It’s Not Witchcraft, It’s Fibonacci

From the July 2013 Issue of Futures Magazine (illustrations not included)

It’s Not Witchcraft, it’s Fibonacci by Billy Williams

Fibonacci numbers are almost as familiar to traders as they are to mathematicians, but they have not been used as effectively in the markets. In many ways, this failure to fully utilize Fibonacci analysis is because of a focus on its application with respect to support and resistance, where it is less effective.

Instead, there are ways to use Fibonacci’s measures of price retracement to peer into price action and better understand the strength of a price move. Employing this practical application of Fibonacci retracements can complement a trading approach as well as serve as a standalone method for identifying pullback entries.

Another powerful aspect of Fibonacci trading is that retracement levels are robust. They can be used in day-trading, swing trading and investing in all markets: Grains, forex, stocks, Treasuries and other commodities. Their measurements are relative and adjust to whatever market and time frame you are using.

A reliable set of guidelines will define the characteristics of key retracement levels so that they offer a practical way to gauge where price is likely to rise and where it is likely to fall. Based on those terms, any price reaction at these levels can help you determine profit targets and areas where caution is advised because of possible weakness. We’ll demonstrate some of these techniques using a grain-based exchange-traded fund (ETF) and equity ETFs; however, these methods are applicable across markets.

Voodoo & prophecy
In its most basic form, a retracement is a price move in the opposite direction of the most recent price move.

Price does not magically reverse at Fibonacci retracement levels and these points are not the Holy Grail of trading. Instead, they are a signpost for a possible destination that acts as a guide for price movement. A lot of things can happen on price’s journey, but Fibonacci helps point its likely path.

While some investors look at Fibonacci numbers as the equivalent of reading tea leaves or fortune telling, the reality is that they have their place in a skilled trader’s arsenal of technical analysis. If for no other reason, Fibonacci levels deserve attention because they are so popular among traders. Like a self-fulfilling prophecy, when price scales back, many institutional and retail traders alike take notice of where price is in relation to the Fibonacci retracements.

However, while it’s important to be aware of Fibonacci levels, it is vital that you view and apply them differently than the vast majority of traders.

There are two retracement levels that deserve the majority of your focus: The 38.2% and 61.8% Fibonacci retracement.

As price trades near each of these levels, a reversal or inflection point often will materialize. In a Fibonacci retracement, the reversal point is where price halts its pullback and resumes trading in the direction of the original price move. At the inflection point, price weakness is revealed and the market could fail to gain a foothold to reestablish the original trend.

These two concepts form the cornerstone of using Fibonacci retracements and are key to unlocking the door of successful price interpretation that can lead you to picking low-risk setups. This will serve as a reference when sizing up turns in price that occur within these retracement levels to measure how strong the preceding price move, or trend, was previous to the pullback.

While opportunities exist with each retracement level, these are general guidelines and broad target areas, not exact points.

For a 38.2% retracement level, the guidelines are:

• If price holds at the 38.2% retracement level, the prior move is considered to be strong. As a result, the counter move should be strong.
• A 38.2% retracement after a strong advance typically is followed by a move to a new high.
• A 38.2% retracement after a strong decline typically is followed by a move to a new low.

For a 61.8% retracement level, the guidelines are:

• If a stock experiences a 61.8% retracement, the prior move is considered weak (or near its end). As a result, the counter move should be weak.
• A 61.8% retracement after a strong advance often leads to a move with a one-in-three chance of exceeding the prior high. The same also applies in reverse.
• The first retracement after a strong up move is considered a buy most of the time, but you need to consider exiting a trade as price nears its previous high or low.

These guidelines act as a safeguard to keep your own emotions under control to prevent any euphoric anticipation of a runaway move or sense of overwhelming fear of a losing trade. Keeping your personal expectations in check will preserve your objectivity and prevent you from projecting those feelings into your trading.

Staying accurate
For beginners, it can be maddening to attempt to use Fibonacci retracements to achieve any kind of real clarity on price points and future price movement. Often, new traders simply draw retracements from every angle, resulting in a price chart that is so littered with Fibonacci retracement levels that it looks more like graffiti than sound technical analysis. In the end, measuring Fibonacci retracements incorrectly can do more harm than good.

It’s important to understand that price highs and lows are relative to retracements when calculating retracement levels. That said, it’s important to look for a strong move without a significant pullback to the 38.2% or 61.8% level. If price pulls back slightly without touching any of those levels and goes on to make a new high or low, then adjust your measurement to account for it. This keeps your measurement of these levels in sync with the dynamics of the market, which are constantly in flux.

When one of these key levels is touched, you are looking for some kind of reaction as this level becomes a pivot. You are looking for support/resistance levels to be established, for a trend to resume or the next Fibonacci level to be tested.

It’s common to look for advice on how an average trader can be successful in today’s market; the answer is not to be average. Average traders lose money, while exceptional traders take money from average traders.

One way not to be average is to examine common technical tools in depth. Cookie-cutter analysis of Fibonacci retracements fails to provide the value add needed for consistent signals over time.

Fibonacci numbers are used pervasively by traders, but the real benefit is looking beyond common beliefs and realizing they are better employed to size up other traders, just as a good poker player doesn’t play his cards, but plays the other players. Measuring the strength of Fibonacci retracements can help you glean insight into what comes next.

Billy Williams is a 20-year veteran trader and publisher of www.StockOptionSystem.com, where you can read his commentary and a report on the fundamental keys for the aspiring trader.

An interesting perspective and some food for thought.

Rick

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