Today’s Trading Lesson From TradingMarkets

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How I Use Fibonacci to Identify Key Support and Resistance Levels

By Carolyn


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

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

Sometimes I also use
.236, 2.618 and
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.

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. 


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
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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