How I Use Fibonacci To Identify Key Support And Resistance Levels
The definition of synchronicity is
meaningful coincidence. In the methodology I use to trade and advise
clients, I look for the “meaningful coincidence†of price parameters and
time parameters that are projected using the ratios derived from the Fibonacci
number series.
These coincidences help me to define
low-risk high-probability trading setups.
In this first tutorial, we are going to
start with how we apply these ratios to price levels.
First, let’s look at the Fibonacci
number series.
Number Series:
0,1,1,2,3,5,8,13,21,34,55,89,144,233,
etc.
This series starts with zero and one
and goes on to infinity by adding the prior two numbers to get the next number in
the series. Thus:
0 + 1 = 1
1 + 1 = 2
1 + 2 = 3
2 + 3 = 5
3 + 5 = 8
and so forth…
As you move further out in the
series, the constant that is found when you divide one number by the next is the
ratio of .618 or what is commonly known as the “golden ratio.”
For example, 144 divided by 233 is .618.
This ratio, and others derived from it,
is actually what I use to analyze the market.
You may be wondering what in the world
is the significance of these ratios? Well, we won’t get into that here because
we can get into some rather lengthy discussions. What is most important about
these ratios is not where they come from and why they work…but the fact that
they continually show up in both nature and the marketplace.
The ratios that I have found work best
in my analysis are:
.382, .50, .618, .786,
100, 1.272
and
1.618
Sometimes I also use .236,
2.618 and 4.236 when appropriate.
There are three types of price
calculations we make from the key highs and lows in a particular market. These
are price retracements, price extensions and price
projections
or objectives.
We make these projections to identify potential
price support and resistance. We pay special attention to an area or price
zone when we see the coincidence of at least three or more price relationships come
together within a relatively tight range. This is called a price cluster. If you
were to learn only how to use price clusters effectively, you will greatly
improve your trading. Please understand that this type of analysis is not
stand-alone. It’s capable of giving you some great results, but you must look
for patterns to set up and confirmatory price action at these price clusters
before there is a trading opportunity.
(The following chart examples were
done on a 60-minute soybean chart of the November 2000 contract (SX0))
This methodology can be applied to both stocks and
futures and all time frames therein. It works very well in all
liquid stocks, stock indexes and commodities with adequate price history.
Retracements: Price
retracements are calculated by measuring prior highs to lows or lows to highs
and then determining the Fibonacci ratio retracements of this range. The ratios most often
used for retracements are .382, .50, .618 and .786.
In the following example, we measured the 446 low to the 515 1/2 high and ran
all the price retracements from that low to high swing. This showed us
potential support at 489, 480 3/4, 472 1/2
and 460 3/4, which coincided with the .382, .50, .618 and .786 retracements.
Extensions: Price extensions are essentially retracements
that extend beyond 100%. Again, we
are measuring prior highs to lows or lows to highs and then making the
projections with the appropriate ratios. For price extensions, we are most often
using the ratios of 1.272 and 1.618. Occasionally, we will use
2.618 and 4.236. In the following example, we measured the
488 low to the 508 1/2 high and came up with our price extension levels of 482
1/2 and then 475 1/2, coinciding with the 1.272 and 1.618 extensions.
Price Objectives or Projections: Price
objectives or projections are always calculated from three different price
points in order to compare swings of the same degree and in the same direction.
The ratios most often used for these projections are .618, 100 and 1.618.
Here we would measure a swing high to a low (or a low to a high) and then project
the ratios from the third point.
In the following example, we measured the
swing from the 515 1/2 high to the 488 low (27 1/2 cents). We then project
rations calculated from this swing from the 508 1/2 swing high. To
calculate the ratios, we multiplied 27 1/2 cents by .618, 1.0 and 1.618, which
equals 17, 27 1/2 and 44 1/2 cents, respectively. We then then projected these
results from the swing high by subtracting from 508 1/2 (for example: 508
1/2 – 17 cents = 491 1/2, or the .618 price projection). This gives us price
projections of
491 1/2, 481 and 464.
So now that we have all these price
calculations and levels all over the chart…which ones do we use to take a
trade against?
Here are my preliminary criteria for
determining whether I have a trade worth considering.
1) Clustering of levels (price-cluster
zone coincidence of three or more Fibonacci price relationships within a
relatively tight range).
2) Qualification via timing
parameters (I see a time relationship coinciding with the price
relationship–I will teach you about this in an upcoming lesson).
3) Analysis of a higher time-frame level agrees with the analysis at the
lower-time frame.
For those reading this article, I
suggest you go further. Look for chart patterns and other technical indicators
to confirm the projected support or resistance levels.
Now let’s look at
this strategy in action…
Notice that in the above examples
there was a confluence of price relationships that came in between 480
3/4 and 482 1/2. There was a 50% retracement at the 480 3/4 level, there was
a 1.272 price-extension level that came in at the 482 1/2 level and there was a 100%
price-projection level which came in at 481. This represents a clustering
of price levels.
In the following chart, we can see
that this “confluence” or cluster
of price relationships within this zone put in a healthy low in the November
soybean contract. The actual low was made at 482 and the rally that
followed took this contract to 502 3/4 within a week and a half.
Note that this is an example of the first
and most powerful way we qualify the Fibonacci price relationships we
use for trading. The other methods will be discussed in a future lesson.
:)
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