Tuesday, January 17, 2012

Correct Way To Properly Draw Fibonacci Retracements

This is almost never explained precisely or correctly so I will provide a precise howto that illustrates which end goes at the top and bottom of an uptrend and downtrend so that you draw the fib retracement in the right direction (not backwords) for meaningful technical analysis.

How to draw Fibonacci Levels in Metatrader:
(This is in Metatrader (mt4) but most other terminals are practically the same)
This part is as simple as pedaling a bike but don't worry it gets more complicated.

I personally use metatrader to do this so that will be our model. The tool should be part of the "line studies" toolbar in mt4 - if not you have to add it by clicking customize and insert. With your line studies toolbar is enabled, click on Fibonacci Retracement, and simply place it to the chart you are using. You may have to also double click it to stretch it.



Placement
The big idea is to find a big movement to measure which can be subjective to the traders eye but in general you want a pretty good chunk of data (a trend) that actually measures the correct starting point of the trend in question (the top of a downtrend or the bottom of an uptrend is the starting point). The end point might still be forming so that is the hard part. You basically use swing points (high to low or low to high) of the movement to draw your extensions.

If you are measuring a downtrend the top (swing high) will be the 100% and the bottom (swing low) will be 0%. If you are measuring a uptrend the bottom (swing low) is the 100% and the top (swing high) is 0%. In otherwords you are always chasing 0% in the direction of the trend and 100% is the starting point.

Finding a top or bottom
It takes participation to find a good retracement and this is subjective to every technician but I'll tell you my own method. You have to continually redraw the extension - because as mentioned you never know exactly where the top or bottom will actually occur unless you are a high profile fortune teller that sees in the future and thus wouldn't need technical analysis at all. So with that said - keep drawing extensions until there's a reaction to a retracement to the 1st Fibonacci level 23.6% and then interpret the pattern at that point with other confirmations (eg is volume picking up? ect).

Interpretation (add more detail)
The key Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8% and 100%. These lines
are simply ratios between two extreme points of a high and a low. The 50% level actually does not have anything to do with Fibonacci, but traders use this level because of the tendency of reversals after retracing half of the previous move. The 50% was added by Dow Theory's. Basically the ratios act as either support or resistance levels.

The 61.8% is considered the golden ratio but my advice is to simply use all levels as support and resistance points to confirm with other indicators such as volume.

Example: If there is strong move but the move starts to loose it's steam. Lets say it's a downtrend and the sellers reduce their position so you draw a fibo extension from the swing high (100%) to the swing low (0%). There is a pullback to approximately the 38.2% and the sell off continues there with selling volume coming into play. What that means is the majority of sellers may have reduced their position by about 38% - the amount of the correction. Or perhaps it retraces to the 50% area and the sell off continues there because the sellers perhaps reduced half of their position (the amount of the bounce you see) and then new sellers came back in at the proximity of the "retracement level" if the trend is strong. If it breaks the 50% perhaps the sellers are not only reducing their position but the pattern may be reversing since resistance is not working.

Retracements are really not meant to be stand alone. They work well with other strategies combined (also called confluence see my article in blog archive). Many sophisticated traders will often combine Elliot Wave Theory, volume analysis, or other strategies with Fibo Retracements. It's just a way of finding weakness in a trading pattern of confirming it's strength instead of a stand alone magic trick. In live trading you need to confirm with other trading tricks especially when you have real money on the table.

In Action:

In an Uptrend:


Here a Fibonacci Retracement manually drawn between a low and a high in a short-term uptrend on a hourly chart for a currency pair. Price falls through the 23.6% and firms up at roughly the 38.2% providing a re-entry point for a long. Notice the candle pattern stays bearish here into the 38.2% - that is ideal. Then candles clearly firm up at the 38.2% which acts as strong support. The implication is that the trend will continue and perhaps set a new high.



Another clear example of a bounce that occurs at ruffly the 38.2% which acts as support because it's an uptrend. There is also some confluence with the 50ema which is considered a key moving average.

Did you notice something? Compare it to the example above. It is the same instrument at a different date. The previous bounce at 38.2% made a new high so this is actually a new fib retracement but it's still in an uptrend and the 38.2% once again turned out to be the buying point.

In fact if you zoom in on each example the only difference is the first Fibonacci retracement is drawn from January 13th 2012 to January 17th 2012 and the 2nd example is drawn from January 24th 2012 to January 26th 2012. That is the power of both a strong uptrend and Fibonacci. Does it work? What's it look like?

In a Downtrend:

Here a fib retracement is drawn from swing high to swing low because it's measuring a downtrend. The bounce occurs at ruffly the 38.2% and the 50ema. Again the fib levels are merely support and resistance points. In the case of a downtrend the 38.2% is resistance.

What can Fibonacci Retracements work on?
Everything that has price data: Bonds, Stocks (Google, Apple, IBM, Dow Jones Index), Currency Pairs/FOREX (aud/usd, gpy/jpy, usd/jpy, usd/chf), Options, Commodities(gold, silver, copper, wheat, sugar, coffee, crude oil), ect.


Historically
The history of Fibonacci dates back to when Leonardo Fibonacci (12th Century Italian Mathematician) was studying the construction of the pyramids and wrote about what he learned in a book called Liber Abaci (Book of Abacus or Book of Calculation).


The number pattern seemed to be found everywhere - even in nature.

Liber Abaci proposed and solved a problem involving the growth of a population of rabbits based on idealized assumptions. The solution, generation by generation, was a sequence of numbers later known as Fibonacci numbers. The number sequence was known to Indian mathematicians as early as the 6th century, but it was Fibonacci's Liber Abaci that introduced it to the West.

In the Fibonacci sequence of numbers, each number is the sum of the previous two numbers, starting with 0 and 1. This sequence begins 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987 ..

The higher up in the sequence, the closer two consecutive "Fibonacci numbers" of the sequence divided by each other will approach the golden ratio (approximately 1 : 1.618 or 0.618 : 1).

When used in technical analysis, the golden ratio is typically translated into three percentages: 38.2%, 50% and 61.8%. However, more multiples can be used when needed, such as 23.6%, 161.8%, 423% and so on.

The primary methods for applying the Fibonacci sequence to finance:
retracements / extensions
arcs
fans
time zones

By Neal Vanderstelt
Forex Trader, Market Analyst, Trading System Designer

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8 comments:

  1. Thx this help alot. It would be great if you could mention and show example how to use the Fibonacci arcs, fans and timezones..

    ReplyDelete
  2. Hey! I just wanted to remark the fact that you actually succeeded in customizing a cool domain. And there is also one thing I would like to ask you. Do you plan to write in a professional way or your blog is a hobby?

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  3. nice article. thank you.

    ReplyDelete
  4. Is fib better than self drawn resistance and support? I'm kind of having a hard time right now I'm still new on this, I thought the 61.8 is the tough Resistance/Support but then why does the trend keep on surpassing it?? Am I doing the Fib wrong? I placed it on the highest and the lowest swing that should do it right?

    ReplyDelete
    Replies
    1. Fibonacci is used in combination with traditionally drawn support and resistance levels. When a Fibonacci level agrees with support or resistance drawn at pivot points you get confirmation that the level is important.

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