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 series we 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.
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%
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 we will talk 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 we would expect to set our two initial targets.
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 detail 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.
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.
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.
I’ve now discussed finding entry points, setting stops, and projecting initial profit targets in the previous lesson. 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 lesson, 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.
In this example, prices bounced off the 23.6% retracement level and looked like the trend would continue but then backed up and would be been stopped out at the intitial stop loss point (3). This is not an infrequent occurrence within any trading system.
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.
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 teh 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.
EUR/USD Weekly 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.
EUR/USD Weekly Chart
Other things to consider
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.
Fibonacci Time Series
Fibonacci analysis can be enhanced by using time projections. Fibonacci time forecasts are applied to a chart like other Fibonacci studies, and work best when combined with either a retracement or fan study.
When you are in a trade, the time study will help you watch for levels at which reversals are likely to occur. When you are looking for new trade opportunities with a retracement or fan study, the time forecast can even be used to add to the probability of a successful outcome.
Time forecasts also add weight to potential support or resistance levels, and help identify when a bounce or change of trend could appear. Knowing where and when you may want to pay the most attention to your analysis is a great way to optimize your trading efforts.
A time forecast uses the Fibonacci number series (1,1,2,3,5,8,13,21…) to identify potential “areas of interest” in the future. They are applied very easily to a chart at a significant price bottom or top. Usually it is applied at the same price point you would have used for the first or second anchor point of a Fibonacci retracement or fan study.
How it works
In the chart below you can see a time projection anchored to the major bottom of the trend in the USD/JPY.
Usually, you should ignore the first five very closely clustered vertical lines as noise (I will explain why in the video) and you will start paying attention to the wider spaced 6, 7, 8 and 9 lines. There are lines beyond that, but they begin trending out so far into the future that you will probably have updated your analysis by then.
As you can see, the time study below identified some likely volatility “nodes” where reversals may have been expected. In this case, the study proved accurate in the timing of three reversals.
USD/JPY Daily Chart
Combining the Fibonacci time projection with a Fibonacci retracement can help clarify the signals and make them more reliable. In the next chart I have left the time projection at the same point on the USD/JPY but have layered a Fibonacci retracement anchored to the prior downward trend. The chart is getting a little crowded but with a little practice it isn’t too difficult to see the signals.
USD/JPY Daily Chart
The time study coincided coincided with several of the retracement levels on the chart. Because neither study uses historical data in the same way a traditional technical indicator does you are not necessarily adding any lag to your entries or exits by using them together.
The advantage provided by the time projection in this case study was that it let me know, in advance, when I should be paying the most attention to a potential support bounce. Expanding your chart to the right will show you the future time study levels so you can make sure you are paying attention on those dates specifically.
How to draw time projection studies
We recommend that the Fibonacci time projection be applied in combination with a retracement or fan study. The time projection should be attached to a major top or bottom in the trend just like you would with other fibonacci studies. Because the time projection lines or intervals are fixed, a second anchor point is not usually required.
Ignore the first 5 intervals
Because the time projection is based on the Fibonacci number series the first interval will be drawn one candle away from the anchor, the second interval will also be one candle beyond the first one, the third will be 2 candles away from the second interval, the fourth interval will be 3 candles from the third, the fifth interval will be 5 candles away from the fourth and so on… (1,1,2,3,5,8,13…)
The point behind this explanation is not only so you will understand how the Fibonacci time study is drawn but also so you can see that the first few intervals are not much more than static. Save yourself some effort and feel free to ignore them. The sixth interval is where you should being your analysis.
Planning a trade
You should design your trade in the same way you would when using a Fibonacci retracement. Do not take more risk than you might normally, as trading is all about consistency and it is bad practice to radically change your position size from trade to trade.
Time projections and risk
As with all Fibonacci studies, time projections can be a good warning that the current trend could be disrupted. It does not mean that you have to get out of your trade just because a time projection interval appears, but it may be a great time to be more conservative in your risk control.
Variations in charting packages
At PFX we make sure we have access to most of the popular charting packages and in almost all cases, Fibonacci time projections are drawn the same way. However, there are a couple of charting programs in which the programmers have misunderstood what a time study is and how it is used.
This is not an uncommon problem with other indicators as well. The end result is that they will not project into the future but only cover the past. You can tweak them a little to get a good forecast into the future but if you find this tool useful for your own analysis you can find plenty of alternatives that will correctly display the information.