Written by A.J. Brown

Do Fibonacci Retracements Fib?

fibonacci_scaledNothing ruffles feathers of some traders more than bringing up the mystical Fibonacci series! Let’s take a closer look…

I’ve found that Fibonacci Price Retracements are a very popular topic in all trading communities (whether they’re subscribed to or not). Volumes of books have been published on how to use them in futures, Forex, equities, and whatever else that can be traded. A Google search last night on Fibonacci Trading came up with 195,000 hits, and 593 books. So there is a lot out there to choose from if you are more interested.

I find it curious that with this much attention being paid to Fibonacci Retracements, is there some actual magic in the technique, or is it a phenomenon made real because many traders make trading decisions because of them?

The  answer to my question may not make a difference as long as we know how to use them effectively in our trading practice, right?

So you don’t have to go out and read a book to understand the rest of this blog, a quick overview of Fibonacci may useful.

Fibonacci retracements are based on the work of Leonardo Fibonacci in the thirteenth century. Fibonacci identified a series of numbers that are essentially the sum of the two preceding numbers in the series. What is important for the retracement is the ratio between the numbers in the series. The most famous is the ratio between two adjacent numbers, which is approximately 1.618. This number is also referred to as the golden ratio, which shows up in nature (eg. Nautilus shells) and has been incorporated into art and architecture as being pleasing to the eye.

For trading, a Fibonacci Retracement is setup by drawing two lines at the extremes of a channel of interest. The vertical space (price) is divided by the following percentages derived from the Fibonacci sequence: 23.6%, 38.2%, 50%, 61.8%, 78.6%, & 100%.

These lines represent potential lines of resistance or support where price may pullback or retrace from a localized trend. In effect, they tend to be decision points where price may pause before continuing, reversing or stalling.

By themselves, Fibonacci retracement lines may not provide enough information to determine direction. Using other indicators in conjunction with the Fibonacci price retracement lines, may help in making entry/exit decisions. In the day trading realm, candlesticks and other patterns are used to validate. For our option strategies a 3 and 5 day simple moving average (SMA) crossing works well. The slow stochastic is also a good corroborating indicator for the SMAs.

One place where I have found using Fibonacci retracement quite useful is with horizontal channeling stocks. The wider the channel, the better since it allows more room for price movement. It is ideal to catch the trade as price is near the 0% or 100% retracement lines.

I use the 3&5SMA crossings as a signal to enter or exit a position. For example, if stock prices is at the bottom of the channel (between the 0% and 23.6% lines, enter when the 3SMA crosses above the 5SMA. As price moves above the 23.6% line, exit if the 3SMA crosses below the 5SMA, otherwise ride it up to the 38.2% level. It is possible to catch a position in the opposite direction as price oscillates within the channel.

An example I’m using this with right now is Deckers Outdoors (symbol: DECK).  I drew my original price retracement lines between the low on March 2nd and the high on April 17th.  I traded it down two increments to the 38.2% line before seeing my moving average crossing.  Now, I’ve drawn my second price retracement lines between the high on April 17th and the low on May 1st.  We’re currently closing around the 50% line.

In fact, I have found that there tends to be a lot of price “gravity” around the 50% level. After a long trend, price seems to easily retrace to there, while moving beyond the 50% past the 61.8% requires a lot more energy. As always, I use volume to gage how much real effort the market is applying to push price.

Of course, I found a screen cast from Adam on the subject from about a month ago.  I’ve been following along with a lot of his videos recently.  This one I found interesting.  In it, Adam applies the Fibonacci Price retracement lines and his own proprietary indicators to the Dow Jones Industrial Average.  This screen case is definitely worth the less than 7 minutes to watch.

==> Click Here To Watch Adam’s Video Now

Please, after reading this post and watching Adam’s screen cast, comment below with your thoughts.  How do you think you can apply Fibonacci Price Retracement lines in this market?  What tickers do you see them working well with?  I’m interested in what you can add.

3 Responses to “Do Fibonacci Retracements Fib?”

  1. Alan Ellman @ 2:37 pm:

    A.J.,

    I enjoyed your insightful explanation of Fibonacci Retracements. With the myriad of technical analysis indicators available, this certainly is one of the more popular ones.

    I congratulate you on encouraging your readers to use other indicators in conjunction with this tool in making buy/sell decisions. No single indicator should have such power. I also liked your use of the short and longer term moving average crossovers in making these decisions. Of course, this is the basis of the MACD indicator you alluded to.

    Finally, if I may, I want to present a slightly different view of one of the comments Adam made. He astutely warned us of a possible upcoming trading range and recommended staying on the sidelines while this occured. For most investors, this is probably true. But this is a covered call site and one of the great advatages of selling CCs is that we can make tremendous profits even in a consolidating market. Perhaps selling I-T-M strikes may be a better recommendation.

    Thanks again for the educational article.

    Alan

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  2. Sandi Braun @ 9:21 pm:

    Options and Cover Calls are so new to me that this is over my head, but the video really helped. Thanks for the free videos you have offered too. I am still at the paper trade stage. Hopefully, I may take some of the courses in the future.

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  3. Michael Correll @ 6:31 pm:

    Thanks A.J.

    Michael S. Correll

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