Fibonacci Techniques for Profitable Trading

Fibonacci analysis can supercharge your market performance, but you'll need to master a few tricks of the trade to gain maximum benefit from this mathematical sequence that was uncovered in the Western world more than 800 years ago. Let's tackle the subject with a quick primer and then get down to business with two original strategies that tap directly into its hidden power.

Twelfth-century monk and mathematician Leonardo de Pisa (later branded as Fibonacci) uncovered a logical sequence of numbers that appears throughout nature and in great works of art. Unknown to the great monk, these Fibonacci numbers fit perfectly into our modern financial markets because they describe – with great accuracy – complex relationships between individual waves within trends, as well as how far markets will pull back when they return to levels previously traded.

Starting with 1+1, the Fibonacci sequence, of which the first number is 1, consists of numbers that are the sum of themselves and the number that precedes them. As a result, 1+1=2, 1+2=3, 2+3=5, 3+5=8, 5+8=13, 8+13=21, 13+21=34 and 21+34=55, which indicates that 1, 2, 3 5, 8, 13, 21, 34 and 55 are all Fibonacci numbers. Subdividing these numerical strings uncovers repeating ratios that have become the basis for Fibonacci grid analysis in swing trading and other market disciplines. (See also: Taking the Magic Out of Fibonacci Numbers.)

The .386, .50 and .618 retracements form the basic structure of Fibonacci grids found in popular market software packages, with .214 and .786 levels coming into play during periods of higher volatility. The initial analysis technique is simple enough for market players at all levels to understand and master. Just place the grid over the ending points of a major high and low in an uptrend or downtrend and look for close alignment with key price turns.

Deeper market analysis requires greater effort because trends are harmonic phenomena, meaning they can subdivide into smaller and larger waves that show independent price direction. For example, a series of relative uptrends and downtrends will embed themselves within a one- or two-year uptrend in the S&P 500 or Dow Industrials. We see this complexity most clearly when shifting higher, from daily to weekly charts, or lower, from daily to 60-minute or 15-minute charts.

A single Fibonacci grid on a daily chart will improve results ,but ratios come into sharper focus when examining two or more time frames. Swing traders taking the next step will find great value in daily and 60-minute charts, while market timers will benefit when they step back and combine daily and weekly charts. In both cases, alignment between key Fib levels in different time frames identifies hidden support and resistance that can be utilized for entry, exit and stop placement. 

For example, in the chart above, you'll see that Microsoft Corporation (MSFT) shares pounded out a deep low at $42.10 in October and rallied in a vertical wave that ended at $50.05 a few weeks later. The subsequent pullback settled on the 38.2% retracement (.382) for four sessions and broke down into a mid-December gap that landed the price on the 61.8% (.618) Fibonacci retracement. That level marks a tradable low ahead of a sharp recovery that stalls at the 78.6% (.786) retracement. (For more, see: How to Draw Fibonacci Levels.)

Notice how other charting features interact with key Fibonacci levels. The sell-off into the 62% level also fills the October gap (red circle) while the subsequent bounce stalls near three November swing highs (blue line) aligned with the 78.6% retracement. This tells us that Fibonacci analysis works most effectively when combined with other technical forces in play, such as gaps, moving averages and easily observed highs and lows. 

Now let's zoom in and identify a Fibonacci technique you can use to find low-risk entries missed by less observant market players. Falling price sits on the 38% retracement for four sessions, sucking in a supply of capital looking for a reversal. The downward gap traps this crowd, which is shaken out at the same time the stock posts a volatile low at the 62% level. While it makes sense to buy at that support level, it's a risky strategy because the gap could easily kill the upside and force another breakdown.

Next comes the important part. The surge back above the 38% retracement reinstates support, triggering a Fibonacci Flush buy signal, predicting that positions taken near $47 will produce a reliable profit. At the same time, shaken-out shareholders are reluctant to buy back at this price because, as the expression goes, "once bitten, twice shy." This lowers interest in the trade while allowing new money to carry risk in a lower-volatility tape, and relying on a long observed tendency for support to hold after it is tested, broken and then remounted. (For more, see: Support and Resistance Basics.)

Referring to the chart above as an example, the 78.6% retracement level stands guard as the final harmonic barrier before an instrument completes a 100% price swing (higher or lower). This is valuable information because it tells us that a breakout above this level in an uptrend, or a breakdown in a downtrend, will extend all the way to the last swing high or low as a minimum target. Doing the math suggests a free ride for the last 21.6% of the rally or sell-off wave.

This Parabola Pop strategy works very well on longer time frames and can even provide early entry to major breakouts and breakdowns on widely held issues. As an example, look at Facebook, Inc. (FB) after it peaked at $72.59 in March 2014 and entered a correction that found support in the mid-$50s. The subsequent bounce reached the 78.6% retracement at $68.75 two months later and stalled out, yielding nearly three weeks of sideways action. (See also: Fibonacci and the Golden Ratio.)

The stock rallied above harmonic resistance on July 21 (red line) and took off, completing the last 21.4% of the 100% price swing in just four sessions. In addition, the fourth day yielded a breakout above the March high, setting off a fresh set of buy signals that gave Fibonacci-focused shareholders many profitable options, including letting it ride, taking partial profits or risking the balance on the new uptrend.

The Facebook breakout highlights a second advantage of the Parabola Pop strategy. Markets tend to go vertical into these 100% levels, as if a magnet is pulling on price action. This parabolic tendency can produce outstanding results over very short time periods. Of course, it isn't a given because anything can happen at any time in our modern markets, but even a slight tilt toward the vertical marks a definable edge over the competition. 

As a final note, the thrust from 78.6% into 100% marks a fractal tendency that appears in all time frames, from 15-minute through monthly charts, and can be traded effectively whether you're a scalper or market timer. However, intraday holding periods are more likely to face trade-killing whipsaws and shakeouts, while the size of the expected rally or sell-off is often too small to book a reliable profit, especially after the negative impact of transaction costs. (For more, see: Introduction to the Parabolic SAR.)

Viewing the trends of the market through the lenses of a Fibonacci grid enables investors to see larger patterns beyond immediate upturns and downturns and to pinpoint prospects for profits that may be just beyond the view of investors who are spooked out by a short-term view of the trends. If used well, the tools of Fibonacci analysis equip an investor with the confidence and insights needed to withstand shakeouts prompted by drastic downturns and to take advantage of opportunities to profit from approaching vertical shifts. However, doing so requires a willingness to withstand the unnerving volatility that exists within compressed periods of time to see the market movements that a Fibonacci believer anticipates, based on math formulas that have stood the test of time. (For additional reading, check out: Strategies for Trading Fibonacci Retracements.)