FIBONACCI THE INTRODUCTIONS

Fibonacci analysis is a way to forecast levels of support and resistance and project price targets. It can be used to set stops as well as timing entries, however, the most valuable information is what it can tell us about risk. In this lesson we will be introducing a few of the tactical concepts and tips you will need for this course.

Fibonacci Concepts

What are the ratios and how are they used?

I will spare you the long, historical (and mostly erroneous) explanation of where the Fibonacci ratios come from and how it appears in the natural world. In the forex essentials course, we introduced Fibonacci retracements and the Fibonacci number series. From that number series we get the Fibonacci ratios, which are applied to price charts. While there are many Fibonacci ratios, in our experience, it is sufficient to stick with the standard levels of 23.6%, 38.2%, 50%, 61.8%, 100% and 161.8%. Slicing these levels into thinner segments results in a crowded chart and probably won’t improve your analysis.

Where do the lines go?

The sticky part of fundamental and technical analysis is that they are both very subjective, which means that they allow for a great deal of interpretation and individual preference. However, with Fibonacci analysis that subjectivity is easy to handle and I have a good example to show you why.

In the chart below you can see a Fibonacci retracement drawn from the “top” of the market in June to the “bottom” of that trend in August where prices started to move back up. Once prices started to move back against the trend in late August we could anchor our Fibonacci retracement lines to that bottom. That analysis may seem a little subjective but I can show that as long as you are picking extremes in the trend it really won’t matter. I have simplified the chart to just show the 23.6% retracement level.

In the next chart (below) you will see that this level continued to be fairly important with consolidations in September and late October but then the market broke below the fib retracement anchor in November and started to form another bottom later that month. Your analysis should probably change to account for the lower bottom in the market but should we move the top anchor down to the top of the rally in October? What if we left it where it is?

In the next chart (below) you see that leaving the top of the retracement where it was and moving the bottom line down to the new low placed the 38.2% retracement level within the same range (about 4%) as the previous 23.6% level, which subsequently was a significant level for a risk of reversal in December.

And in chart 4 below, you see that I did move the top anchor down to the top of the rally in October, which then placed the 61.8% retracement level within that same price range. This is not a coincidence it’s the way this analysis works and how price trends frequently move relative to Fibonacci ratios. Not all levels will be repeated like this as you move your retracement anchors but experience has shown that critical levels will remain clear. The key factor that separates good Fibonacci analysts from bad ones is not where the anchors are but what they do when prices are at those levels.

Bodies or shadows?

There is always a minor debate about whether you should anchor your Fibonacci retracement to the body of a candle or the shadows. I prefer to use the shadows so that the study includes the extremes of market sentiment. Most of the time, the difference is insignificant but sometimes it can be critical. In the examples above you can see that I anchored the Fibonacci retracement to the shadows of the candles at the top and bottom of the trend.

Support and resistance lines or areas?

We feel that support and resistance is more often an area around the Fibonacci lines than a specific to-the-pip point in the charts. You will find that prices move around a support or resistance line, especially during a consolidation. Discounting that level because of a temporary break may lead you to ignore a valid signal in the future. In the examples I will use in the course I will show how to evaluate that support and resistance area and how to use it to be aware of risk as well as opportunities.

FIBONACCI RETRACEMENTS

n this section, I will discuss how to use a Fibonacci retracement to time trade entries and to control risk. This is done through identifying profit targets and initial stops or hedges. In the next section, I will go into more detail about how to move those profit targets and stops as the trade progresses.

As with most analytical tools, there are many great ways to accomplish the same task. Analysis will vary due to individual risk tolerance, personal preference and experience. While I have included some specific ideas in this module, there is no satisfactory substitute for your own experience. Take the concepts I have shared here, and practice using and adjusting them in the live market.

Timing Entries

Fibonacci retracements are very productive for timing entries in the direction of the trend. However, defining the trend is where many trip up in their analysis. This can be simplified considerably by defining the trend simply as the price area that you applied the Fibonacci retracement to.

Let’s look more closely at an example from the past. In the chart below, you can see the Fibonacci retracement level attached to the rally from November to December on the USD/CAD. Let’s assume for a moment we’re back in December and we’re looking at the chart at that time (the non-shaded area).

We have a clear trend in that time frame, so its time to start looking for potential support levels. The retracement study has drawn four horizontal lines that correspond with each of the major Fibonacci levels I will be using. (If you are unclear where to draw the lines.

Each of these lines is a potential candidate for support and an entry position for a long trade. But which one should we pay attention to? The answer is: we wait. The Fibonacci level does not become important until price reacts to it. Once that happens, we can take some action.

In the chart below you can see that prices bounced neatly off the 38.2% retracement level. If we’re pretending again that we’re looking at this back in December, we’d determine that this looks like a great entry opportunity.

