Fibonacci Analysis Read online

  In Figure 2.3, a price high is defined at pivot A for Caterpillar, and a price low at pivot B, as most traders have been taught. However, Caterpillar never realized the first support level within this subdivided range near $29 (the 38.2 percent retracement) when the pullback occurred to the price swing low at pivot C. What happened? Fibonacci doesn’t work, some will say. They would also be right if all they ever do is take a price high and price low to define the range in this manner and think they have a viable target price. The reason this calculation is off is this market is expanding.

  Caterpillar was preparing to explode upwards in price as you see in Figure 2.4. This is the same weekly chart for Caterpillar, but the retracement ratios to define a price target for the trade entry level have been taken from a different swing range. In this chart, the high at point A is the same price selected in Figure 2.3. But point B, marking the low of this new range, is one swing higher than selected for the calculations in chart Figure 2.3. W.D. Gann stated in his stock course4 that he often found the secondary swing away from the actual bottom, or the secondary high after the end of a trend, to be of greater value than the actual price that ends the prior trend. By moving the low of the range first selected up one swing, we find the market retracement to point C trades at our calculation for a 38.2 percent support target. I have found this to be true and will show you how markets give us internal price clues that tell us when we should make adjustments like this and when we should not. But first we need to build a stronger foundation on the concept of market expansion and contraction, because this is the reason why the calculation in Figure 2.3 did not let a trader enter the market at his target.

  FIGURE 2.4 Caterpillar—Weekly Chart

  Connie Brown, www.aeroinvest.com. Source: Copyright © 2008 Market Analyst Software

  Every reader has likely seen the stunning curvature that forms in the ivory shell from the Indian Ocean called Nautilus pompilius (Figure 2.5). This sensuous curve can be found in many other forms of nature such as hurricane clouds (see Figure 1.1), DNA nucleotides, sunflowers, the solar system, and in chemistry the uranium oxide compounds U2O5, U5O8, U5O13, U8O21, and U13O34.

  Opposing spirals of seeds in a sunflower generally appear as adjacent Fibonacci numbers, typically 55 : 34 (1.6176) or 89 : 55 (1.6). Scales of pinecones are typically 5 : 3 (1.666) or 8 : 5 (1 : 6). Artichokes display eight spirals going one way and five spirals the other. Pineapples have three spirals, often 8, 13, and 21 where 21 : 13 : 8 approximates φ : 1 : 1/φ (0.618 : 1 : 1.618). Nature pulses with cycles and rhythms that increase and decrease. Plato noted, “The way up and the way down are one and the same.”5 On the way up, nature uses additive and multiplicative relationships. On the way down, nature uses subtraction and division to diminish and create the logarithmic growth and decay cycles you see exemplified by the nautilus shell. The simple logarithmic growth spiral, or golden spiral, is derived from Fibonacci numbers.

  When the spiral is logarithmic, the curve appears the same at every scale, and any line drawn from the center meets any part of the spiral at exactly the same angle for that spiral. But the bigger question is this, how do you make money from a curve that wraps round and round when your market chart has the current data on the right side of your computer screen and the oldest data is dropping off the left side of the screen?

  Every book I have seen has these stunning images and authors seem to think this relationship between the curve and a two-dimensional chart on paper is intuitively clear. Well, it is not. In fact, it took me some time to really get it. It’s not the Fibonacci numbers that everyone is talking about that will turn you into a market guru; it’s all about the ratios that form between these numbers that will take you to the bank. Depending on how these ratios fall within our market data, the ratios that cluster together can even warn us how fast the market will move towards the target. You will see examples in Chapter 6 when we consider market character between target zones.

  FIGURE 2.5 Nautilus Pompilius Shell Compared to the Golden Spiral

  Source: Private photograph collection of Connie Brown

  Look very, very closely at the mathematical representation laid over top the nautilus shell in Figure 2.6. When you study this shell as an overlay with the theoretical Fibonacci squares that create the spiral, you can see more easily that the shell curvature departs from the ideal mathematical model for perfection. Side by side in the first diagram (Figure 2.5), they looked the same but they are not.

  FIGURE 2.6 The Nautilus with the Golden Spiral

  Source: Photograph and artwork Connie Brown

  The curvature of the shell tracks the math model to perfection closely up to the line for 21 units in length. Then the curvature of the shell departs the math model by showing a tighter growth spiral than the ideal math projection. This contraction is reality. The math model is theory. Anyone who has ever calculated a Fibonacci ratio by slapping a mouse pointer on a price high and defined the extreme end of the range at the price low, has missed the boat about what these ratios mean within the context of an expanding or contracting growth cycle. You may have thought Fibonacci doesn’t work in the markets as a result. But Fibonacci ratios work no differently in markets from how they unfold in nature. There is nearly always a contraction or expansion factor at play within the market price swings, and this forces you to depart from making a theoretical projection. If you learn to work with the laws of nature and change your expectations that markets will mirror theoretical perfection, you will find that all markets in any time horizon will respect your targets more often.

  Market Symmetry, Expansion, and Contraction

  Staying with the weekly chart for Caterpillar in Figure 2.7 allows us to measure an expansion cycle within this stock. In Figure 2.7 are three market ranges (d, e, and f ) marked with vertical lines on the right side of the chart. The market swings for Caterpillar have been marked with light gray within the chart. Focus first on the shortest range, d, found in the middle of the chart. A double vertical line is used for range d to help your eye focus on the first range drawn.

