Fibonacci For The Intermediate-Term Trader
Believers in the efficient market hypothesis scoff at the idea that chart
patterns can give anyone a winning edge over the market. Successful technical
traders know otherwise. From the inventors of Japanese candlesticks centuries ago to great chartists today like David Ryan and Mark Minervini, patterns have served as an effective mechanism to time trades.
Whatever you think about why
technical analysis works, the fact remains that it works! Traders don’t fret about why.
Instead, we concern ourselves with the practical task of making money off useful patterns while using money management to control our losses and risk. Theory can be fun, but let’s save it for fighting over beers with the efficient-market sissies!
Some pattern traders, however, can act
like arrogant boneheads, too. For example, many
chartists dismiss out of hand the use of Fibonacci ratios to time trades. In part, this is because many
self-styled Fibonacci educators have only a superficial understanding of how to
use this mathematical tool to trade, and have turned out complete junk as a
result. However, just as there are bad Fib materials, there are bad chart-analysis books as well.
Meanwhile, sophisticated pattern traders like Kevin
Haggerty include Fibs in their trading. It’s worth noting as well that Jesse Livermore,
arguably the greatest trader of the 20th century and inventor of pivotal points, group work, leadership stocks and many other tactics in today’s intermediate-term trading arsenal,
discovered and used Fibonacci-like ratios. Richard
Smitten, author of The
Amazing Life of Jesse Livermore, shared this biographical nugget in a
conversation with Loren Fleckenstein in February 2001.
Even if you don’t trade off Fib numbers as a primary signal, they can come in handy for the intermediate-term trader as a means of confirming pivotal points and subsequent levels of resistance, as you carry a position in the weeks ahead. We’ll explore this idea in this special report.
The mathematician Leonardo Pisano
(1170-1250) is best known to posterity by his nickname, Fibonacci. (He also liked going
by the name “Bigollo,” which may have meant “wandering good-for-nothing.”)
Our greatest debt to Fibonacci goes to his famous book, Liber abaci
(1202), which introduced the Hindu-Arabic place-valued decimal system and Arabic numbers into Europe. In Liber abaci, Fibonacci also described problems which laid out what we now call the Fibonacci summation sequence and
ratios derived from it. The Fibonacci sequence emerges from the resolution of one of the problems in the text:
If one places a rabbit couple in an enclosed place, how many rabbits would one obtain after a certain time assuming they reproduce once per month, and that those born can reproduce at the age of a month?
The following infinite progression results: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144 … after each month. For you party animals out there, here’s the formula for this progression:
F(n+2) = F(n+1) + F(n)
Starting with the number 5, by dividing each number in the sequence by its predecessor, one obtains the ratio 1.618, one of the key ratios used by Fibonacci traders. Dividing a series elememt by its successor yields approximately 0.618, another key Fib ratio.
For further information on Fib numbers, see Carolyn Boroden’s lessons in the futures education section of TradingMarkets. Suffice it here to say, Fib proportions occur throughout nature, from spiral galaxies to
sea shells, and in human art, geometry and artifacts, such as the Christian
crucifix, the pentagram, Pythagorean triangles, the works of Leonardo da Vinci and Michael Angelo. For our
purposes, Fibonacci ratios frequently crop up at key junctures in the financial markets. Here’s a portrait of old
Good-for-Nothing.
Leonardo Pisano (Fibonacci)
Key
price levels based on just one or two Fibonacci ratios have little validity. However, in her research and real-world trading, Carolyn Boroden has demonstrated that when three or more Fib-derived price levels “cluster” close
together, such price zones often coincide with meaningful resistance and support. This valuable insight forms this basis of her Fibonacci cluster technique.
How you exploit this knowledge depends on your overall trading strategy. Subscribers to Carolyn’s Fibonacci service, for instance, have their own individual
trading styles and have found a wide variety of uses for Fib-generated price levels over different timeframes and financial instruments.
