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Tuesday, April 20, 2010

The Truth About Fibonacci Trading

Leonardo Fibonacci was a great Italian mathematician who lived in the thirteenth century who first observed certain ratios of a number series that are regarded as describing the natural proportions of things in the universe, including price data.  The ratios arise from the following number series:  1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144 ……
This series of numbers is derived by starting with 1 followed by 2 and then adding 1 + 2 to get 3, the third number. Then, adding 2 + 3 to get 5, the fourth number, and so on.
The ratios are derived by dividing any number in the series by the next higher number, after 3 the ratio is always 0.625.  After 89, it is always 0.618.  If you divide any Fibonacci number by the preceding number, after 2 the number is always 1.6 and after 144 the number is always 1.618.  These ratios are referred to as the “golden mean.”  Additional ratios were then derived to create ratio sets as follows:
Price Retracement Levels
0.236, 0.382, 0.500, 0.618, 0.764
Price Extension Levels
0, 0.382, 0.618, 1.000, 1.382, 1.618
The first set of ratios is used as price retracement levels and is used in trading as possible support and resistance levels.  The reason we have this expectation is that traders all over the world are watching these levels and placing buy and sell orders at these levels which becomes a self-fulfilling expectation.
The second set is used as price extension levels and is used in trading as possible profit taking levels.  Again, traders all over the world are watching these levels and placing buy and sell orders to take profits at these levels which becomes a self-fulfilling expectation.
Most good trading software packages include both Fibonacci Retracement Levels and Price Extension Levels.  In order to apply Fibonacci levels to price charts, it is necessary to identify Swing Highs and Swing Lows.  A Swing High is a short term high bar with at least two lower highs on both the left and right of the high bar.A Swing Low is a short term low bar with at least two higher lows on both the left and right of the low bar.
Fibonacci Retracement Levels
In an uptrend, the general idea is to go long the market on a retracement to a Fibonacci support level.  The price retracement levels can be applied to the price bar chart of any market by clicking on a significant Swing Low and dragging the cursor to the most recent potential Swing High and clicking there.  This will display each of the Retracement Levels showing both the ratio and corresponding price level.  Let’s take a look at some examples of markets in an uptrend.  The same points made by these examples are equally applicable to markets in a downtrend.
Example 1:  Here we plotted the Fibonacci Retracement Levels by
clicking on the Swing Low at about $71.31 and dragging the cursor to the Swing High at about $89.83.  You can see the resultant levels plotted by the software.  Now the expectation is that if the market retraces from this high it will find support at oneof the Fibonacci Levels, because traders will be placing buy orders at these levels as the market pulls back.


Example 1.1:Now let’s look at what actually happened after the Swing High occurred.  The market pulled back right through the 0.236 level and continued the next day through the 0.382 level before finding support.  After a few days, the market resumed its upward move.  Clearly buying at the 0.382 level would have been a good short term trade.
Example 2:  Again, the Fibonacci Retracement Levels were plotted on the chart in the same manner as described in Example 1.  Again, we are looking for the market to retrace from the Swing High and find support at one of the Fibonacci levels.
Example 2.1: Now let’s look at what actually happened.  The market again pulled back right through the 0.236 level and continued to pull back until it found temporary support at the 0.50 level (a lot of buyers at this level).  However, once the buying power was exhausted, the market continued to retrace all the way down to the 0.764 level before resuming its upward trend.  In this case, buying at the 0.764 level would have been a good short term trade.


Example 3:  Here’s another example.If the market retraces from the Swing High, where will it find support?

Fibonacci Price Extension Levels
In an uptrend, the general idea is to take profits on a long trade at a Fibonacci Price Extension Resistance Level.  The Price Extension Levels can be applied to the price bar chart of any market by clicking on a significant Swing Low and dragging the cursor to the most recent Swing High. Then by clicking on the Swing High and back down to the retracement Swing Low and clicking there. This will display each of the Extension Levels showing both the ratio and corresponding price level.Let’s take a look at some examples of markets in an uptrend.  The same points made by these examples are equally applicable to markets in a downtrend.
Example 5:Here we plotted the Fibonacci Price Extension Levels by clicking on the Swing Low at about $38.20 and dragged the cursor to the Swing High at about $47.67 and then down to the retracement Swing Low.  You can see the resultant levels plotted by the software.Now the expectation is that if the market continues higher it will find resistance at one of the Fibonacci Levels, because traders will be placing sell orders at these levels to take profits on there long trades.
Example 5.1:Now let’s look at what actually happened after the retracement Swing Low occurred.  The market rallied making new highs pausing at the 0.382 level and again at the 1.000 level after a retracement down it rallied again going right through the 1.382 and 1.618 levels.  Taking profits at the 0.382 level would have been premature, but taking profits at the 1.000 level would have made a nice trade.


