Technical Analysis (Part 13): Direct Price Analysis (DPA): Fibonacci
In the last article we looked at how to determine whether markets were trending or ranging. In Part 13, we look at a very interesting method used to calculate support and resistance and capture the behaviour and psychology in any given market: Fibonacci. Fibonacci has become an extremely popular tool amongst technical analysts.
The Fibonacci tool on your charts, is one of the best bits of kit for predicting support and resistance levels and price targets. It works across all markets, but in my experience, it works better on the longer-term charts e.g. 4hr, 1 day, 1 week. (Anything less than 4hrs and I like to use Pivots.)
What is Fibonacci?
Fibonacci was a 13th century Italian mathematician and accountant. You may be familiar with his number sequence from your maths lessons: e.g. 1,1,2,3,5,8,13,21. As you progress through the sequence, the ratio of each number to its preceding number approaches closer and closer to what is known as the golden ratio: approximately 1.618. Each number is also approximately 0.618 of its successor. This reciprocal number is known as ? (phi).
In the non-financial world, the Fibonacci sequence is employed in all manner of fields; from architecture through to physics and engineering. In nature, as well, we can see Fibonacci patterns at work. Some would argue that Fibonacci's sequence and methods were nothing new even back in the 13th century. It is thought the Egyptians designed and built their pyramids based on similar mathematical laws.
Fibonacci's concept, when translated to trading and investing, has to some extent become a self-fulfilling prophecy. In trading terms it works, because it is based on the behaviour of groups following patterns and lends itself perfectly to the analysis of financial markets. The concept is saying to the analyst that price retraces by a certain given amount and these amounts are governed by the Fibonacci sequence. What makes it so effective, is that the Fibonacci tool generates movements in advance that you can anticipate.
Creating Fibonacci lines
Fibonacci lines are placed on top of the price.
To set these lines, you need to look for a high and low and connect them (this is a pure discretionary process, but in most cases, it is obvious).
The points you select depend on your trading time period. I like to break a chart into 3 Fibonacci sections based on the rules of technical analysis. So, on a daily chart, I will have 3 different sets of Fibonacci lines: short, medium and long term. I'm also looking if there is any overlap between the three, signifying to me stronger points of support and resistance.
It works in all time frames (better > 4 hrs)
It is a subjective process – but you will instantly see, when you draw the lines, if they fit the asset you’re potentially trading.
Almost all the charting software I know has Fibonacci functionality.
Example using S&P500 Index daily chart with Fibonacci lines applied (Chart: TradingView):
Application
Four ratios are normally plotted (although most charting packages allow you to add on or take off many more Fibonacci lines). The four most commonly used and most important are:
0.618 (or 61.8 per cent), the reciprocal of the golden ratio.
0.50 (or 50 per cent) - the second number divided by the third (1 divided by 2).
0.382 (or 38.2 per cent) - the reciprocal of the golden ratio squared (i.e. 89 / 233).
0.236 (or 23.6 per cent) - the reciprocal of the golden ratio cubed (i.e. 55 / 233).
NB: The weakest of the Fibonacci ratios is 0.50. (not really a Fibonacci number). The strongest two are 0.618 and 0.382.
Imagine the lines as price magnets - you will see the action bouncing between the upper and lower boundaries, using these lines as key support and resistance areas. This price 'map' is great for trading and investing as it lets you build strategies - breakouts, reversals etc and helps with your risk management - setting stops and targets. Fibonacci, like most technical tools, works better in combination with other indicators.
Example using IAG Plc (Charts: Stockopedia) Fibonacci in combination with the stochastic oscillator:
Other Fibonacci methods
Fibonacci application is not just carried out in the manor presented above; there are other Fibonacci methodologies you can apply. Some further types of Fibonacci methods you may like to investigate are Extensions, Time and Circles. These can be found on most decent charting packages.
Further reading and learning
If you are interested in learning more about Fibonacci, then the following reading may help:
Fibonacci Ratios with Pattern Recognition, Larry Pesaento, Traders Press Inc, 1997.
Fibonacci Analysis (Bloomberg Market Essentials: Technical Analysis), Constance Brown, Oct 2008
Technical Analysis of the Financial Markets, John J Murphy, New York Institute of Finance, 1985.
Technical Analysis, The Complete Resource for Financial Market Technicians, Charles D Kirkpatrick, FT Press, 2006.
Conclusion
Fibonacci is one of my favourite tools for the longer-term charts. It's very useful for laying out a map of future price support and resistance levels and possible targets. It's also great for risk management. It may be a strange concept in financial markets and trading, but it works!
Next time: Technical Analysis (Part 14): Direct Price Analysis (DPA) - Pivots
Disclaimer
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13 comments
Set of multiple moving goal posts at best
good to get a discussion going. There are many "fundamentalists" who are just that.... often blind to a whole suite of tools that can help in improving their performance. Success in this business requires an open mind and an ability to change one's view when new evidence is presented.
