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

It’s not witchcraft, it’s Fibonacci

Fibonacci numbers are almost as familiar to traders as they are to mathematicians, but they have not been used as effectively in the markets. In many ways, this failure to fully utilize Fibonacci analysis is because of a focus on its application with respect to support and resistance, where it is less effective.

Instead, there are ways to use Fibonacci’s measures of price retracement to peer into price action and better understand the strength of a price move. Employing this practical application of Fibonacci retracements can complement a trading approach as well as serve as a standalone method for identifying pullback entries. 

Another powerful aspect of Fibonacci trading is that retracement levels are robust. They can be used in day-trading, swing trading and investing in all markets: Grains, forex, stocks, Treasuries and other commodities. Their measurements are relative and adjust to whatever market and time frame you are using.

A reliable set of guidelines will define the characteristics of key retracement levels so that they offer a practical way to gauge where price is likely to rise and where it is likely to fall. Based on those terms, any price reaction at these levels can help you determine profit targets and areas where caution is advised because of possible weakness. We’ll demonstrate some of these techniques using a grain-based exchange-traded fund (ETF) and equity ETFs; however, these methods are applicable across markets. 

Voodoo & prophecy

In its most basic form, a retracement is a price move in the opposite direction of the most recent price move.

Price does not magically reverse at Fibonacci retracement levels and these points are not the Holy Grail of trading. Instead, they are a signpost for a possible destination that acts as a guide for price movement. A lot of things can happen on price’s journey, but Fibonacci helps point its likely path (see “Corn pullback,” below).

While some investors look at Fibonacci numbers as the equivalent of reading tea leaves or fortune telling, the reality is that they have their place in a skilled trader’s arsenal of technical analysis. If for no other reason, Fibonacci levels deserve attention because they are so popular among traders. Like a self-fulfilling prophecy, when price scales back, many institutional and retail traders alike take notice of where price is in relation to the Fibonacci retracements.

However, while it’s important to be aware of Fibonacci levels, it is vital that you view and apply them differently than the vast majority of traders.

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