Courtesy Copyright The Truth About Fibonacci Trading International.This content copyrights protected by Bill Poulos

Symmetrical Triangle

The symmetrical triangle, which can also be referred to as a coil, usually forms during a trend as a continuation pattern. The pattern contains at least two lower highs and two higher lows. When these points are connected, the lines converge as they are extended and the symmetrical triangle takes shape. You could also think of it as a contracting wedge, wide at the beginning and narrowing over time.
While there are instances when symmetrical triangles mark important trend reversals, they more often mark a continuation of the current trend. Regardless of the nature of the pattern, continuation or reversal, the direction of the next major move can only be determined after a valid breakout. We will examine each part of the symmetrical triangle individually and then provide an example with Consesco.
1.Trend  : In order to qualify as a continuation pattern, an established trend should exist. The trend should be at least a few months old and the symmetrical triangle marks a consolidation period before continuing after the breakout.
2.4 points: At least 2 points are required to form a trendline and two trend lines are required to form a symmetrical triangle. Therefore, a minimum of 4 points are required to begin considering a formation as a symmetrical triangle. The second high (4) should be lower than the first (2) and the upper line should slope down. The second low (3) should be higher than the first (1) and the lower line should slope up. Ideally, the pattern will form with 6 points (3 on each side) before a
breakout occurs.
3.Volume:: As the symmetrical triangle extends and the trading range contracts, volume should start to diminish. This refers to the quiet before the storm, or the tightening consolidation before the breakout.
4.Duration:: The symmetrical triangle can extend for a few weeks or many months.If the pattern is less than 3 weeks, it is usually considered a pennant. Typically, the time duration is about 3 months.
5.Breakout Time frame:The ideal breakout point occurs 1/2 to 3/4 of the way through the pattern’s development or time-span. The time-span of the pattern can be measured from the apex (convergence of upper and lower lines) back to the beginning of the lower trendline (base). A break before the 1/2 way point might be premature and a break too close to the apex may be insignificant. After all, as the apex approaches, a breakout must occur sometime.
6.Breakout Direction:: The future direction of the breakout can only be determined after the break has occurred. Sound obvious enough, but attempting to guess the direction of the breakout can be dangerous. Even though a continuation pattern is supposed to breakout in the direction of the long-term trend, this is not always the case.
7.Breakout Confirmation:: For a break to be considered valid, it should be on a closing basis. Some traders apply a price (3% break) or time (sustained for 3 days) filter to confirm validity. The breakout should occur with an expansion in volume, especially on upside breakouts.
8.Return to Apex:: After the breakout (up or down), the apex can turn into future support or resistance. The price sometimes returns to the apex or a support/resistance level around the breakout before resuming in the direction of the breakout.
9.Price Target:There are two methods to estimate the extent of the move after the breakout. First, the widest distance of the symmetrical triangle can be measured and applied to the breakout point. Second, a trendline can be drawn parallel to the pattern’s trendline that slopes (up or down) in the direction of the break. The extension of this line will mark a potential breakout target.
Edwards and Magee suggest that roughly 75% of symmetrical triangles are continuation patterns and the rest mark reversals. The reversal patterns can be especially difficult to analyze and often have false breakouts. Even so, we should not anticipate the direction of the breakout, but rather wait for it to happen. Further analysis should be applied to the breakout by looking for gaps, accelerated price movements and volume for
confirmation. Confirmation is especially important for upside breakouts.
Prices sometimes return to the breakout point of apex on a reaction move before resuming in the direction of the breakout. This return can offer a second chance to participate with a better reward to risk ratio.Potential reward price targets found by measurement and parallel trendline extension are only meant to act as rough guidelines. Technical analysis is dynamic and ongoing assessment is required. In the first example above, SUNW may have fulfilled its target (42) in a few months, but the stock gave no sign of slowing down and advanced above 100 in the following months.

Conseco formed a rather large symmetrical triangle over a 5-month period before breaking out on the downside.
1.The stock declined from 50 in Mar-98 to 22 in Oct-98 before beginning to firm and consolidate. The low at 22 probably was an over-reaction, but the long-term trend was down and established for almost a year.
After the first 4 points formed, the lines of the symmetrical triangle were draw. The stock traded within the boundaries for another 2 months to form the last 2 points.
2.After the gap up from point 3 to point 4, volume slowed over the next few months. There was some increase in volume in late June, but the 60-day SMA remained in a downtrend as the pattern took shape.
3.The red square marks the ideal breakout time-span from 50% to 75% of the pattern. The breakout occurred a little over 2 weeks later, but proved valid pattern. The breakout occurred a little over 2 weeks later, but proved valid nonetheless. While it is preferable to have an ideal pattern develop, it is also quite rare.
4.After points 5 and 6 formed, the price action moved to the lower boundary of the pattern. Even at this point, the direction of the breakout was still a guess and its was prudent to wait. The break occurred with an increase in volume and accelerated price decline. Chaikin Money Flow declined past -30% and volume exceeded the 60-day SMA for an extended period.
5.After the decline from 29 1/2 to 25 1/2, the stock rebounded, but failed to reach potential resistance from the apex. The weakness of the reaction rally foreshadowed the sharpness of the decline that followed.
6.The widest point on the pattern extended 10 1/2 points. With a break of support at 29 1/2, the measured decline was estimated to around 19. By drawing a trendline parallel to the upper boundary of the pattern, the extension estimates a decline to around 20.
Courtesy Copyright Stock Charts.com .This content copyrights protected  Written by Arthur Hill.