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.