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"}

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Tony,

One rabbit, by itself, doesn't reproduce - it just tells stories about all the bunnies it's had...

Pedantry doesn't give me an edge in the market - and I fight it - daily. Please give generously.

OK, but for me it still takes two (1+1=2) to party and so I guess we’ll just have to settle for the fact that bunnies have to do what bunnies have to do?

Cheers

Mayfly

PS Here's a link for anyone who's interested: http://www.math.utah.edu/~beebe/software/java/fibonacci/liber-abaci.html

I think people are slightly misunderstanding the progression of the golden logarithmic principle for the ratio's 0.382 , 0.618 ect...

As for the 0.50..... The benchmark for the division of unity (1.0).. is first the half (0.50).

Mayfly points out a good Arithmetic ratio ( generated from the simple division of whole numbers by other whole numbers).

Also when I view the 0.50 I see the harmonic ratio series of the square.

I know many may see this as a little pedantic but for those who venture into Sacred/Dynamic Geometry the differences are stark. Many will say whats the point?....but identifying rhythm is powerful tool for technical traders to use.

To quote Naz
Trading is an individual thing and i always use fibs in my own special way

That's the key... we all have special ways with ratio's, but if they work for the user.. who cares how they differ in application..

The hard part is first finding your own way..

CJ

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It's true everyone can use fibs in their own special way.This is how i use them again.

I use a Nasdaq level 2 screen to spot the turn at a fib level,(if i'm wrong i get out immediately with a small loss.) In the big picture i hope that it slowly dawns on others that we've now turned and they hit their internet accounts to enter,then we make some kind of small breakout of the last high which drags another lot of day traders in and hopefully the breakout of the days high which attracts so many others.....and all the time i watch each pullback to make sure the level 2 guys are still running with it.When they've had enough or start selling at any time i'm gone.

Its those guys who make the prices that cfd's,spread betters and others take their quotes from.So for me its better to watch and understand them than to look at a quote from someone else or to look at a chart which is a reflection of someones reaction to their pricing.

My idea is to spot t/a set ups that are coming up and then watch to see if its going to be played or not on the Nasdaq level 2screen.Because i know that if it forms on a chart,so many people in the market believe in t/a that they will blindly go in and create a momentum that enhances my profit. By doing this i've found that my profits will more than out weigh my losses often by staggering amounts.Like the trade i showed in my last post.

Naz

Alan,
Your enthusiasm for Level II is unparallelled, but I don't think I've ever read another post from you where you've expressed the reasons for your enthusiasm so succinctly and so persuasively. I'll start putting some loose change in my piggy bank so that one day I can attend your course!
;-)
Tim.

Naz.
Thanks for the insight.
Does Connors produce data for the converse of buying on strength or weakness?
e.g. what would be the effect of shorting after three consecutive up days, compared with three down days?

Out of interest i attended a seminar given by Marc Rivalland. His strategy was very similar to what Naz suggests. His method of timing the entry was to wait until there had been three consecutive down days and then set a buy limit order one tick above the previous days high. This way it would only be triggered if there was a turn in the market.

Thank you for such a nice post.

I also found the following post is very useful about Fibonacci Retracements http://www.financialtrading.com/fibonacci-retracements/

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