This report takes a look at the basics of using Fibonacci ratios and Elliott Wave theory.
Fibonacci ratios and Elliott Waves help us look ahead and be prepared for what the financial markets will do over the coming weeks and months.
What are Fibonacci Ratios?
Leonardo Fibonacci was a 13th century accountant who worked for the royal families of Italy. In 1242 he published a paper entitled "liber abaci." The basis of the work came from a two-year study of the pyramids at Gizeh.
Fibonacci found that the dimensions of the pyramid were almost exactly the same as the golden mean or (.618).
Fibonacci is most famous for his Fibonacci Summation Series which enabled the Old World in the 13th century to switch from Roman numbering (XXIV=24), to the arithmetic numbering (24), that we use today. For his work in mathematics, Fibonacci was awarded the equivalent of today's Nobel Prize.
Fibonacci Summation Series
The Fibonacci Summation Series takes 0 and adds 1. Succeeding numbers in the series adds the previous two numbers and thus we have 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89 to infinity. At the eighth series, by dividing 55 by 89, you have the golden mean: .618. If you divide 89 by 55 you have 1.618.
Do you see the pattern? 1+1=2, 1+2=3, 2+3=5, 3+5=8, 5+8=13.....
These ratios, and several others derived from them, appear in nature everywhere, and in the financial markets they often indicate levels at which strong resistance and support will be found. They are easily seen in nature (seashell spirals, flower petals, structure of tree branches, etc.), art, geometry, architecture and music.
Why are they important to the financial markets? Because the markets tend to reverse right at levels that coincide with the Fibonacci ratios. Whether you see this as cosmic or coincidence makes little difference. It happens and tens of thousands of traders make decisions based on Fibonacci ratios, thus amplifying the results.
For example, if the Nasdaq rallies 100 points and then corrects, it will often correct 61.8%. Right at, or close to the 61.8% retracement (you have heard us use this term many, many times) the Nasdaq is likely to reverse and start advancing again. Of course it is not this simple. Fibonacci support and resistance levels can fail. There are other Fibonacci levels which may turn the markets (78.6%, 127.2%, 161.8%, etc.). But the fact that it does happen is what is called a trader's "edge."
A trader has an edge when he knows the probabilities of a particular action are greater than normal. Trading strategies are built around this information, or multiple similar probabilities.
Elliot Wave Patterns
Elliot Wave Patterns, in short, are usually a three or five wave series of advances, or declines, that define a trend. They are the result of crowd psychology, and thus are usually more reliable when found in broader based indices, such as the S&P 500 Index, Nasdaq Composite Index, etc.
Typically, if the S&P 500 Index moves higher in a 5 wave pattern, and then falls below the top of wave 3, it signals the start of a retracement that normally consists of 3 waves.
In a bear market it works the other way. A five wave pattern defining a declining trend, which is then reversed by a 3 wave rally, which eventually reverses and another five wave pattern begins to the downside.
Finding a wave pattern that completes at a strong Fibonacci support or resistance level can be a very reliable indicator of a change in trend.
By having an Elliott Wave pattern complete right "at" a Fibonacci support or resistance level, you in essence have increased the probabilities of being correct.
Because the markets often move in 5 wave and 3 wave patterns, and the turning points that create these patterns are often at Fibonacci support and resistance levels (61.8, 161.8, etc), you can expect that eventually, a way would be found to use them to forecast the future direction of the financial markets.
There are several trading patterns used by advanced traders, including day traders, which take advantage of the combined strength of Elliott Waves and Fibonacci retracements.
These patterns commonly repeat in stock and index charts and traders who use them are called "pattern traders."
Although pattern recognition is a potent tool in trading, we suggest that no one try using them without thorough training in pattern trading. There is more to it than just knowing the patterns, including risk management and money management, without which the patterns are more likely to cause headaches than profits.
An excellent book on such patterns is, "Profitable Patterns for Stock Trading" by Larry Pesavento. Larry is an authority on trading patterns, and I studied with him at his home in Arizona some years ago.
How We Use Them
At FibTimer, we use Elliott Wave Theory and Fibonacci support and resistance levels to map out where we think the financial markets are headed.
Recognizing that these tools are NOT always right, we use them to prepare for what is to come, but not for actual trading decisions. It is always good to have a feel for what the markets will do so that we are ready emotionally for the trading decisions ahead.
Although both Fibonacci support and resistance levels and Elliott Wave theory are good tools, they fail too many times to be used for market timing. Many would disagree with this statement, but our research shows that over the years they will give accurate forecasts only about 50% of the time.
They are great when looking at previous chart data, but because there are so many variables, they are not as accurate looking forward. Good... Useful... But not good enough for us.
All trading signals at FibTimer are generated by non-emotional and non-discretionary trend indicators. Our trend indicators catch "every" trend and when a trend fails, they quickly tell us to reverse so any losses are very small. Much better for "profitable" market timing as our market timing trade history pages show.
There is no way to separate emotions from market analysis. If a strategy offers variables that need to be interpreted, emotions will sway those interpretations. It is human nature and cannot be avoided.
This is why FibTimer follows non-discretionary trend following indicators... so that emotions cannot sway any buy or sell decision.