This article will show the intermediate-term trader simple examples of how Fibonacci clusters can be used to help confirm breakouts from classic chart patterns favored by Loren Fleckenstein. Beginning
intermediate-term traders are well advised not to incorporate new, exotic elements like Fib ratios into their work until they have established successful track records. Don’t feel forced to change a successful trading method.
Carolyn typically uses her Fibonacci clusters play anticipated reversals for trading the QQQ’s as well as a variety of futures contracts. Intermediate-term momentum traders trade common stocks and play
breakouts rather than reversals. In other words, they look for the resumptions
of price trends rather than reversals of
trends. As an I-T trader, Loren has found Carolyn’s Fib-derived resistance areas
useful to corroborate possible pivotal points that he uses to
detect breakouts. Loren will still trade a valid-looking breakout even without
such confirmation. However, the presence of Fibonacci clusters close to a pivotal
point can provide him with an additional level confidence as he pre-sets his entry
points for prospective trades.
A warning to the wise, though. Confidence does not equate certainty. As traders, we seek out the highest probability setups, but any trade can turn against you. All stocks are risky. In
any new trade, curtail your risk by limiting your position size and setting a
protective price stop where you will exit in
case the market turns against you. For an introduction to combining price stops
with position sizing, see Loren Fleckenstein’s lesson,
Risky Business.
The co-authors of this article decided
to try an experiment. Loren shared with Carolyn several
picture-perfect pattern breakouts that produced superb medium-term moves, and asked her whether her Fibonacci clusters showed up in the patterns. The results proved quite interesting. In many cases,
Loren’s initial entry points coincided with Fibonacci clusters. Carolyn also
identified Fib clusters just beyond breakout points which a trader could use to
verify that a nascent move was following through in the direction of the trade.
Our little experiment suggests that the chartist’s visual
approach and the Fib trader’s mathematical approach at times often lead them to
similar findings of resistance and support. This might come as a surprise only because the Western mind-set tends to divide
things into artificial categories. As a result of this contrivance, we often regard artistic and mathematical talents as unrelated. However, some scholars have noted how these two
approaches often uncover the same truths. In The
Mathematical Basis of the Arts (1956), Joseph Schillinger posited the
notion that great artists derive their talent from an innate sense of
mathematical proportion. Fibonacci-inspired proportions and rhythms, Schillinger
contended, appear in the works of such masters as Bach, da Vinci and Keats.
OK, enough philosophy! Back to the
markets and trading.
If you are unfamiliar with how
Fibonacci numbers are derived and how Carolyn uses them in her high-probability
cluster zones, you should read the tutorial on the Carolyn
Boroden page in Trading Subscriptions.com. Once you’re on the page, scroll down to the link
to the tutorial file. Although intended for clients who
subscribe to her service, the tutorial
shares plenty of valuable education for free, to anyone interested in this trading
method. In particularl, you will need to understand the concepts on Carolyn’s
Fibonacci projections and extensions
before proceeding further in this lesson. You also should study Carolyn’s work
on Fibonacci retracements. More lessons by
Carolyn are available in the Futures education section of TradingMarkets.com.
Now let’s examine two breakouts,
Sawtek
(
SAWS |
Quote |
Chart |
News |
PowerRating) in 1999 and Metro One Telecommunications
(
MTON |
Quote |
Chart |
News |
PowerRating) in 2001.
The following chart shows a breakout
from a type of long or flattish base by Sawtek in 1999. The top field of this
chart uses a logarithmic price scale and displays a 50-day price average in
red. In the second field, a
blue relative strength line represents the displayed security’s price
performance relative to the S&P 500. The third field displays vertical daily
volume bars in black, with a 50-day moving average in blue for volume.
As you can see, Sawtek was in a strong
uptrend until peaking on April 13, 1999. Thereafter, the stock corrected,
bounced off support in mid-April, then proceeded to recover. On subsequent
pullbacks within the base, the stock marked a series of progressively higher
lows while respecting the April 13 peak as a resistance level. This kind of
progressive tightening can indicate a bullish formation. Also note the healthy support above the 50-day moving average line (in red).
