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Coach's Corner: Sometimes It’s Good to Fibonacci

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October 1, 2011

Let’s face it: trading the markets would be a whole lot easier if you knew what was going to happen tomorrow (or next week, or next year). Of course, nothing can predict the future, but you might consider using a charting tool called Fibonacci retracements in your pursuit of a consistent trading strategy.

Leonardo Fibonacci was an Italian mathematician in the Middle Ages who used his brilliance to, among other things, help solve a problem about rabbit population growth. (It can’t be proved that he also opened a ristorante to solve it.) The solution was a sequence that later became known as Fibonacci numbers. Starting with 0 and 1, each number is the sum of the two previous numbers, so the sequence goes 0,1, 1, 2, 3, 5, 8,13, 21, and so on. As the sequence gets higher and higher, dividing two consecutive numbers by each other keeps getting closer to the “goldenratio” of 1:1.618 (or 0.618:1). The golden ratio appears frequently in nature and has been used in architecture for centuries.

SPX fib retracement

FIGURE 1: In January 2011, SPX was in the midst of a strong uptrend. The index pulled back on January 28, and then the trend resumed. In the thinkorswim chart shown, the Fibs are drawn from the January 28 high to the January 20 low, and the 161.8% retracement line indicates the target near $1,322. The SPX made it to the target on February 7 and 8. For illustrative purposes only. Source: thinkorswim Charts


Rabbits and Trading

So now you’re wondering how this applies to trading, right? Well, it just so happens that a lot of math geeks like trading, too. So they started applying Fibonacci numbers and the golden ratio to stock prices and, presto! Fibonacci retracements (we’ll call them Fibs) were born. Fibs are based on the idea that stocks tend to retrace part of a move before continuing in the original direction. One of the ways you can use them is to set target exits for “swing” trades—short-term momentum trades that typically last from a few days to a few weeks. After all, getting into a trade is the easy part, but it’s the exits that can make or break you.

Here’s how it works: find a stock that’s been trending fairly strongly up or down. For an up-trending stock, draw the Fibs from the most recent high to the low point where the move began (for a down-trending stock, draw the Fibs from low to high). Enter the trade on a pullback from the high point, and set your target at the 161.8% Fib level (there’s that golden ratio again).

Now, the trade isn’t going to work every single time, of course, so make sure you manage your risk with a stop-loss, too (1 % to 3 % below the entry price is a popular choice). You may find that setting up the orders ahead of time helps you manage your trading emotions better.

One of the keys to trading success is finding a regular, repeatable strategy. It’s not about predicting the future; it’s about finding a consistent approach to taking profits. Fibonacci retracements can help.

SWEET ALTERNATIVE

You can draw Fib retracements on Trade Architect also. Just click on the Charts tab at the top. In the upper left of the chart, click the "drawing tools" icon, then the "Fibonacci Retracement" icon. Then follow the same logic as thinkorswim Charts.

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