There are many stocks trading indicators out there, the ones that are relatively easier to understand are Moving Averages (MAs), MACD, RSI, and Stochastics. Juan can easily read about these in Investopedia etc. One charting tool that I find very cool and interesting, short of magical is the Fibonacci retracement, which is based on Fibonacci ratios. Fear not if you are not good in Math because there is no need to compute for the ratios manually — charting tools can plot it for you.
Just a quick refresher:
The sequence is credited to Italian Mathematician Leonardo Fibonacci and he observed that nature is governed by this sequence:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377,…
This sequence goes on and on, the next one derived by adding the previous 2 numbers (0+1=1), (1+1=2), (1+2=3), (2+3=5) etc.
Now if we divide any two consecutive numbers in the sequence, the quotient will approach and eventually settle to the golden ratio: (2/1=2), (3/2=1.500), (5/3=1.666), (8/5=1.600), (13/8=1.625), (21/13=1.615), (34/21=1.619)…. (144/89=1.618), (233/144=1.618), (377/233=1.618). The quotients approach 1.618.
Doing the reverse, (3/5=0.6), (5/8=0.625), (8/13=0.615), (13/21=0.619), (21/34=0.618)…. (89/144=0.618), (144/233=0.618), (377/233=0.618). This time the quotients approach 0.618.
The golden ratio is 1.618 or in terms of percentage, 161.8%, which later on you’ll see the relevance in stocks retracements.
GOLDEN RATIO IN NATURE
If you want proof of how the fibonacci sequence and golden ratio manifest in nature, take a look at these articles:
- 15 Uncanny Examples of the Golden Ratio in Nature
- Examples of the Golden Ratio You Can Find in Nature
Now that we have established that the ratios and sequence are very much part of nature, stocks chartists also realized that since human nature drives stocks prices, the ratios may actually be present in the price movement of stocks. Here enters the fibonacci retracements. The main numbers are 0.618, 1.618. There’s also 0.786 (the square root of 0.618), 1.27 (square root of 1.618). The secondary numbers are 0.236, 0.382, 0.5, 1.0 etc.
Now let’s see the retracement in action. Using Investagrams or Trading View, go to charting and click on the third option from the top left (default option is pitchfork). Choose Fib Retracement.
Then select a completed leg of the chart you wish to study (high and low has been established already) and drag the fibonacci retracement tool. For below PSEi chart, drag the retracement tool from the low 8083 and the high 9054.
The retracement tool will then automatically segment the range into the fibo ratios (0.236, 0.382, 0.5, 0.618 etc). Again, the climb from 8083 to 9054 has already been completed and the purpose of the retracement is to plot where the index can possibly go next. From this chart, after a doji peak at 9054, the next big red candle bounced at 23.6% retracement to close above it, but the next day, this level (8825) became the resistance and persisted for the next 3 days. Further gap downs occurred and the 38.2% level (8683) became the resistance for the remaining candles. Meanwhile, support so far is at 61.8% (8454).
Using the retracement tool, Juan can see possible support and resistances, as well as potential target prices. This need not be an exact science, but more of an area where a possible pivot point / reversal can occur. And for us chartists, that narrows down the range where we can profitably trade.
Let’s look at a downtrend stock, PSE: URC.
The retracement tool is plotted in the two stars (previous high of 155.47 and low of 131.15). The objective is to see how the price will retrace the 155.47 to 131.15 downward range as it tries to go up.
As we can see from the candles after the 131.15 low, the stock had a long green candle and raced upward towards 50% level (143.31), then another bullish run towards 155.47 (100% retracement) where it consolidated for a few days. Next, 3 more candles to a slight overshoot of the 161.8% retracement (170.5). But the trend got exhausted and the 161.8% retracement is now a major resistance, until the recovery lost steam and the downtrend resumed once again. On its way down, the significant retracement ratios are being breached day by day (100%, 78.6%, 61.8%, 50%). It remains to be seen whether the 50% will now hold or we’ll see the 38.2% and 23.5% breached as well.
- When plotting the Fibonacci retracement, use a leg that is already finished (downward leg or uptrend leg). If the trend is not yet finished, do not plot the retracement there.
- The more candles involved, the better. Weekly or monthly time frames are also more powerful.
- Plot consistently. I prefer to plot using the open and close of the highest and lowest candles. I do not use the wicks. If you prefer to use the wicks, always use wicks all throughout. If you will plot using the candle bodies, then use the candle bodies only.
- As the retracements can indicate potential reversals, one can also plan potential entries and exits from these levels.
- Important levels to be respected / breached are 38.2%, 61.8% and 161.8%. The rest of the retracement levels are secondary. A breach of these major levels (i.e. a close beyond these levels) should be accompanied by good volume to be more decisive.
- After a breach of a major level, a retest is possible. During the retest, the breached level should hold to indicate that the new trend will continue. Unsuccessful retest may mean a fakeout and prevailing trend might continue.
ICHI MOKU’S FIBONACCI INTRO VIDEO
Here’s a good introductory video from Ichi Moku, who’s a Pinoy OFW trader specializing in fibonacci retracements and ichimoku clouds. Not claiming any credits, just want to share to every Juan else the valuable lessons I learned from the video. Anyway, it’s publicly available in YouTube.
Some further notes from the video (again, credits to Ichimoku):
- Use fibonacci retracements together with other indicators such as stochastics, RSI or MACD
- Possible entries:
- High risk trader: bounce / reversal at 38.2%
- Medium risk trader: bounce / reversal at 61.8%
- Low risk trader: when price breaks recent high
- Cut Loss levels
- Low Risk trader: breach of 38.2% support
- Medium risk trader: when price breaks previous low
- High risk trader: breach of 61.8% support
Caveat emptor. Watch the video and study further before you execute! Hope these basics made you more familiar with fibonacci retracements, and how it can help you plan your trades.
Scott Carney’s book The Harmonic Trader also covers the Fibonacci ratios comprehensively. I am giving away a copy of this ebook, together with 20+ more ebooks for FREE to those who will avail of our #10Steps ebook and #3M (Money Management Modules).
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