Well, we can see what happened next in the chart below. We bounced off that support level, and after a short downside move after the first of the year, we got the long-term move we anticipated, all the way up to the peak.

I want to make a quick note on the downside move, and trading emotions. Many, many traders let their emotions get in the way of their analysis, and they panic when they see a downside move against their trade. If we had panicked at the first of the year on this trade, we may have missed the long upside move we had predicted in our analysis. You should give your trades room to move. The market is volatile and rarely moves in just one direction. Before you exit a position early, make sure you have a good reason to do so.

Be educated and prepared

This historical example is great, but we’re looking at it in hindsight. When you are in the live market, even with proper analysis, you can’t always predict is going to happen. To really complete your analysis, and be prepared for the unknown, ask yourself these three questions..

1. What constitutes a bounce?

2. What is the initial profit target?

3. Risk control – where should a stop be set?

Is it really a bounce:

Traders will often use some sort of percentage movement to trigger a trade based on a support bounce. I set my entry order at the mid point between the Fibonacci level acting as support and the next Fibonacci level above it. In this case, with the 38.2% line at .9800 and the 23.6% line at .9960 the entry order should be set half-way between the two, at .9880. This can be adjusted depending on your own tolerance for risk but is a pretty good rule of thumb.

The initial profit target:

Since this analysis is designed to conform to the previous trend I would target the top of the Fibonacci retracement at the 0% line, or 1.0250. If prices break this level, you will need to reevaluate where you think the market will go. In the next section in this series we will talk about developing profit targets beyond the bounds of the Fibonacci retracement. However, as an initial profit target the 0% line or top of the retracement is where we would expect to have seen the top of our trade, based on the previous trend.

Risk control:

Risk control is extremely variable, and depends on what your risk tolerance is. However, placing a stop about a 3rd of the distance between two lower fib levels is a reasonable rule of thumb. In this case, if the 38.2% level is at .9800 and the 50% level is at .9650 the stop will be at .9750, or 33% under the support level. Most traders use stop losses to control that risk, and that is recommended for new traders. But more experienced traders could consider a call option in this same scenario. A call option limits the risk, but leaves the trade open, avoiding “whipsaws,” where the uptrend is preceded first by a quick downtrend below your stop level. To learn more about using call options as an alternative to stops.

In the next section we will talk about adjusting stops or as the position improves.

Bringing it all together

So let’s tie this all back together. In the image below I’ve drawn in the entry, target and stop levels on the graph, based on the directions above. Pretending we’re back in December, not knowing what would happen, we could complete our analysis and know where to get in, where to set our stop to limit our risk, and where what we expect our profits to be.

X-Factors:

One thing you can be sure of is that most technical systems, if applied too rigidly, will be unprofitable in the long term. There are just too many other issues involved. However, being aware of the x-factors can help you prepare and become more productive.

Fundamentals:

Trading a currency pair in the direction of the overall fundamental balance in a great idea. It helps support the trend and can increase your chances of success. In the Forex Essentials course, we talked about fundamental factors you should consider as you compare two currencies. Be aware of the fundamental balance and changes as your trade progresses. A major shift in fundamentals can turn your technical analysis on its head quickly. Here’s a great series of videos that teach more about combining technical and fundamental analysis.

News releases and market developments:

Imagine knowing what news was going to be released in advance? How much would that help your trading? Would you ignore that information because “all you really need are technicals?” Of course not and yet, that is what many traders do all the time. As news is released or changes take place in the market you should reevaluate your trade. For example, the CAD is very sensitive to oil prices. Should I remain long if oil prices begin breaking out to the upside? Should I leave the trade alone and not use that information? Of course not, I should consider the live market and new information as one of the most important tools I have access to.

Channels:

One question traders always ask is how long you should stick with your analysis when the trade channels around its entry price without hitting either your exit point or profit target. I think most traders should reconsider their analysis once the channel has lasted the same length of time that the previous trend lasted. In the example above, the trend started on 11/7 and lasted through 12/14 before the retracement. That means that if the trade has not made some meaningful movement before 01/17, you should probably abandon it and look for something else.

FIBONACHI STOP AND TARGETS

We've now discussed finding entry points, setting stops, and projecting initial profit targets in the previous lesson. I’ve found that it’s usually harder to decide what to do with the trade once you have entered it. Especially when the trade moves as you expected it would. Is it appropriate and possible to adjust stops and project price targets once initial projections have been met?

I find Fibonacci retracements invaluable when trying to answer these questions. In this section we will talk about adjusting stops and projecting price targets beyond initial estimates.

Stop Losses

Risk control is critical for survival in the forex. One of the most popular methods for risk control (on a trade-by-trade basis) is the stop loss. In the last section we talked about how to set an initial stop. But once the market begins to move, it may make sense to adjust those stops. In this example we will repeat the steps from the previous lesson but look at a specific scenario for moving your stop.

