Fibonacci Analysis & Best Practices

Introduction


Fibonacci retracements and extensions are commonly associated with Elliott Wave Analysis, a technical approach I have studied but do not personally use. Numerous traders, like me, apply Fibonacci tools independent of Elliott Wave, while an equal (if not greater) number argue that Fibonacci analysis is inconsistent and unreliable, and will assign any perceived relevance to borderline mysticism.

Adam Grimes, author of The Art and Science of Technical Analysis, and a technician I respect, holds this view quite adamantly. Furthermore, through the process of studying for the CMT (Chartered Market Technician) designation, with nearly 2,000 pages contained in the curriculum over three levels, I have been perplexed by the relatively modest mention of “Fib” ratios, particularly given its prevalence amongst technicians. Why is Fibonacci not considered to be foundational, and why the strong polarity of opinions amongst technicians?

The Art & Science of Fibonacci


My opinion? Detractors of Fibonacci likely a.) misapply the tools, and b.) misunderstand why the tools are relevant to markets in the first place. Borrowing from the title of Grimes’ book, applying Fibonacci ratios is, in practice, just as much art as science. The scientific approach, of course, is to simply plot a Fibonacci retracement from the peak to the trough of a cycle, and analyze where the lines land on the chart, and to where they extend. It has been my experience that the vast majority of technicians – both amateur and professional – stop there. When the lines appear to lack relevance, the reaction is that Fibonacci “does not work.”
 
The chart of Avalon Bay ($AVB), depicted below, is a good example. The cause of their scrutiny is obvious. 
 
Charts made with Optuma Software
 
Note how key peaks and troughs, as well as important areas of consolidation, fail to honor any of the key Fibonacci ratios. The chart looks “sloppy.”  By the time $AVB definitively broke its prior cycle high, the move was already well underway, and any trade entry on that break would have diminished the favorability of the risk-reward setup.
 

Is the Camera Broken?


An apt analogy for applying Fibonacci tools is that of using a camera or smartphone. The objective is to bring the picture into focus, not to just snap the photo. And while everyone takes pictures, we are certainly not all photographers. Photography – even basic photography – is an art. Photographers consider external variables like lighting, motion, depth of view, and color when framing a picture and bringing it into focus. Similarly, internal variables like lens type and camera quality also affect the final product. Learning to be a photographer takes time and practice. Thankfully, Fibonacci tools are not quite so complicated.
 
One of the best “Fibonacci photographers” is Connie Brown, author of Fibonacci Analysis and a well-respected technician. Brown states: “The secondary swing away from the actual bottom, or the secondary high after the end of a trend, [is often] of greater value than the actual price that ends the prior trend.” I have found this to be the case in my own analysis.
 

Bringing the Picture Into Focus


If we revisit the $AVB chart below, and use the shelf following the blow-off spike as the start of the Fibonacci retracement, the picture finally comes into focus. Five key pivot points and a key area of consolidation align precisely with Fibonacci ratios. The breakout of the shelf (or the secondary high), which was initially tested and strongly rejected, became the definitive break on the chart. The retest of the breakout of the $193 level became the ideal entry point, right at the beginning of the move higher and before future buyers waiting for a breakout of all-time highs at the peak (~$199). This trade entry dramatically improves the risk-reward profile. Therefore, by focusing the Fibonacci ratios into areas of precision, you can increase the predictive value of the analysis. Simply put: the picture becomes clearer if you adjust the focus of the lens.

Fibonacci AVB

Charts made with Optuma Software

Why Does This Work? (Yet Another Metaphor)


The market has its own rhythm, and I would argue that the rhythm of the markets tends to follow Fibonacci patterns, consistent with the rest of nature. The broader – almost metaphysical – question of why Fibonacci patterns matter in the universe remains the subject of many a philosopher and beyond the scope of this article.
 
But the technical question of why, at certain times, Fibonacci should be applied to the peak and trough of the cycle, while at other times the ratios are better applied to secondary (or even tertiary) pivot points, is more easily explainable. 
 
Blow off tops, huge sell offs, or other one off spikes are more likely to be outlier events within the rhythm of a chart; they are the cymbals, not the base drum. For this reason, applying Fibonacci ratios at price peak works best when the peaks are rounded or in an area of congestion, rather than the rapid crescendo associated with big blow offs. Furthermore, I have found that logarithmic scaling tends to be more indicative of chart rhythm than arithmetic scale, which often exaggerates aspects of the chart. If the chart is a piece of music, the aim is to find the rhythm, and trade with that rhythm. The rhythm is not always obvious because the rules are not absolute, but with a little practice and technique, identifying the correct rhythm is not too difficult.
 
I hope this is helpful. As always, shoot me a note if you have questions or comments.
 
Tarek Saab
 
Tarek I. Saab
 
Founder, fibonacci.com 

 

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