From the March 01, 2012 issue of Futures Magazine • Subscribe!

Fibonacci: Trading the numbers game

Applying Fibonacci

Of course, theory means nothing without application. There are ways we can put Fibonacci’s lessons to work for us.

Perhaps first and foremost is identifying Fibonacci retracements. These work best as an intermediate- to long-term forecasting tool. One of the textbook examples you will see is in the SPX covering the period from the bottom of the bear market in 2009 through the low in October 2011 (see “Back for more,” below). The first phase of the bull peaked in April 2010 and retraced approximately 38.2% of the move, which bottomed in July 2010. The bull resumed to May 2011 where it pulled back throughout the summer and found a trading low in October 2011, very close to the 38% retracement of the larger move once again.

An important point to consider is that while many traders are looking for perfection and precision, the reality is that many times the retracement will be close to the ideal but overshoot or undershoot the target by a modest amount. Also, the Fibonacci retracement analysis will be more reliable if it lines up with another universal methodology, such as Andrews’ pitchfork channels (see “Andrews’ pitchforks and the price failure rule,” June 2011).

The market doesn’t ring a bell at highs or lows, but does provide a hint in terms of various clues. The degree of the retracement is the market’s way of playing its hand. A 38% retracement is considered a minimum correction and in an unscientific study (observation and not statistical), it has been evident dating back to the Great Depression. In instances where the Dow pulls back 38% on a weekly time frame, odds are enhanced greatly that the market at least will touch the prior high. No other retracement level comes close in reliability.

A 61% retracement portends overall weakness to the main trend, but it has value as a trading leg. In fact, many traders use the Gartley trading method, devised by H.M. Gartley, which looks for an A-B-C pattern that places stops going at the 61% retracement. After a 61% retracement of the main trend, it is not a requirement that the pattern make a new high beyond the old low for the trader to be consistently profitable using that method.

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