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.

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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

As always our videos are free to watch and there is no need to register. After you watch the movie, please feel free to comment on blog.

I am scalper, that’s why. I am looking for very short fluctuations in the markets to exploit and earn 12 ticks, or three points. It’s my only goal in trading. I don’t care if the market it going up or down as I am as comfortable being long as I am being short the ES Emini contract. All I seek is movement and the ability to ascertain which way the market may move for the next ten minutes.

I don’t let any trades go overnight, ever.

I don’t let a winning trade turn into a losing trade. (This is sometimes easier said than done)

I have a system, and I never “guess” what the market might be going to do. The variables in my system must meet certain criteria before I trade.

If I don’t feel good about a potential trade, I don’t take it.

I use an 89 period SMA and if the price action is significantly above the average, I only take long trades and, conversely, if the price action is significantly below the average I take only short trades.

I avoid counter-trend trades like the plague, yet I find myself taking the occasional counter-trend trade.   Don’t ask me why, I do not know why.

I use the MACD, CCI, Average True Range, DecisonBar and Stochastic indicators in combination to select my trade.

The entry points for the CCI and Stochastic indicators must be in agreement for me to take a trade.

I never break my entry rules.

I pay close attention to pivot points, and Fibonacci Retracement levels.  I use these tools as background information, not primary indicators.

I recommend most people start with the YM contract, and then only after a month or so of paper trading where the trader can consistently profit on a daily basis.

There are no born traders, there are well trained, intuitive traders.

My mother thinks trading is for idiots.  (I hope she is wrong, on this one)

On the CCI, pay careful attention to the +100 and -100 levels, they are your entry points.

On the stochastic indicator, pay careful attention to long and short crosses.

Never trade without stops, ever.  Never trade without stops, ever.

Have a target profit point, too.

I sometimes let trades run, but you often risk giving back all your gains when you implement this strategy.  Pigs get fat, hogs get slaughtered.

Decision Bar has kept me out of more terrible trades than I care to think of.

A change in the direction of the divergence line on the MACD might be a good reason to consider exiting a trade.

I never double down on a losing trade.

I’ve never been able to make head or tail of chart formations, as they make no sense to me.  They may work for some people, I ignore them.  To me, Head and Shoulders is shampoo, not a potential entry point.

While you should profit most days, there will be days when you don’t.   That’s okay.

There is an indicator which has been around since 1957. It has accurately forecasted every inflationary and deflationary cycle since.

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Leonardo Pisano, better known by his nickname, Fibonacci, was an Italian mathematician born in Pisa in the 12th century.

He is known to have discovered the Fibonacci Numbers, said to be based upon observations of the Great Pyramid of Gizeh in Egypt. Fibonacci Numbers are a sequence of numbers where each successive number is the sum of the two previous numbers.

e.g. 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, etc.

There are varying views on the significance of the numbers, and it’s important to understand that it is not the numbers themselves that are important, but the ratio between the numbers, also called the “Golden Ratio.”  When used in technical analysis, the golden ratio is most often translated into three percentages: – 38.2%, 50%, and 61.8%

The key Fibonacci ratio of 61.8% – also referred to as “the golden ratio” or “the golden mean” – is found by dividing one number in the series by the number that follows it. For example: 8/13 = 0.6153, and 55/89 = 0.6179.

The 38.2% ratio is found by dividing one number in the series by the number that is found two places to the right. For example: 55/144 = 0.3819.

The 23.6% ratio is found by dividing one number in the series by the number that is three places to the right. For example: 8/34 = 0.2352.

Okay, so there is some background….

The real question is whether Fibonacci retracements are a valid tool in trading emini contracts.  There has been a great deal of debate over this issue when Fibonacci systems began making their way into technical analysis in the early to mid 1990′s.

To utilize Fibonacci retracements it is important to identify the period of time you plan to analyze and ascertain the peak to trough numbers of that cycle in price movement.  Some investors use very short time periods, while swing traders may look to use far wider ranges of time periods.  Of course, you can calculate the retracements by hand, but most programs have drop and drag functions that will do it for you with a couple clicks of your mouse.  You will end up with a chart that looks as follows:

fibonacci retracements

Fibonacci theorists usually use the three main numbers, 38.2%, 50%, and 61.8% to calculate the retracement patterns in a market move.  Note:  50% is not a Fibonacci number but is commonly used.

fibonacci retracement

So, as you can see, Fibonacci theorists calculate the retracement patterns by using the retracement numbers we have outlined.   There are times when the market, for unknown reasons, follows these retracement patterns…there are other times when the market pays absolutely no attention to the numbers and they are of limited value.

A Google search will turn up scores of articles on Fibonacci retracements and a wide variety of trading applications for their use.  There are also academics who completely discount any value in the numbers and associate any apparent validity to sheer coincidence.  Some technical analyst swear by them, and they are an integral part of their trading strategy.

So, you ask, what do I think of Fibonacci Numbers?

I don’t use them very often, as it is fairly easy to eyeball the retracement patterns.  I am a chaos adherent and the Fibonacci system doesn’t dovetail very well with my investment beliefs.  I see them as having limited value in my trading scheme, which does not mean they aren’t important for other traders.  I simply don’t need them to be profitable when it comes to the scalping techniques I employ.  I encourage you to investigate Fibonacci retracements and play with them some during your trading and see if they are of value to you…we all view trading strategies in different ways.  Again, there are tons of articles on this subject and many Fibonacci adherents are very vocal in their defense of the technique.  Whether it works or not, I simply don’t use or need them.