The Most Effective Way to Utilize Fibonacci Ratios

Opening the power to forecast accurately

Fibonacci Ratios are used by many traders and analysts and in a variety of ways. They are a central requirement to my style of analysis but must be used carefully and in a way in which helps you understand the market. There are many analysts which use them in “clusters” identifying areas where several Fibonacci ratios lie which they consider strengthens the odds for a winning trade. This can help at times, but the problem with this type of analysis is that it doesn't really help you understand price behavior and what to expect, where price should move. To me, unless you have a strong grasp of the structure of price development, you risk making trading decisions that leave you puzzled when things go wrong.

Let's take a brief look at how the ratios are derived.

Leonardo Pisano Fibonacci was a mathematician born in 1170 in Pisa, Italy. He developed a simple sequence of numbers that has fascinating properties. He began by taking zero and adding 1. He followed by adding 1 to 1 to arrive at two. He then took each answer and added to it the previous number which produces the sequence:

0, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987 and so on…

Now the interesting feature to this sequence is in the ratios. From 1 onwards Fibonacci then calculated the results of dividing one number by the next in the sequence and vice versa, then performed the same calculations with numbers two apart in the sequence, then with those three apart and so on and came to the following:

It can be seen that as the number progress in the sequence the results are exactly the same. From the bottom line note the sequence of ratios:

0.146, 0.236, 0.382, 0.618, 1.618, 2.618, 4.236, 6.854

We can then derive further ratios by multiplying or dividing numbers in the sequence thus:

Even by multiplying or dividing one Fibonacci number by another the result is always another Fibonacci number. We can also add the reciprocal of 0.236 and 0.146 which provides numbers of 0.764 and 0.854, then include ratios of the first numbers to arrive at the following:

0, 0.146, 0.236, 0.382, 0.50, 0.618, 0.764, 0.854, 1.00, 1.618, 2.618, 4.236, 6.854

I also include 1.382 which, while not a true Fibonacci ratio does provide some excellent projections.

How to use Fibonacci most accurately

Most proponents of Fibonacci will base their entry levels on areas where various Fibonacci retracements or projections tend to develop in clusters. The chart below shows how this is generally achieved:

The technique is basically applied by measuring Fibonacci relationships by measuring various start and end points. In this example I have measured from point A to point C and also Point A to the very high. I have then measured from Point B to Point C and from Point B to the very high.

It can be seen that there is a cluster of Fibonacci lines around the 1.2450-1.2500 area and it is within here that price bounces to get to the 1.3367 high.

However, the process is very in-exact and doesn't really provide any information of what to expect, whether the support will hold and where price can eventually go. By utilizing a combination of Elliott Wave and Fibonacci it is possible to achieve a greater level of accuracy.

Within the ratios I also use are the 2/3 value of 66.66% and also a harmonic ratio of √2 which is 0.414 or 41.4%. I also use projections of 166.66%.

Now look at this example. After identifying the end of Wave (i) and the retracement in Wave (ii) I can take various ratios to establish the potential end of Wave (iii). Most commonly these are 138.2%, 166.67% and 223.6%. In this case Wave (iii) completed at the 166.67% projection. Once we have established the end of Wave (iii) we can derive possible Wave (iv) corrections that normally stall around 41.4% - 50% of Wave (iii). In this case Wave (iv) was 41.4% of Wave (iii). Again, once Wave (iv) has been established we can project an end to Wave (v) that is normally 61.8%, 66.67% or 76.4% of the distance from the beginning of Wave (i) to the end of Wave (iii) and added to Wave (iv). In this case Wave (v) found a high around the 66.67% projection.

Each wave will have internal waves and can be used to highlight the most likely stalling point in advance. In additon you will have an idea of how the move will develop and if it deviates from this pattern then it will give you and eary warning of breakown or incorrect wave count. Thus it is possible to have greater control over your expectations and trades.

While Elliott Wave is quite complex and needs a great deal of practice, it is the most accurate form of prediction and is well worth learning. If you find the process too difficult then it can be worthwhile subscribing to an Elliott Wave based forecasting service such as FX-Strategy's Pro Commentary.

Common Indicators and Simple Trading Rules

There are a number of simple strategies we can create with the use of two or three common technical indicators. The (1-hour) chart below shows the EURJPY over the course of around 1-week's trading period. The market initially broke to the downside, as the candlestick activity remained below the 20-SMA (Simple Moving Average) and steadily following the lower Bollinger Band to new lows. Once the market reversed direction back to the upside, trading then emerged above the 20-SMA, following the upper band to recent highs. This brief example provides us with the basis for a few simple trading rules:

1. We should make every attempt to trade only in the same direction as the current trend.
2. The trend can be defined by studying the market's position in regards to the Bollinger Bands and 20-SMA.
3. Protective stops should be placed below the lower band in uptrend's, and above the upper band in downtrends.
4. Finally, we may initiate a trade at or below the 20-SMA, while taking profits at the upper band; in up trending markets. The opposite holds true in down trending markets.

This strategy may have to be adjusted depending on the currency pair and market condition, however by analyzing a segment of our charts; we can begin to isolate specific conditions telling us when to trade, and when to simply wait…

Bullish and Bearish Divergence Signals

Using price/momentum divergence to identify trend completion

Momentum indicators are normally used more as overbought/oversold indicators with levels above an upper level between 70 and 80 suggesting potential for a reversal lower and a lower level between 20 and 30 suggesting potential for a reversal higher.

When used carefully with strong reference to price these signals can be quite accurate. However, it is also possible to utilize momentum indicators to warn of a deceleration of a trend and subsequent risk of and end to the trend.

The latter signals are normally highlighted by what are known as "divergences." These can be defined as:

Bullish divergence: Rising price highs in an uptrend while corresponding highs in the momentum indicator are declining

Bearish divergence: Declining price lows in a downtrend while corresponding lows in the momentum indicator are rising.

When price and momentum direction begin to diverge in this manner it is basically identifying that the speed of the trend is beginning to lose momentum and as such there is greater risk for the trend to reverse.

Note how in this diagram that price has been rising in a sequence of higher highs and lower lows (an uptrend) but over the last three price peaks the corresponding RSI has marked lower peaks in the indicator.

The chart above shows three examples of divergences. The first towards the left of the chart is a bullish divergence where price has been declining with lower highs and lower lows but over the final two lows the RSI (Rapid RSI) has seen a higher low.

This signals a reversal higher in price which then sees an strong uptrend develop until towards the right center of the chart at the top of the trend we note that while the two last price highs are still rising, the Rapid RSI below has seen a lower high on the second price peak. The break of the trend support line confirms reversal.

Finally, from the peak at the right center of the chart we see a downward correction develop within which the price lows move lower but the Rapid RSI lows fail to confirm the downward momentum and this bullish divergence signals a reversal higher once again.

Does this mean that every time we note a divergence forming in this way that we should enter a trade? Most definitely not. It is always vital that such signals are confirmed by price. Remember the definition of an uptrend is a series of higher highs and higher lows, and vice versa for a downtrend. Until the prior low (in an uptrend) is broken, there is no reversal of the uptrend. The opposite is true for the downtrend.

Look at the chart below:

You can see here that price is rising very consistently in an uptrend while an apparent bearish divergence develops in this weekly chart over a period of nearly one year. However, no downward reversal occurs. There are two features to note here. The first is that at no time does the prior low point in the uptrend ever get broken and the second is that towards the right of the chart the break above the divergence line (effectively a trend resistance in Rapid RSI) price then accelerates higher once again.

However, divergences when used in conjunction with signals generated from price are an exceptionally strong indicator of a reversal and can provide you with excellent trading opportunities.