Technical Analysis

# Trading with Fibonacci

Many traders will rather play a pullback than a breakout of the highs. In fact some research by Larry Connors in the US showed that on the
S&P in a ten year period from 1993 if you had bought 10-day-high breakouts and exited when prices crossed the 10 day moving average you would have lost over 312 points.

However, during the same time if you had bought every 10-day-low and exited when price crossed its 10 period moving average then you would have made over 830 points. Many trade the breakout of the highs but as Connors says ?In reality it appears to be very wrong.?

Although playing breakouts can be said by others to be a valid tool in a trader?s tool kit, many often find that what they perceive as a breakout is actually a swing high or low and they have entered at the extreme of a move, just before it goes in the opposite direction. Playing pullbacks allows the trader to be in profit before any potential breakout thus giving some kind of profit if it turns out to be a false signal and reap extra rewards if the breakout follows through.

One way of playing pullbacks is with the use of Fibonacci. This phenomenon works very well on liquid markets like
currencies and large US stocks.

Who and what is Fibonacci?

Leonardo Fibonacci was an Italian mathematician who once entered a mathematical competition and had to work out an equation for the reproduction of rabbits. This gave rise to a numbered sequence where the sum of the previous two numbers equals the next. i.e. 1,1,2,3,5,8,13,21,etc. Within this numbered sequence the value of the following number is 1.618 of the last and the previous number works out at 0.618 times the next.

This ratio has been called the ?golden section? or ?golden mean.? It has been found that these ratios appear in nature and all around us. The golden section plays an important part in the structure of DNA and atomic particles as well as the shape of our galaxies, ocean waves and our bodies.

Other important numbers are 0.382 and 0.5.Put as percentages these numbers translate to 61.8%, 38.2% and 50%.

These percentages are very often used by the financial markets to calculate where important retracement levels might be found in many time frames. Some may think that all this seems like hogwash but over the years it has become a self-fulfilling prophecy with turning points occurring at these levels so often that Fibonacci levels are offered by almost every good financial package available.

Fibonacci retracements

Most moves react as waves, some small and others larger. In order to advance in any major move the retracement of the last substantial move must be less than the whole move itself. By taking the high and low of that move a charting package will overlay the Fibonacci grid on the chart so that a trader can spot a potential turning point at these levels. In the example shown I placed the Fibonacci grid on the last major move from \$68-\$69 and was presented with the red grid marking out the three major Fibonacci pullback points.

{\$image002 alt="Chart"}

As the stock turns to continue its upward run a stop can be placed under one of the other grids for a low risk trade.

{\$image003 alt="Chart"}

We can see by the continuing move how the Fibonacci retracement entry was an excellent place to enter this trade. Fibononacci retracements will work in both rising and falling markets. US stocks and indices can respond very well to Fibonacci, indeed the sell off of the
NASDAQ Composite Index in 2000 was to be found after a Fibonacci retracement.

{\$image004 alt="Chart"}

As many items fall faster than they go up, spotting Fibonacci retracements after the top of a strong move up is an excellent way to profit from an impending collapse and change of trend.

In this example, this stock has moved up strongly and many may think that it?s poised for another move up.

{\$image005 alt="Chart"}

But by using the Fibonacci grid on its last move down, we can see that it can?t get back through the 50% retracement. This signals a low risk trade with a stop over one of the grid levels, which was the prelude to a \$40 drop in the next 13 weeks as shown in the next chart.

{\$image006 alt="Chart"}

##### Alan Rich

Alan is a Stockmarket Trader, Coach and Mentor and was previously a US markets trading instructor in the city as well as a regular contributor on CNBC Europe. Alan has also appeared on the BBC, Financial Times and Wall St Journal Europe. He has lectured on Trading and the Stock Market at Guilford University and at many large trading shows both in the UK and internationally.

Alan is a Stockmarket Trader, Coach and Mentor and was previously a US markets trading instructor in the city as well as a regular contributor on CNBC...