1. The Fibonacci retracement was drawn from the top to the bottom of the trend from early to mid November (1). Because the trend was down, you would have been looking for short opportunities.

2. Following the bottom in November, prices rebounded to the 38.2%% retracement level at 229.00 and then bounced down to continue the trend. The move up to the retracement level is what creates the opportunity to short the market as the trend continues to the downside.

An opportunity for a trade could have been found with a limit order (automatic order at a certain price) to short this pair midway between the 38.2% retracement level and the 23.6% retracement level (2) at 227.50. This would be placed in anticipation of the potential bounce down off resistance at the 38.2 level. In the last lesson, we discussed using the midpoint between two Fibonacci levels as a good entry point following a support or resistance bounce.

3. At the same time that a limit order to short the pair was filled, a stop order for risk control should also be entered. In the last section we discussed placing the stop on the other side of the Fibonacci level that prices bounced off about a third of the way towards the next Fibonacci level. In this example, prices bounced off the 38.2% retracement level at 229.00, and the next Fibonacci level is the 50% at 231.50. Therefore, the stop would be placed at 229.83 (3).

In steps 1-3 we talked about the initial trade setup. So far we have used the information from the last section to establish a short position on the GBP/JPY based on the Fibonacci levels. In the next few steps we will talk about how this trade worked out and how we adjusted the stops.

4. Following the entry at 227.50, prices almost immediately fell to the next Fibonacci level of 23.6%. This was in line with the original forecast. But don’t get antsy and adjust your stop yet. We recommend you wait until the next Fibonacci level has been reached. In this case, the 0% level was not reached before the trade was stopped out on Dec 12th.

This is a good example of how even the best analysis, predicted correctly, will sometimes not always work out. But the good news is there’s another good setup around the bend.

5. The stop in December was bitter-sweet since, prices immediately moved back below the 38.2% retracement level, proving the analysis is correct. That move would have triggered another trade because prices are again bouncing off the 38.2% retracement level with an identical setup to the trade constructed in steps 1-3.

6. Prices followed the trend and hit the 0% line on 12/31 which was a trigger to reevaluate the stop loss. A good rule of thumb here is to move the stop down a full “level” to rest just above the 23.6% retracement level. This pattern can continue to be repeated as prices exceed lower benchmarks, however, it is important to leave plenty of room between current prices and the stop loss or you may find yourself right on direction but wrong on the whipsaw. Always remember: Tightening your stops reduces your downside exposure but increases the chances for a whipsaw.

Adjusting the Profit Target

Once the initial profit target, of the bottom of the formation has been exceeded you can use Fibonacci retracements to project a new profit target. In this situation move the Fibonacci analysis so that it encompasses the price action from the bottom of the original study to the top of the bounce (late Nov. to early Dec.) that triggered the original trade above. See the chart below for an illustration.

This would have projected new fib levels above or below the original price range. The key level is the 161.8% retracement as the next likely target, but even further beyond that is the 261.8% retracement level. As prices reach either of these levels you could reevaluate your stops again and even consider an exit to take some profits off the table.

This simple analysis is surprisingly predictive and provides a basis to evaluate new targets. Let’s take it further now.

1. A new retracement has been drawn from the bottom of the November decline to the top of the rally at the beginning of December.

2. A new profit target can be seen at the 161.8% retracement level at 216.00. You can see that prices did consolidate at that level for about a week in January. This is a great time to consider moving your stop to just above the bottom of the retracement.

3. At that point, you could have decided that if prices breakthrough the 161.8% retracement level and there are no other reasons to exit the trade, you may consider moving your profit target to the 261.8% retracement level.

As you can see, this turned out to be quite predictive as the bottom of the market.

Beware of the X-Factors

1. Stops and/or diversification

Using stops for risk control is advisable but they can lead to some volatility when the market whips you out of a position on your stop, as it did in our example today.

Using stops is great, but it leaves your risk control strategy incomplete, in that it’s the only thing you are using to reduce account volatility. Diversification is another compelling way to reduce systemic risk and improve returns. Used together these two tools can help smooth your equity curve and make your trading less stressful.

Generally, I try to establish 10 or more uncorrelated positions and/or strategies at the same time. This allows me to benefit from diversification without increasing my management responsibilities too much. This is a great argument for longer term investing. It is easier to manage 10 or more positions when the trades last longer than a short-term or day-trading basis.

2. Adjustments and new information

In general I am opposed to sticking to a trade’s original analysis in the face of new and better information. Reducing your risk means that you are willing to reevaluate what you are doing with tighter or looser stops based on the information you have today. This is a concept I mentioned in the last section and I think it is one of the most important things traders can learn to become successful.