My primary objective is not to be right, it is to make money . Ed Seyoka puts it nicely, "Win or Lose people get what they want out of the market". That is more profound that it looks on first or several readings
I use a blend of macro, fundamental and technical. I have a background in sums too with a PhD in Physics and Chemistry. I simply don't understand why so many investors ignore the physics of how price behaves: as Buffet puts it, the first rule is not to lose (money), the second rule is not to forget the first one.
Technical analysis can really help when fundamentals fall down ( and they often do), price action can give early tells of oncoming events : good or bad. It simply isn't a matter of opinion, a lot of this stuff works and is self evident in that. The subjectivity of application is akin to how a good craftsman uses a tool, with skill and judgement born from experience and expertise. There is art but there is some science. Like any area there are charlatans and dilettantes
. In the above thread the range of biases shown should be red flags: as much as skill and education is needed, self awareness and psychology are paramount in achieving success whether you consider yourself an investor or a trader. Some will be both and many will be neither: all are welcome in the ebb and flows of the markets which care not a jot for what you think you are.
Many deride technical analysis out of ignorance so good show on Stocko for trying to educate.
As for using Fibs, I am not a huge fan though I have similar uses to yours Stephen: confluences and overlapping symmetries can be portents but as you say, they are part of a mix. . Projections can help in setting targets and many breakouts in liquid stocks do follow similar patterns . Paul Tudor Jones, a billionaire many times over from trading , is quoted in Jack Schwagers Market Wizards book as a Fibs/EWT man ( again I find all that waving a bit arcane for me but each to their own). I doubt if he would attribute his billions to Fibs but then I doubt any sensible trader or investor would attribute success (or failure) to one tool. Life (and investing/trading) is a bit more multidimensional than that. James Simons is another billionaire trading guy and a brilliant mathematician, he's done ok from a bit of pattern recognition . FWIW, Schwager's book is well worth a read irrespective of your persuasion. There is more to the art that Buffet, Graham and Livermore
Good show Stephen, it's bound to be a tough crowd but some of the zealots may have a Damascene moment
"Your assumptions are your windows on the world. Scrub them off every once in a while, or the light won't come in.” Isaac Asimov
Fair point - a lot of technical analysis is subjective rather than objective and can only be measured (in my opinion) through practical trading experience. Probably part of the reason why people treat the subject of technical analysis a bit like people treat Marmite!
I use Fibonacci as part of a suite of tools rather than a one off trading system - I personally don't think it can be used on its own and works better in combination with other technical tools. I use it most for risk management and helping me to set stops and find potential 'soft' targets. I also assume that because most of the market (the big money ie the flow) uses basic technical analysis & Fibonacci and its rules are basic - find obvious highs and lows then the users of this tool are going to come up with the same levels and this info can be used to gain an edge.
Professional traders also use these sort of tools: Fibonacci/ pivots to flush people out around stops / key round numbers etc. Its a good behavioural tool and also becoming self-fulfilling as more and more people turn to technology and that makes it easier to produce a set of numbers. A lot of this is based around behavioural analysis of markets.
The biggest market in the world is Forex - $5 trillion traded every day. It is controlled by maybe a dozen big banks with about 80% of the flow. This market is very technically driven - they trade down to the 4th decimal place on billions of dollars a trade and often moves extremely quickly. These traders need to know levels and have an idea in their head where their entries / exits/ targets are. You need to go with the flow and where the money is at - and these guys are using these tools. The ideas of these sort of levels have drifted into other markets. I find the more liquid the market is, the better these sort of technical tools work - therefore in small stocks a concept like Fibonacci may not work and you need to be aware of when to deploy such tools. I started trading in commodities as a professional trader and at that time most of the flow was fundamental - by the time I left that market, 50% of the money came from technicals, HFT / systematic systems, funds etc all using the techniques I mention - its the changing face of the market.
Fibonacci does have its uses in the equity space - I find most investors haven't a clue about trade and risk management which is also vital for longer term success and they through away cash pointlessly clinging onto something that is a waste of time - and they could utilise Fibonacci in combination with their fundamental analysis to improve their lot.
That's my lot on Fibonacci - it doesn't suit everyone and I'm not saying it has to be used, as I pointed out earlier I am educating those who want to learn about technical analysis - I will leave it down to the reader if they want to take it any further.
Personally I can't think of any good reasons why the Fibonacci sequence should govern the behaviour of financial markets. Also, in my opinion, there is too much subjectivity in deciding where to place the Fibonacci lines, so the effectiveness of Fibonacci technical analysis cannot be properly tested in a statistical study, because whenever it doesn't work its proponents can claim that the Fibonacci lines were placed incorrectly.
Morning All :)
I'm glad I'm sparking such discussion! I''m all for other people expressing their opinion - the world works better if we can debate and discuss sensibly. I'm all for listening to different reasoned pov's it often creates opportunity!
