From the February 2014 issue of Futures Magazine • Subscribe!

Fibonacci expansion: A better way to time price targets

Identifying turning points in the market can be a daunting task. If you are already in a position, it’s easy to let your emotions take over and throw your larger goal out the window in favor of smaller, more immediate returns. Often, this is the wrong approach and you will stand on the sidelines as prices continue to rise or fall in accordance with your initial bias as you mentally slap yourself for your lack of discipline.

When your instincts are telling you that the odds are in your favor, why is it so difficult to just stay the course? For most, the reason boils down to confidence. While the seeds of confidence are often sown in instinct, it is reason that nurtures your ability to trust those instincts.

The greatest key to building confidence and hanging onto winning positions longer is to have a solid target and exit strategy in place before initiating a trade. The majority of traders try to improve their odds of correctly identifying these targets through the use of indicators. Most indicators, however, are only as good as the trader using them and correct applications and interpretations can take years to master.

A disconcerting fact for those studying market indicators is that there are relatively few that can assist in all aspects of trade management. One exception is a form of market analysis that we know today simply by the name of the author who is credited for introducing the system’s underlying numerical sequence to the West: Fibonacci.

Sweet sequence

Fibonacci indicators that have become popular in technical analysis today are based upon ratios that are derived from the numbers that make up the “Fibonacci sequence.” This sequence is the result of adding each new number to the one that precedes it, beginning with 0 and 1. For example: 0+1=1, 1+1=2, 1+2=3, 2+3=5, 3+5=8, etc.

After the first several numbers, an interesting symmetry begins to develop. For example, from 13 onward, every time you divide a number by the one to the right of it, the result is 0.618. When you divide a number by the one two places to the right, the result is 0.382. These numbers are converted by market analysts into 61.8% and 38.2% respectively.

The significance of the Fibonacci numbers and resulting ratios is a topic that has been debated widely over the years. While scholars argue the veracity of many claims that Fibonacci is part of the underlying fabric of natural design, in the financial markets it is the skeptics that often take a back seat. Support and resistance levels based on Fibonacci numbers and ratios hold remarkably well when applied to chart analysis. This is true especially for forex and futures markets and in individual, high-volatility securities.

There are numerous applications for Fibonacci ratios in technical analysis. Among the most popular are Fibonacci retracement levels, price and time extensions and Fibonacci fans. While these tools transcend markets, they also transcend time frames and are viable for traders and investors alike.

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