Fibonacci Analysis To Create Trading

Strategies
Learn how to use fibonacci retracements to identify support and resistance

Technical and fundamental analysis are based on the assumption that things that have
happened in the past will often indicate what will happen in the future. Fundamental
analysts depend on the past underlying financial performance of a company, economy or
industry to make forecasts while technical analysts will look at past currency price
movements for the same purposes. From that perspective you can imagine fibonacci
analysis as the technical equivalent to the fundamentals of interest rates or trade flows.

Fibonacci analysis gives us 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
to understand these tools and begin using them as a technical analyst.

Through the subsequent sections in this article I will examine several case studies to
understand how these ratios work in the live market and why they are considered one of
the most important tools available to technical analysts.
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 they appear in the natural world except to say that
fibonacci analysis is based on the fibonacci number series and the Fibonacci ratios, which are
then applied to price charts.

While there are many Fibonacci ratios, in my 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.

How are fibonacci ratios calculated?

The ratios are based on the distance between fibonacci numbers. If we use three numbers
from a simple fibonacci series (1,1,2,3,5,8,13,21,34,55…) you can see how this works in the
examples below.
1. (34-21)/34 = 38.2%
2. (34-21)/55 = 23.6%
3. (34-21)/21 = 61.8%
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 within this article I have a
few good example to show you why.
Typically you want to apply the
fibonacci anchor points to the major
highs and lows of the most significant
recent trend. In the chart below you
can see how this was applied to the
EUR/USD and the subsequent
resistance/support bounces that
coincided with those levels over the
next year
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?

I feel that support and resistance is more often an area around the Fibonacci lines
than a specific to-the-penny 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.
Learn to use fibonacci retracements to time trade entries and exits on bounces

In 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 article, 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. 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
January to June on the GBP/JPY.
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. 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% and 50%
retracement levels a few times. These each may have been great reentry opportunities
for a long position
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. You can see this detailed in the
chart below using the October bounce up from the 50% level. 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 next Fibonacci retracement level and beyond that the 0% line. If prices break this
level, you will need to reevaluate where you think the market will go. In the next section
in this series I will go into more detail about developing profit targets beyond the
bounds of the Fibonacci retracement. However, as an initial profit target the next
fibonacci level and the 0% line or top of the retracement is where I would expect to set
the two initial targets.

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. You can see this displayed in the chart below. Most traders use stop
losses to control risk, and that is what we would recommend to 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 thereby avoiding “whipsaws.” A whipsaw
occurs when the breakout is preceded first by a quick down move below your stop level.
To learn more about using call options as an alternative to stops, check out our options
section.
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
section of the Learning Markets website we cover the 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.

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. As news is
released or changes take place in the market you should reevaluate your trade. For
example, the GBP/JPY is very sensitive to oil prices. Should I remain long if oil prices
begin breaking out. 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.
Learn to use Fibonacci retracements to adjust stops and project price targets beyond
the initial trend

I’ve now discussed finding entry points, setting stops, and projecting initial profit targets
in the previous section. These are all important concepts but I find that it is 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. I will discuss a few ideas around these concepts with a case study detailed
below
1.A Fibonacci retracement was drawn from the top to the bottom of the trend based on
the most recent major highs and lows. Because the longer term trend was down, you
would have been looking for short opportunities.

2. Following the bottom prices rebounded to the 23.6% retracement level and then
bounced down to continue the trend (2). 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 23.6% and the 0% Fibonacci levels.
This would be placed in anticipation of the potential bounce down off resistance at the
23.6% level.

In the last section, 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, a stop order for risk control could 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.
At points 1-3 we talked about the initial trade setup and a whipsaw. 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 a re-entry how this trade
ultimately worked out.

4. The first whipsaw was bitter-sweet since prices quickly moved back below the 23.6%
retracement level, proving the analysis is correct and triggering another potential entry
(4). Ultimately, this opportunity was not stopped out and hit the initial price target of the
next fibonacci level (0%) within a few days.

5. Once prices followed the trend and hit the 0% line it triggers an opportunity to
reevaluate the stop loss. A good rule of thumb here is to move the stop down , 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 next 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, 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. You
can see that analysis on the chart
below.