#### DESKPRO

##### Active member
120 0
Interested in ant studies that have been done on breakouts versus retracements - Alan refers to oen at the beginning are there any other articles on this subject?

#### Naz

##### Experienced member
1,391 24
Here's a chart which Connors has recently issued on his findings.

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#### Salty Gibbon

##### Experienced member
1,535 6
Nice article Mr Naz.

It didn't break any new ground for me but it was a timely and pertinent reminder of the power of the Fibonacci sequence.

Regarding the Connors article, my intuition is to buy weakness and sell strength.

#### Trader333

Moderator
8,658 984
Regarding the Connors article, my intuition is to buy weakness and sell strength.

Hmm, At what point do you know when to buy the weakness or sell the strength ? The ultimate in this is being able to pick tops and bottoms which is not easy. There are times and ways of doing it when general market conditions allow it but it is not something that can be done every day in my view.

Paul

#### Mr. Charts

##### Legendary member
7,370 1,194
Very nice article, Naz.
It should be remembered that until 2000 the S&P was in a secular bull market so any pulllback had a natural bias to snap back upwards . We then entered a bear which bottomed in the second half of 2002.
Out of 15 years only 2.5 were bearish.
You can view this as a natural secular tendency to bounce back when pushed down.
If the markets continue north to the 1400-1450 level over the next year or two as seems likely, then this pattern may well be useful for index swing players.
Beware, however, we are approaching the 50% Fib retracement of the 2000 high to 2002 low ;-)
Richard

#### a320

##### Established member
689 8
I still carn't work out how people say 50% is a fib number ...

Also just because the price pulls back into a "classic" fib retracement zone of an alternate wave doesn't mean it will stop....Other technical evidence must be present within the price* ( wave ) structure..

*If one is purely concertrating on price analysis.

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#### Mr. Charts

##### Legendary member
7,370 1,194
a320,
I only care about what works a significant %age of the time.
I do not "believe" in cycles, Uranus (Mmm.....) being in conjunction with Saturn, Soy beans going down and pork bellies going up if the Heat score more than 120, Elliot, Gann, Fib, secrets of the universe, dark side, light side, Inkashabble effects, Delta etc - I only observe and act accordingly in line with what actually works. The more something is used, the more it becomes a self-fulfilling prophecy. In my opinion none of these things has an intrinsic truth or value, only what is generated by its use. Even then some is simple happenstance.
Fibonacci, I do find useful in certain circumstances, however.
Reading the market cuts to the chase.
Richard

#### a320

##### Established member
689 8
Mr. Charts said:
a320,
I only care about what works a significant %age of the time.
I do not "believe" in cycles, Uranus (Mmm.....) being in conjunction with Saturn, Soy beans going down and pork bellies going up if the Heat score more than 120, Elliot, Gann, Fib, secrets of the universe, dark side, light side, Inkashabble effects, Delta etc - I only observe and act accordingly in line with what actually works. The more something is used, the more it becomes a self-fulfilling prophecy. In my opinion none of these things has an intrinsic truth or value, only what is generated by its use. Even then some is simple happenstance.
Fibonacci, I do find useful in certain circumstances, however.
Reading the market cuts to the chase.
Richard

Richard you know me better than that .....

What prompted that slightly derogatory response...:?:

My posting style is never ment to be demeaning ..

CJ

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#### TheBramble

##### Legendary member
8,394 1,170
Fibonacci is wildly b*astardised today CJ - you know that. The 50 creeps in because it 'works' - sometimes and has nothing to do with Fib series at all.

What is interesting is that few ever go any further than "the series".

Leonardo Pisano (Fibonacci) left us a large number of (some quite esoteric ) works which are of interest for their own sake and for application outside the narrow realm of financial trading.

People do tend to get defensive when they're under pressure. Don't take anything personally.

Keep the faith.

