Fibonacci combines well with other strategies, such as technical price pattern analysis. Typical price patterns in which the Fibonacci expansion tool is particularly useful are continuation strategies such as bull flags, triangles, ABCD patterns, etc. When the momentum of a price move breaking out of these periods of congestion is comparable to the impulse wave heading into them, Fibonacci expansion is most useful. These patterns can create a great deal of choppiness, however, before a breakout occurs. This can lead traders to question whether or not their anchor points are placed properly.
In the E-mini Dow trade, we look at two different price points that were used for the third anchor in the Fibonacci expansion. In the first chart in “Expanding opportunity,” you will find the most commonly used third anchor: The low of the trading channel. The 100% expansion of this move meant that the primary target would have been 15,249. Instead, the breakout move took the YM into the 138.2% expansion zone of 15,294.
There are several reasons for this larger price move on this particular breakout. First, the Dow congestion held within the middle of the original impulse wave of buying. This created stronger resistance at the prior highs, which you will note corresponded to the 61.8% Fibonacci expansion level in the first chart. Second, once those highs broke, the pace of the buying was much stronger than the original impulse wave. When this is the case, it is more common for the breakout move to aim for higher expansion levels than 100%.
Alternately, if the breakout move had been slower than the original impulse wave, it may have been necessary to adjust for a lower Fibonacci target, such as the 61.8% level that paused the original breakout.
The second chart includes an alternate Fibonacci expansion based upon using the last low in the tightest portion of the congestion as the third anchor point. While the absolute low is the most common third anchor, often a 100% expansion target based upon this last pivot low tends to hold most often when the pace of a breakout move is similar to the pace or momentum of the impulse move. This meant that 15,270 would be the most common target going into a position such as this one.
Notice, however, that a number of the Fibonacci resistance levels that result from using the last low within the congestion itself as the third anchor point are almost identical to those in the first chart. The only difference is the percentage label attached to each level. The 38.2%, 76.4% and 123.6% Fibonacci expansions in the second chart are each within a few ticks of the 61.8%, 100% and 138.2% Fibonacci expansion levels in the first chart. Either method would have yielded comparable price points as targets. While the increased momentum on the breakout allowed the Dow futures to push past the typical 100% expansion target, using the Fibonacci expansion tool demonstrated that we were working with the next target zone, removing some guesswork from the trade.
While Fibonacci expansion is an excellent tool to help traders visualize target points on continuation strategies, other popular Fibonacci tools, such as retracements and fans, offer traders a similar edge. The particular tool varies depending upon the type of strategy being traded and whether or not you are timing an entry or exit. Regardless, if you want to improve your trading and build consistency in your models, Fibonacci expansion is a solid tool to have.
Toni Hansen is president and co-founder of the Bastiat Group, Inc., DBA Trading From Main Street. She can be reached through her website www.tonihansen.com.