Update: Fibonacci and the Forex Market (Part 1)

12/30/2009 2:00 pm EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

As the year draws to a close, I hope all of you feel that you have become better traders in the past year as you have continued to refine your trading techniques. For those who were not previously using Fibonacci analysis, I hope you have at least considered adding it as one of your trading tools. If not, I hope this updated article on Fibonacci analysis of the forex markets will stimulate your interest, and I have included the current hourly analysis of the euro.

Over the years, I have occasionally been asked which of the Fibonacci methods I use the most. I started using just the standard retracement methods, but then soon also started using the Fibonacci fan and arc lines. In the past couple of years, I have learned through the work of three Fibonacci experts—Joe Dinapoli, Robert Miner, and Carolyn Boroden—how to use Fibonacci projections in my trading. In this article, I will begin to show how I apply these methods to the cash FX markets.


Figure 1 - Click to Enlarge

In this euro example, I would like to demonstrate how the Fibonacci fan, arc, and retracement analysis can be used together to enter and exit a trade. The Fibonacci points are all derived from the July highs (point a) and the October lows (point b). The euro moved sideways after the October lows, but did not make new lows with the US stock market in November. In early December, with the weekly close of 1.2961, the 38.2% fan line was overcome (point 1). On the upside, the first barrier was the minor 23.6% retracement resistance at 1.3200 with a more significant target at the 50% fan line and the 38.2% arc line. Three weeks later, the euro closed above the fan line at 1.3350 (point 2). After consolidating for a week, the euro accelerated to the upside over the next three weeks, moving above the 38.2% arc line and the 38.2% retracement resistance at 1.3750 (point 3). The 50% retracement resistance was overcome the next day. By December 18, just eight weeks after breaking the initial Fibonacci fan line, the euro had exceeded the 61.8% retracement resistance, but then reversed to close the day lower (point 4). The ceiling, as represented by the 61.8% arc line, was never tested, which supported the view that it was a failing rally.


Figure 2 - Click to Enlarge

This type of analysis can be used on any market and any time frame, but relationships are clearest when using the longer time frames. The hourly chart shows the euro’s decline from the high at 1.3585 on April 5 (point a) to a low of 1.2885 on April 20 (point b). The extent of the first stage of the decline to the 1.3150 level (point b) suggested that the euro was ready for a rebound, yet the declining daily technical studies suggested that a rally would be an opportunity to sell. But what kind of rebound was reasonable? Using this high and low, I was able to draw both the Fibonacci arcs, as well as the retracement levels, which identified major resistance in the 1.3400 area. The first confirmation that a rebound was indeed underway was the move above the 23.6% resistance at 1.3200. After consolidating for a few hours, the euro then accelerated to the upside, which made a move to the major 61.8% resistance at 1.3390 (point c) possible. This level was reached on April 13, but the euro failed to overcome the 61.8% arc line before turning lower.  Once the rally was completed, the distance between points b and c could be used to determine the 127.2% downside projection target at 1.3008 (line d) and the 161.8% target just above 1.2900 (line e).

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Figure 3 - Click to Enlarge

Another way of determining Fibonacci targets is to use the distance from a to b and then project down from point c to get a downside target. I never really understood this approach until I read Robert Miner’s excellent new book (click here to read my review). In most cases, you would look for a move that equaled 50%, 61.8%, or 100% of the prior rally or decline that also coincided with a major support or retracement resistance level. Using the decline from a to b, and then measuring down from point c, the 100% target (i.e. c to d equals a to b) came in just under 1.2900. This corresponds nicely with the alternative 161.8% projection using b to c as noted in Figure 2.


Figure 4 - Click to Enlarge

One of my favorite techniques for forex trading has been to use a simple momentum-type indicator as an entry signal after the entry/exit points are identified by the combination of Fibonacci retracements and projections. The challenge, of course, is to be patient enough to wait for a good opportunity and to have enough confidence to use wide stops initially so that the market noise does not take you out of your position. One of the simple momentum-type indicators that I use is what I call the RSI3, which is a three-period simple moving average of a five-period RSI. I use this on any time frame chart, and as I have written here previously, with the same methods of analysis.

