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Friday, December 18, 2009

Fibonacci as a Technical Analysis Tool

While there have been countless books and articles written on the use of Fibonacci in technical analysis, the basics are
On the price scale, these ratios, and several others related to the Fibonacci sequence, often indicate levels at which strong resistance and support will be found. Many times, markets tend to reverse right at levels that coincide with the Fibonacci ratios.  On the time scale Fibonacci ratios are one method of identifying potential market turning points. When Fibonacci levels of price and time coincide you have high probability entry points.
In the next few pages I will talk about how I use the two most common applications of Fibonacci:
•     Price Retracements – A strategy for quality entry points
•     Price Extensions – An approach to determining how far price will run
Then after we have covered the basics we will talk about bringing it all together and using both Fibonacci Retracements
and Fibonacci Extensions at same time and how clustering of these ratios increases the probability of profit.
Fibonacci Retracements:
The Fibonacci Retracement is probably the most heavily used Fibonacci tool in the toolset. You will find Fibonacci
Retracements as a solid tool in identifying key support and resistance areas.
If prices have fallen from a recent swing high down to a swing low, the expectation is that price should retrace distance, high to low, by a ratio ofthe Fibonacci sequence. .  I have Fibonacci Retracements successfully used on tick charts  through monthly and yearly charts. It is important to note, the larger price move from swing high to swing low, the more accurate the retracement projections. Identification and selection of the correct swing points are keys to success.
While there are many variations of the ratio set, simple is better, let’s focus on four major retracement levels.
•     23.6% — The shallowest of the retracements. In very strong trending markets price typically quickly bounces in
the area of this ratio.
•     38.2%   — This is the first line of defense of the current trend. Breaking this level starts to erode the underlying
•     50% — the neutral point of any retracement. This is the critical tipping point.
•     61.8% — retracing to this typically signals a breakdown in the trend.
•     100% — matching the move
In this section we will also show examples of how potential opportunities when price retraces beyond 100% by following
another set of Fibonacci ratios:
•     138.2%
•     161.8%
•     200%
Notice in each case we have simply added 100% to the standard ratio set. I use this set of retracements on a daily
basis, from 23.6% all the way to 200% and sometimes 300% For my style of trading I find 38.2%, 50% and 61.8% quite
reliable.I use the other primarily as confirmation levels.
So let’s take a look at some examples of Fibonacci Retracements in use.
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Basic Fibonacci Calculation Method

Who was Fibonacci?
Leonardo Pisano, was Italian mathematician born in Pisa during the The middle  Ages. He was renowned as one of the most talented mathematicians of his day. The name Fibonacci itself was a nickname given to Leonardo. It was derived from his grandfather’s name and means son of Bonaccio.
While most attribute the Fibonacci Sequence to Leonardo, he was not responsible   for discovering the sequence. In 1202 Leonardo published a book called,Liber  Abaci.In it he derived a method for calculating the growth of the rabbit population.
Suppose a newly-born pair of rabbits, one male, one female, are put in a field.Rabbits are able to mate at the age  of one month so that at the end of its   second month a female can produce another pair of rabbits. Suppose that our rabbits never die and that the female always produces one new pair (one male, one female) every month from the second month on. The puzzle that Fibonacci posed was…How many pairs will there be in one year?
At the end of the first month, they mate, but there is still one only 1 pair.
At the end of the second month the female produces a new pair, so now there are 2 pairs of rabbits in the field.
At the end of the third month, the original female produces a second pair, making 3 pairs in all in the field.
At the end of the fourth month, the original female has produced yet another new pair, the female born two monthsago produces her first pair also, making 5 pairs.
This mathematical progression is now recognized as the Fibonacci Sequence.  Starting with zero and adding one,each new number in the sequence is the sum of the previous two numbers. In our example, 0+1 = 1, 1+1=2, 1+2=3,
2+3=5, and so on.
The sequence of numbers looks like this: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, to infinity. From this sequence.you can easily reason that at the end of one year there would be 233 pairs of rabbits.
This sequence has repeatedly appeared in popular culture from architecture to music to television. While the series is a powerful tool, the analysis of one number with the number up to four places to the right. The first three are shown below. While some are not exact, if you repeat this mathematical analysis through multiple sets of data, you will see.we arrive at some well known and fairly consistent ratios.
21/34   = 0.61764  ~  0.618                                34/21    =  1.61904  ~ 1.619
21/55   = 0.38181  ~  0.382                                55/21    =  2.61904  ~ 2.619
21/89   = 0.23595  ~  0.236                                89/21    =  4.23809  ~ 4.238
The dimensional properties adhering to the 1.618 ratio occur throughout nature and the ratio is most referred to as The Golden Ratio. The uncurling of a fern and the patterns found on various mollusk shells are commonly cited examples of this ratio.
This number, when added to 0.618, equals 1.
These ratios have been used for over a hundred years in the financial markets by the likes of W.D. Gann and Ralph Nelson Elliot. Up until the late 90s the tracking and use of these numbers were a manual process.  With the proliferation of real-time charting and data, software that automatically calculated and displayed these levels brought Fibonacci into the financial mainstream.
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