This would have projected new fib

levels below the original price
range. The 161.8% retracement is
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.
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 the example in this article.
Using stops is great, but it leaves your risk control strategy incomplete if it’s the only thing
you are using to reduce account volatility. Diversification is another compelling way to
reduce market risk and improve returns. Used together these two tools can help smooth
your equity curve and make your trading less stressful.
Many traders will establish several uncorrelated positions and/or strategies at the same
time. This allows a trader to benefit from diversification without increasing trade
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 a
very short-term or day-trade.

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.
Learn to use Fibonacci fans to identify support and resistance within a trend

Fibonacci fans are very similar in concept to Fibonacci retracements and in many
ways they are used the same way. Both are effective tools for identifying support
and resistance levels, entries and exits, and stop and price target levels. Ultimately,
you may decide to only use the one that works best for your trading style and
analytical preferences or you may find that using them in combination may be more
useful.

How Fans and Retracements differ

1. Fans are more useful when a currency is trending, because the projected lines
follow the trend diagonally rather than horizontally on the charts.
2. Fans will often stay valid longer than a Fibonacci retracement analysis because the
can follow the trend.
 How Fibonacci Fans are Constructed
The fibonacci fan study is derived
from a right triangle. The two anchor
points are attached to the major
highs and lows of a particular trend
and the diagonal line between them
becomes the hypotenuse of the right
triangle. The base and the other leg
of the right triangle are not shown
on the chart but I have included
them as dashed lines in the image
below.
The diagonal fan lines are based on
the same ratios of 38.2%, 50% and
61.8% that were discussed in earlier
sections. They are drawn by drawing
three lines that start at the first
anchor point that intersect the
triangle’s leg at 38.2, 50 and 61.8%.
In the chart below you can see how
this would look if you could see that
vertical line drawn on the chart.
Each level of the Fibonacci fan acts as support and resistance line and is very useful
when the market is trending. As you can see in the weekly chart of the EUR/USD above,
the market recently paused at the 61.8% level. A bounce back up here could be a great
new long entry point.
The lines create candidate support areas during an uptrend and potential resistance
areas during a downtrend. We usually like to see a confirmed bounce before taking
action but the analysis helps us plan ahead for those technical areas that are likely to
become important.

How to draw Fans

The process for drawing Fibonacci fan lines is similar to Fibonacci retracements but
because they accommodate the trend, they may have to be adjusted less frequently.
First, identify the trend by anchoring the Fibonacci fan study to the major top and
bottom of the trend you are analyzing. In the example above, we used the top and
bottom of the 2009 rally in the EUR/USD.
Here are a few tips that will help you better understand how Fibonacci fans work, and
how you can begin experimenting with them in your own trading.
How to anchor Fans

Like a Fibonacci retracement

analysis, determining where the
tops and bottoms of the trend
are is somewhat subjective.
However, Fibonacci rays, like
retracements, can tolerate a fair
amount of variation as long as
you are picking significant highs
and lows.
Here is an example of the same
EUR/USD chart but rather than
anchoring the bottom of the
analysis with in March was
replaced with the major bottom
that occurred in November. As
you can see the fans lines were
still very helpful in identifying
December’s support level.
When to adjust the anchor points
Because fan lines are drawn to accommodate a trend you don’t “have” to move the
anchor points until the trend moves outside, either above or below, the range of those
lines. In the video we will look at a specific example of this kind of situation. Quite
often the study will stay intact as long as the trend itself lasts.

Entry points and profit targets

The distance between fan lines becomes wider the further the trend extends. Be aware
that this makes developing a consistent rule of thumb for entry points and profit
targets more difficult than it is for Fibonacci retracements.

Don’t get too steep

Not every analytical method will work in every situation. Very steep trends are not very
conducive to this kind of analysis. In the video you will see the affects of this problem
when the trend used to anchor the Fibonacci fan study was a result of a very fast
moving market.
In these situations the market almost immediately moves outside the range of the
Fibonacci fan study and limits its usefulness. Alternatively, very fast trends or
corrections can be ideal situations for a Fibonacci retracement study to find potential
areas of support or resistance.