#### Mayfly

##### Established member
514 28
Guys,

The 0.5 ratio, is simply the ratio of the second two Fibonacci numbers 1 and 2, and you’ll find it together with the other Fibonacci ratios which are used in the calculation of Fibonacci retracements and extensions. These are set at: 23.6%, 38.2%, 50%, 61.8%, 78.6%, 100%, 161.8%, 261.8%, 423.6%.

The 0.5 ratio is also used to construct Fibonacci Fan Lines and Arcs.

HTH

Cheers

Mayfly

#### Salty Gibbon

##### Experienced member
1,535 6
Hmm, At what point do you know when to buy the weakness or sell the strength ? The ultimate in this is being able to pick tops and bottoms which is not easy. There are times and ways of doing it when general market conditions allow it but it is not something that can be done every day in my view.

Yes Paul, I know all that and it is probably therefore a good thing that I rarely act on intuition alone.

Intuitive trading is for the gifted and I aint that !!

#### Mr. Charts

##### Legendary member
7,370 1,194
Hi a320,
No, you misunderstand. It was NOT meant to be derogatory to you in the slightest and I apologise if I came over that way. I did not intend to be unpleasant to you in the slightest.
I was trying to say that I PERSONALLY have no time or interest in such things because my own use of pattern, price and volume tells me all I need to trade successfully and has done so for several years.
I also have a scientific training and my mind requires proof and logic before I accept that any particular approach has any validity. These requirements are not met by any of the more esoteric approaches.
I am also aware that if something works consistently long term that it may require re-examination.
To me, trading is essentially scientific and analytical, above all evidential, but requires a degree of art as well.
I certainly do not disrespect you or your methods. After all, as you know I have huge respect for Tom and he is involved in some more beyond-the-envelope matters.
Reading my post again I do see why you took it as being dismissive, please accept my apologies.
Anyone making false implications about what I have said (this is NOT a320) misquoting me, claiming I have said something I haven't, sending rather vicious but pathetic anonymous emails from hotmail addresses and so on - your innuendoes, mischief making and efforts are all in vain.
I will not debate with you under any circumstances and WILL continue to post.
Richard

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#### Naz

##### Experienced member
1,391 24
All i'm interested in is where a stock will turn. Fibonacci will give a possible turning point however i believe you need something else to go with it.Otherwise which level will it turn at.

Intra day there is only one tool for me that will give you that edge and that is astute reading of the level 2 screen.(ie using t/a with level 2,which is how i trade.)

A trader has to transact at prices that are obtainable.The level 2 screen will show what those prices are and the sentiment behind their movement.Hence when it approaches key t/a turning points reading the sentiment will give the level 2 trader an edge on where the stock is likely to go next.

If things go badly the level 2 trader can scratch his trade or take a minimal loss very quickly because the entry point can very often be so near a possible turning point.If it fails he's gone.

On any pullback in the run the level 2 trader knows what happened before and looks for the some of the players to do it again.However a day trader just using charts could just see a big red candle and his profits going down the pan and is very likely to get out thinking its the end of the move.

Here's an example from the other day.(The level 2 shots of this move are now in the t2w L2 course.)

Chart 1,The entry using level 2.Fibonacci giving the possible entry area.

Chart 2.Suffered the first pullback and move through the whole number.

Chart 3.Two more pullbacks with the same level 2 play that went on before.

Chart4.The full move.

Playing the pullback using Fibonacci gave twice the profit than a trader waiting for the breakout of the day's highs.In fact chart 5 shows that anyone buying the highs of that move and holding expecting more movement could have suffered because the stock then sold off.Perhaps echoing some of what Connors says in his research?

I hope that might be of interest.

Naz

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#### a320

##### Established member
689 8
Thank your for explaining your post.

You don't have to apologies, I know you didn't mean to come across that way. I just thought it was a little strange the way the post was worded.

Anyway I hope the idiots don't give you any grief....

Take it easy.

CJ

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