As the stock moved sideways above
support at 20, volume dried up. This kind of elongated action on low volume
within the base wears out the weak holders, while suggesting the strong holders
are sitting tight. The breakout came on July 8 with an increase in volume over
the prior sessions, as well as average daily volume. The relative strength
confirmed the price breakout by moving into new high ground.
Now let’s take a closer look. This
next chart shows the progression of higher lows on April 20, May 19 and June 14
prior to the July 8 breakout. Normally, a trader would use the pre-correction
peak (in this case, on April 13) as the key for the pivot point to signal an
entry. However, you also could have used the handle-like high on June 18 as a
key for a slightly earlier entry. The volume expansion on the breakout day shows
up clearly, in contrast to the prior volume contraction.
If you had used the April 13 peak as
your entry key, the buy signal would have come once the stock had exceeded the
April 13 peak by 1/8 point: 23.625 + .125 = 23.75. You would enter at that price,
or within 3% of that price. If you had used the June 18 high of 23.5 as your
key, you would enter at 23.625, up to 3% above that price level.
Analyzing the Sawtek breakout and its
prior chart pattern, Carolyn identified four Fib levels clustered closely
together between 22.81 and 23.65. This grouping of Fibonacci levels, coming so
close to the classic intermediate-trading pivotal points of 23.75 and 23.625 described above,
added greater credence to those entry thresholds.
The following chart shows how those
Fib levels were calculated. Note that the chart uses a linear (or arithmetic)
price scale. The price ranges for the extensions are lined in black, for the
projections in red. The upper and lower borders of the Fib-derived resistance
areas are defined with a black rectangle.
Extensions:
The price range from the May 13 high
to the May 19 low extended to a 1.618 extension of 22.81.
The price range from the June 4 high
to the June 14 low extended to a 1.272 extension of 23.64.
Projections:
The
price range from the April 20 low to the May 13 high, projected from the May 19
low, gave us a 1.272 projection of 23.65.
The price range from the June 14 low
to the June 18 high, projected from the June 24 low, gave us a 1.00 projection
of 23.87.
Another potential Fib application for
intermediate-term pattern traders deals with follow through. Once you’ve entered a successful
breakout trade, you can look for the presence of Fib-derived resistance areas,
above and beyond your pivotal point and/or the top of the prior base. Assuming
you’re long a stock, your stock’s ability to push through such hypothetical
resistance can be a positive sign. For an example of this scenario, let’s look
at Metro One Telecommunications.
As you can see in the next chart,
Metro One was in a strong uptrend when the stock peaked on Jan. 31, 2001,
corrected, recovered, completed a cup-with-handle-like pattern and broke out on
April 18 on a huge volume expansion with RS line confirmation.
Depending on where you identified the
beginning of the “handle” or “platform,” the classic pivotal
point would have been at 35.25 (a rounded sum of the March 27 high plus 1/8) or
34.875 (a rounded sum of the April 11 high plus 1/8). Here’s a closer look at
the pattern.
Subsequent to the breakout on April
18, Metro One shares ran into a bit of turbulence above the base, a normal
phenomenon, as some shareholders consider the move to new high ground as a
prudent time to take profits. The intermediate-term momentum trader, however,
seeks to hold through these bouts of volatility, in hope of catching an extended
run into new high ground. Carolyn’s Fib work identified a four-price Fibonacci
cluster suggesting a resistance zone between 39.58 and 40.75.
As you can see in the next chart, the
stock whipped around that area in the last week of April and the first week of
May, then punched through
successfully.
Extensions:
The price range from the Jan. 31 high
to the Feb. 21 low extended to a 1.272 extension of 39.58.
The price range from the March 27 high
to the April 6 low extended to a 1.618 extension of 40.71.
Projections:
The price range from the Feb. 21 low
to the March 27 high, projected from the April 6 low, gave us a 1.00 projection
of 40.68.
The price range from the Nov. 29 low
to the Jan. 31 high, projected from the Feb. 21 low, gave us a 1.00 projection
of 40.75.
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