Ratios obtained by dividing a number in the Fibonacci sequence with the number before it and with two numbers before it are always the same. These two numbers 1.27, 0.618 and 0.382 are very important and occur frequently in nature. These three ratios are used to construct Fibonacci Retracements and Extension Levels.

When there is a trend, price action is steadily going higher or lower. In case of an uptrend the price action makes higher highs and higher lows. While in case of a downtrend, price action makes lower lows and lower highs. This is hard to explain in words visualizing but I will make an effort. It is much better explained in front of a price chart. In case of an uptrend, price action starts from the support A, goes to resistance B, bounces back retraces itself and reaches a newer support C somewhat higher than A bounces back and reaches a higher resistance D before it again bounces back and reaches a still higher support E. So the price action can be broken into these three segments AB, BC and CD.

Now let’s start and draw Fibonacci Retracements. From B when price action bounces back, it retraces the past price action and the most likely place for the new support is one of these Fibonacci levels 0.382, 0.5 or 0.618. Either the price action is bounce back close to 0.382 level or 0.5 level or 0.618 level and then move back to the new resistance. This new resistance will be higher than the previous resistance at B. This new resistance can be at 1.27 or 1.618 from B.

Now while constructing Fibonacci Retracement and Extension, we will start from price A. Calculate the price difference between A and B. Take the three ratios 0.382, 0.5 and 0.618 for this price difference and plot them on your chart. Don’t worry, your trading software will do that nicely for you automatically but you need to understand the concept. Suppose the price difference between A and B is 100 pips. If the price bounces back from 0.382, we say that the retracement was 38.2%. If is bounces back from 0.5 level we say that the retracement was 50% and if it bounces back from 0.618 level, we say that the retracement was 61.8%.

After the market bounces back and takes a U turn at one of these retracement levels and rallies to the point D we say that the market has moved 27% above the original move AB or a total of 1.27%. Now if you want to become a serious trader no matter what market you trade, you should learn Fibonacci Retracement and Extension.

Mr. Ahmad Hassam has done Masters from Harvard. Get the Ultimate Swing Trading Software FREE. Learn Fibonacci Retracement!

Do you find it ironic that we understand the more about the subatomic world of molecules than we know about how the market and it’s functions?  Some of the best and brightest academics claim there is no predictive ability in using Fibonacci trading.  Why?  The science of predictive indicators does not pass the litmus test of scientific legitimacy.  If you have ever traded Fibonacci numbers, can you tell me whether the market will turn on 38% retracement, 50% retracement, 61.8 retracement?  That’s the problem academics have with these systems, there are no empirical facts.  Yet many traders swear by them and are very successful in trading them profitably.

Welcome to the world of day trading.  It’s a world where traders use systems that are wildly varied and the results are unpredictable.  Because the functions of the market are not well understood, as evidenced by the universe of varying opinions on market price action, you will find a plethora of divergent theories and traders who vociferously defend the system they trade to the exclusion of other trading systems.  Further, you are unlikely to find two traders who trade identically, even if their investment philosophy is identical.

Let’s start with the Fibonacci numbers.  The ratio used to calculate this set of numbers is 1.618 and it stays constant throughout the sequence.  Originally identified by mathematician Leonardo Fibonacci in the thirteenth century, their popularity has increased exponentially in day trading.  The question is whether they work, and why do they work.  Anyone who has traded Fibonacci numbers comes to realize that the market often pauses, sometimes turns, and often blasts right through the sequence of Fibonacci retracements.  There is no denying the numbers are relevant, and traders pay attention to them.

But why does the market stop and start so often on these numbers?  In trading we don’t necessarily worry about the “why” questions, if something works or has predictive value it is used.  You cannot necessarily predict which Fibonacci number the market will choose to honor.  On the other hand, many people identify market high and possible lows using Fibonacci ratios, but any trader could identify these point using the alternate method of support and resistance.  Yet this support and resistance often occurs right at the 50% or 61.8% Fibonacci levels.  Sheesh…..

It is my opinion that Fibonacci numbers work just fine, but the reason they work is because so many technical traders use the system.  When the market makes a move from trough to peak, most technical traders will immediately add the Fibonacci retracements to the entire move, and hence the system becomes a self fulfilling prophecy.  And that’s okay.  Many true Fibonacci traders take offense to this explanation, and claim there is relevance in the ratio.  Perhaps there is, but I’m not buying that explanation.  As a chaos theory adherent, I feel the only scientifically relevant explanation is the self-fulfilling prophecy argument.  The Fib people point to ancient architecture and a wide variety of natural phenomena that use the Fibonacci sequence.  It’s true, lots of ancients architects and unexplained phenomena have relevance in their respective fields, but I cannot connect the dots.  Which is to say, “yes there are Fibonacci numbers all about, but what does that have to do with investing?”  The answer is a resounding “nothing at all.”

But I still use Fibonacci numbers in my trading…

As a day trader, my job requires me to take profitable trades.  Whether the Fibonacci sequence is scientifically verifiable is irrelevant to me, as I am only concerned with profitable trades.  I cannot recommend using only Fibonacci ratios in your trading.  However, I always trace in the retracements after a significant market move, up or down.  You would be surprised how often the market honors them, too.  I especially like to trade the Fibonacci when it has already stopped and turned on a specific number, as this establishes real legitimacy for this point on the chart.  Then I can go to work trading, based on the info the Fibonacci has imparted.

So there you have it, the reason the Fibonacci ratios work is unclear, and I am unwilling to bestow mythic credibility based on the history of the ratio.  On the other hand, there is no denying the market pays attention to these numbers.  Whether I believe they are a self-fulfilling prophecy is irrelevant, because as traders we only deal in profitable trades and growing account balances.  The “why” just doesn’t matter.

detailed ES Emini day trading chart ESZ9 for Nov 23, 2009

Well, the market started out with a great up move and then sort of unwound for the rest of the day.  Notice that I put the Fibonacci replacements in the chart and the market found support at the 61.8% level and then hovered above and below that level for quite some time.

It was not an exciting day to trade, though I had to fight impulses as the market faded of the highs to stay and in the trade and let it ride.  Not an easy thing for a devout scalper, but I managed to stick by my guns.  The volume, as it has been for quite a while, was not overly impressive which, in my mind, doesn’t point to a terribly robust market.  We shall see.

I was just looking at the charts and they are beginning to look very, very bullish. The formation I show you in today’s video is a classic continuation pattern to the upside. This pattern also confirms a Fibonacci target number we are looking at.

This video is short and to the point and I think it will get you thinking about this energy market.

Click here to see where crude oil is headed

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