NASDAQ was acting weaker, and should be a better index to trade from the short side than the S&P.

I hope these articles on Fibonacci analysis have spurred your interest in this type of analysis. In future articles, I will examine how Fibonacci arcs and time analysis can be used as part of your overall trading strategy.

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