For those who dont already know my trading is a combination of behavioural science, technical analysis and fundamental analysis - it is purely based on what works!.
My background to clear that one up is purely professional. I am not an armchair trader. I've worked from the very bottom to the very top of some of the biggest and best trading houses, investment banks, brokers in the world, in Commodities, FX, Fixed Income, Interest Rates, Credit Derivatives, so I have seen what works and what doesn't. I've also worked on both sides of the fence as poacher and gamekeeper in these institutions so it was also my job to know what worked and what didn't. I also have a mathematical background (MSc) and various professional qualifications. As well as being one of the few people in the UK who are a qualified as a professional technical analysis teacher (and I suppose legitimately allowed to teach this sort of stuff) - teaching professional traders,Universities etc. I do a lot of technical analysis consultancy work in the 'professional' space - In fact recently I've been commissioned to teach technical analysis to a well known bank - sure they wouldn't spend money if they thought it didn't work!
What I dont think is coming across is the mindset I have from working in that world - essentially I dont care where the idea comes from (technical, fundamental, quantitative etc)if it works and makes me money that is it period. That's what it is all about isn't it? So who cares how wacky the idea is - I'm not in it for the debate, I'm in it to make money. Technical Analysis is one of those things that works for me - I actually only use a handful of technical tools - I specialise in Japanese charting methods that date back hundreds of years and used by Rice traders along time ago: charts I use Kagi, Renko, Line Break, Ichimoku, Heikin Ashi, blended with only a couple of Western tools - I keep it simple. This is the mindset of a trader.
Also to clear another point up - Stockopedia have engaged me (I am not an employee of Stockopedia) to provide education around the technical analysis tools they provide / recently launched; along the way imparting some of my experiences and what I can honestly say I think works and what doesn't. It is then up to the reader to decide whether to take this further or not. I agree there are some things in technical analysis that don't work for me as there is in fundamental analysis etc. I am here to support the Stockopedia tool and not here to justify whether one form of trading is better than another - it is horses for courses and I don't have the time - I'm too busy trying to make money trading and become 'famously stinking rich'!!
"In trading terms it works, because it is based on the behaviour of groups following patterns and lends itself perfectly to the analysis of financial markets".
Those are big statements - but how do you support them?
Do groups in the market follow patterns? How do we know which patterns they follow? How does it lend itself perfectly to the analysis of financial markets?
Who has got famously stinking rich applying Fibonacci to the markets?
a) Do groups in the market follow patterns? ...................................................
b) Who has got famously stinking rich applying Fibonacci to the markets?
a) How else do you explain the vast fluctuations in prices of securities which have reasonably constant earnings?
The June day after the Brexit vote, the 19 October 1987, March 2009, Feb 2016 are examples of groups following patterns. Only huge Groups of people can change prices that much. It creates a pattern.
The 1999-2000 Euphoria and now are manifestations of different patterns. Huge Groups of people bidding prices up.
b) It is like asking 'Who has got famously stinking rich applying the P/E ratio to the markets?'
It is a tool among other tools. The P/E ratio may be more familiar but it is difficult to defend mathematically. That is another debate. The point here is that it is an accepted convention for valuing securities which, through popular use, enables people to make decisions. Fibonacci ratios are just less familiar to retail investors.
In the Foreign Exchange market there is little fundamental analysis except for National accounts yet it is vast and the volume surpasses the equity markets many, many times. There you find the Treasury departments of all major banks, Soros and the hedge funds proving Fibonacci and other technical tools make you 'famously stinking rich.'
Here's an alternative point of view:
http://www.followingthetrend.com/2014/05/why-technical-analysis-is-shunned-by-professionals/
The author seems to contradict himself - technical analysis is shunned, then he says:
"As I said, I and many others in the hedge fund business use ideas and concepts from technical analysis"
Though he clearly doesn't like the Fibonacci tool!
Unfortunately you cant format the lines on the chart for Fibonacci as well as I'd like - normally you'd be able to make them fatter, take away / add etc. I agree hard to see IAG example- that was the best I could get it after playing about.
If you change the colours of the lines they may show up? If not, sounds like you need to send that one to the helpdesk through the online chat facility - they maybe able to sort it. Or at least it may raise a product tweak.
Regards
Stephen
Hi,
They do come out quite faint on the Stockpedia charts - also very difficult to see the key % numbers. Do you get to see anything Fibonacci at all? Process: You go to: Draw / Fibonacci line - click on that - then click on price highs and lows on selective range inside chart and should fill in. What part dont you see - or all of it?
Regards
Stephen
I don't see anything Stephen. No lines and no percentage notations on the side. I could hardly see much on your IAG example but I could see the percentage at the side which do not appear on my screen. Maybe it's my computer but everything else shows up okay. Thanks for replying anyway.
Regards
Ron
When I try to depict the Fibonacci lines on the Stockopedia graph nothing comes up. Am I doing something wrong?