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Last week, in my inaugural newsletter for Online Trading Academy, we discussed the results of a recent academic study of Fibonacci retracements and their use in various trading markets. Today, I'd like to present some tips on the effective use of this trading tool in the Forex market.
Let's revisit our two Fibonacci chart examples from last week, both to see how they've progressed and to view them within the context of today's discussion. Please note that both charts are of the daily time frame, and in both cases commonly used retracement levels are applied.
First, let's look at last week's AUD/JPY (Australian Dollar/Japanese Yen) chart. We saw a nice bounce off of the 38.2% level, coinciding with a reversal candle. The pair traded at an exchange rate of about 90.60, meaning that one Australian Dollar was worth approximately 90.6 Japanese Yen at the time (see Figure 1):
Figure 1: AUD/JPY bounces off of the 38.2% Fib level in November of 2006.
Source: FXtrek IntelliChart(TM) Copyright 2001-2006 FXtrek.com, Inc.
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One week later, AUD/JPY has pulled back after rising as high as 91.00. This healthy bounce represented a 125-pip move at its peak, and the possibility remains that the 38.2% level might be tested again (see Figure 2):
Figure 2: AUD/JPY pulls back after a 125-pip bounce from the 38.2% level.
Source: FXtrek IntelliChart(TM) Copyright 2001-2006 FXtrek.com, Inc.
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Next, we'll check in on GBP/USD (Great Britain Pound/U.S. Dollar). Last week we noted repeated support at the 50% retracement level (see Figure 3):
Figure 3: GBP/USD finds support at the 50% Fib level in November of 2006.
Source: FXtrek IntelliChart(TM) Copyright 2001-2006 FXtrek.com, Inc.
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A week later, after Fib support held successfully, we see the exchange rate has soared by 500 pips! At $10 per pip (per contract, or "lot" in Forex parlance), traders who caught even a small slice of this move were handsomely rewarded. Not bad for a one-week move! (see Figure 4):
Figure 4: GBP/USD soars 500 pips after bouncing from the 50% Fib level.
Source: FXtrek IntelliChart(TM) Copyright 2001-2006 FXtrek.com, Inc.
What's It All About?
First, for the uninitiated, we'll start with a brief summary. Leonardo Pisano Fibonacci was a mathematician who traveled widely with his father, an Italian diplomat. His book,
Liber abaci, was published in 1202 after his return to Italy, and introduced the numeric sequence that came to be known by his name.
Fibonacci includes a series of ratios that are found throughout all of nature. These ratios appear just about everywhere - in music, in Greek architecture, in the alignment of planets, in the way a tree sprouts its leaves, in the way a mollusk grows its shell. There are simply countless examples of this phenomenon.
What on earth does any of this have to do with trading? If you are a natural-born skeptic like me, you're probably not terribly impressed by anything you've heard so far, and rightly so. There is no logical reason to believe that any trading vehicle (stock, commodity, or currency) will suddenly stop and change direction of its own volition when the price or exchange rate retraces by a particular ratio.
So why does Fibonacci work in the Forex market? Because Fibonacci ratios are a deeply ingrained part of the Forex culture. Big banks, hedge funds, and individual traders alike all pay close attention to these ratios, and frequently place their orders at Fibonacci retracement levels.
If enough orders accumulate at a particular level, the combined power of these orders can actually change the direction of the exchange rate when that level is achieved. This is the essence of the self-fulfilling prophecy that we discussed in last week's newletter.
If my assumption is correct that Fibonacci works in the Forex market not because of magic but due to a self-fulfilling prophecy, then there are certain conclusions that we can extrapolate from this premise:
Fibonacci Is More Effective on Longer-Term Charts
If we truly believe that Fibonacci is a self-fulfilling prophecy, then we should live by the credo, "the more, the merrier." In other words, the more orders that are placed at a particular level, the more likely it becomes that the level will hold as support or resistance.
What can improve the chances that there will be a large quantity of orders at a particular Fib level? Visibility is the key. If the other players can't see the Fib level, they can't place their orders accordingly.
For example, if a Fibonacci level forms on a five-minute chart during the Asian trading session, any opportunity to place a trade based on this retracement is likely to come and go before European and American traders have wiped the sleep from their eyes. Since many of these traders will never observe this opportunity, there will be fewer orders placed at that level. This makes it less likely that the level will hold when the price reaches that area.
However, if the same scenario occurs on the daily chart, traders all around the world will have the time and the opportunity to place their orders accordingly. Since Forex is truly an international market, with traders located on every part of the globe, this aspect of Fibonacci trading takes on added significance.
Fibonacci Is More Effective on Commonly Used Retracement Levels
The most commonly used Fibonacci ratios are 38.2%, 50%, and 61.8%. However, 23.6%, 78.6% and 100% are also legitimate Fib levels. Some traders even use Fibonacci "extensions" that go beyond 100%, such as a 161.8% retracement. There are also Fibonacci Arcs, Fibonacci Fans, and Fibonacci Time Zones.
Which of these techniques will be the most effective? If we truly believe that a sizable quantity of orders (or a quantity of sizable orders) will make the difference, then we must give more weight to the levels that garner the most attention – the 38.2%, 50%, and 61.8% levels. In Fibonacci, as in many aspects of trading, sometimes it's better to keep things simple.
The Week Ahead
The big day for U.S. data is Tuesday, with Durable Goods Orders, Consumer Confidence, and especially Existing Home Sales on the docket, plus a phalanx of Fed speakers, including Ben Bernanke. Remember, the market is keenly focused on housing numbers right now, so traders will watch this housing indicator closely.
U.S. GDP is scheduled for release on Wednesday, along with New Home Sales. Traders will watch for not only the quantity of new homes purchased, but also the median price, which slipped drastically last month as builders cut prices and offered incentives.
Jean-Claude Trichet, President of the European Central Bank, will speak on Wednesday, and European and Canadian GDP numbers will be released on Thursday. Friday will be packed with data, featuring U.S. Construction Spending, as all eyes will remain on the U.S. housing market.
Final Thoughts
I had the opportunity to spend Thanksgiving in Boston, and visited the campuses of Harvard, MIT, and Wellsley. Boston Commons is beautiful at this time of year, and the architecture and artwork of the old Trinity Church is a sight to behold.
Now that the Online Trading Academy's new Boston campus is open for business, there is one more reason to mix business, pleasure, and education in this fascinating and historic city. Perhaps I'll see you there!
Online Trading Academy is growing worldwide and you can check out all locations at
www.tradingacademy.com/locations.htm.
Until next week – happy trading!
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