The hourly chart shows that the euro began to stabilize in the 1.3100 area, and when the RSI3 moved above the 70 level, it signaled a change from negative momentum to positive. I have observed that in a downtrend, the majority of rallies will fail in the 55-70 area. The euro, after a three-hour setback, accelerated to the upside and quickly reached the 61.8% resistance at 1.3390. Though the RSI3 was at overbought levels, the first sign that the rally was over was when it first dropped below 70 (point 1) and then violated its uptrend (line 3).  The euro’s rebound to the 1.3360 area set up a good selling opportunity, as the RSI3 rallied back to the 55 level (point 2), and using a stop above the prior highs (1.3390) would have limited the risk. The euro did reverse to the downside and declined pretty steadily for the next six days. You will note that the RSI3 rebounded to the 55-70 level several times during the decline, all of which were good selling opportunities. The downside target in the 1.2900 area was reached on April 20, and the next day, the RSI3 rallied sharply to 70 (point 4) before turning lower. The 70 level was overcome the following day, suggesting that the downside momentum had been reversed.

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Figure 5 - Click to Enlarge

The combination of Fibonacci retracement and projection analysis can be quite powerful when a momentum study is added into the mix. I am quite sure that those of you who use stochastics or CCI could use them instead to further validate turning points at converging Fibonacci levels. In this example, I will look at the daily analysis of the JPY/USD, as it is one of my favorite markets since I started trading it when the dollar was trading over 200 yen/dollar. The dollar appeared to be making a bottom in January as it had declined from a high of 110.65, and the double test of the 87.15 level appeared to be successful. The series of higher lows in the RSI3 was also a plus, and by mid-February, the dollar was accelerating to the upside, reaching a high of 99.48 (point b) and slightly exceeding the major 50% retracement level. After moving sideways for almost two weeks, the dollar dropped sharply, and in three days, it tested the 93.50 area, which was enough to break the uptrend in the RSI3 (line 1). This made it clear that if the dollar did move above the previous rally highs (point b), the RSI3 would form a negative divergence.

The key, of course, was trying to determine a high-probability upside target. Since the major 50% retracement had been exceeded, the next upside target would be the major 61.8% resistance at 101.60. Using the alternative projection method discussed earlier, you could also take the distance from a (87.15) to b (99.67) and project up 61.8% and 100% from the low at c (93.58). The difference of 99.67-87.15 was 12.52, which if multiplied by .618  (61.8%), gives you 7.37. This, when added to 93.58, equals 101.31.

The April 6 high was 101.43 (point d), which was also just short of the 61.8% major retracement resistance at 101.60; therefore, the actual high fell right in the middle of these two projections. The RSI rallied back to just above the 70 level and formed a significant negative divergence. The dollar moved sideways for a few days before dropping more sharply, declining for the next three weeks and eventually reaching 98.30 (point e), the 38.2% support of the rally from 87.15 to 101.43.

The dollar quickly rebounded from these lows, and in just three days, it was back to the initial resistance at 99.60. Using the decline from d to e, and then measuring down from the rebound peak at f, you get a 100% target at 93.88, just below the 50% retracement support. In other words, this means that the distance from f to g equals the distance from d to e. Therefore, when the dollar made its lows at point g, and if you observed that the RSI3 was forming a positive divergence (line 4), there was a good reason to take profits or tighten trailing stops. The dollar did have a nice rebound, as in just eleven days of trading, it rallied back to a high of 98.88 (point h), which coincided with the 61.8% retracement resistance of the decline from d to g. The RSI3 had managed to rebound back to the 70 level on this rally (point 5) before turning lower. Once again, using the decline from f to g and projecting downward, the 100% target was at 93.30, and on July 13, the 127.2% projection target at 91.80 was hit. This was just below the 61.8% support level.


Figure 6 - Click to Enlarge

On December 16, with the euro trading in the 1.4550 area, we shared an hourly chart (click here to view) and gave downside projections in the 1.4300 area. These were calculated using the distance from a to b and then measuring down the same distance from point c, giving a target at point d. The euro’s low has so far been at 1.4228, with the major 38.2% support level at 1.4126. The euro’s rebound from the lows has so far failed at 1.4450 and the 23.6% resistance level. There is more important resistance at 1.4570 (38.2%) and again in the 1.4700 (50%) area. Though the technical studies suggest the euro is forming a short-term low, one more new low is still possible over the near term. This could take the euro to the 1.4126 area and maybe even the 161.8% projection target just above 1.4000. Of course, if the euro does make new correction lows, the Fibonacci resistance levels will need to be recalculated. If the lows at 1.4226 do hold, I would look for a rebound to the 1.4570 to 1.4700 area before the euro’s decline resumes as the technical picture indicates that a weekly top has been completed (click here for more).

I wish all of you a healthy and prosperous 2010, and as always, I appreciate your feedback.

Happy Holidays,
Tom

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