  The purpose is to see if this stock is developing swings that are expanding, contracting, or remaining symmetrical. Range d is the strongest part, or most forceful swing, of the move up in this chart. I am selecting a price high and low that allows the 50 percent line to fall within the strongest single bar within this swing. (If you know the Elliott Wave Principle the bar to study is Wave 3 of iii.) Line A is the result of bisecting range d equally, giving the 50 percent value of the range. Now move up to range e, where one corrective swing and one rally swing have been added at either end of range d to expand the first range used.

  Range e defines the 50 percent division at line B. This line is slightly higher than line A. This means the market has expanded its proportional swings in e relative to range d. Now consider price range f created from a range enclosing the price high and price low in this chart. The 50 percent line at C has shifted slightly higher than line B in the second range. The expansion cycle in this market is increasing. If a trader only used Fibonacci retracements by taking a price high and low, the trader would have to chase or never get in the market because the market reverses before reaching their targets.

  FIGURE 2.7 Caterpillar (CAT)—Weekly

  Connie Brown, www.aeroinvest.com. Source: Copyright © 2008 Market Analyst Software

  When a market is contracting, the 50 percent lines within multiple swing ranges will fall below the 50 percent lines. It means the final swings are likely contracting as the market loses momentum.

  The only time a trader will have success by using a Fibonacci ratio derived by taking the extreme market high and low is when all the 50 percent lines fall on top of one another. In this case, the market is developing swings in a symmetrical proportion, and the upper swings likely mirror the lower swings. Markets spend more time developing expansion and contraction proportional swings than they do symmetrical. So a trader with basic understanding of how to create Fibonacci retracements will only hav
e marginal success. The other problem is if you start to define your ranges from the wrong direction. You will always be forced to assume the market is forming symmetrical swings because you cannot see any other result. All ranges to define support will start from the same high. All ranges to create resistance will start from the same price low. But do not assume the actual market extreme is the correct starting point.

  It is hard to abandon old ideas or ways of applying a method, so another example is offered. In this example, the market will show us it is contracting. In Figure 2.8, we see a weekly chart for Centex Corporation (CTX). Consider the chart with no data created after the high marked point A. We want to determine a retracement price target to enter this stock. From point A, we start from a high and work down to a low to define our range. The end of this strong swing up is at price level B.

  FIGURE 2.8 Centex Weekly Chart

  Connie Brown, www.aeroinvest.com. Source: Copyright © 2008 Market Analyst Software

  Level B has something extra you should notice: it marks a double bottom that is a directional signal. After the range is subdivided, look for internal milestones within the price data to confirm you are on track. In this case you are, because the price high at d is exactly under the 61.8 percent line. Therefore, you can see the market has respected this ratio before. It is important to say that you should not pick level B because d fits. Only look back after the range is set. Confidence you selected the correct range occurs as you study numerous internal milestones within the price data, which I will discuss shortly.

  The simple retracement calculation at the 38.2 percent line holds the market perfectly at price low C. This corrective pullback confirms you made the right calculation, but it comes after the fact. Another problem develops with just one range selected; you cannot tell where the market is going next or where the market should not go. You have not defined where to put your stops either. So there is much more ahead for us to discuss.

  Centex Corporation (CTX) is displayed again in Figure 2.9. A new range has been selected when a new high develops at point A. The end of the range is marked B and the 50 percent line falls within the middle of the strongest swing up. However, this time there is a big difference from the example for Caterpillar. This time the 50 percent line subdivides the larger range below the 50 percent line that marks the middle of the smaller internal range discussed in Figure 2.8. Centex is showing that the weekly data is beginning to contract. If point B truncated the small key reversal spike by bringing the bottom up to the low of the bar behind the spike, we would have found the key reversal at point C was off by the same amount. So I used the price low of this swing low at C to confirm this was the correct range to select.

  I will show you more about how to select the ranges and what internal milestones or clues to look for, so you can have confidence that you are doing it correctly. The key and concept people miss when analyzing the nautilus shell is that the logarithmic spiral is the same at every scale, and any line drawn from the center meets any part of the spiral at exactly the same angle for that spiral. You will see that markets give you the points you should use to create your analysis. The same markers will form in every market, regardless of time horizon, but you have to know what points to use to subdivide a range and create your ratios. Markets often ignore the price bar when trader sentiment runs amok forming a key reversal. The markets give little weight to the fact someone was foolish enough to enter a market order during the lunchtime doldrums of the day allowing a market maker to run the stops. I will give you a consistent blueprint for uncovering individual price grids hiding within price data. These points have proven to be reliable over twenty years of trading in trending or volatile market conditions.

  FIGURE 2.9 Centex Weekly Chart

  Connie Brown, www.aeroinvest.com. Source: Copyright © 2008 Market Analyst Software

  Figure 2.10 displays a 3-day chart of Centex Corporation. This chart clarifies why Figure 2.9 showed a market beginning to contract within its internal proportions during the rally and for good reason. A major top in the home building sector was approaching. So we understand markets expand and contract and it raises the question, how do we select a range to be subdivided if the market proportions are shifting in expansion and contraction cycles all the time? The market will show us how it is using specific bars to bind the proportions, allowing us to calculate meaningful support or resistance targets using Fibonacci ratios.

  FIGURE 2.10 Centex 3-Day Chart

  Connie Brown, www.aeroinvest.com. Source: Copyright © 2008 Market Analyst Software

  Figure 2.10 contains the first internal milestone that always helps define the start and end of a range. Always align a gap near the 50 percent retracement line. In this chart the market has declined sharply to price low A. From A, the stock has a bounce and then marginally breaks below A. What is the correct low to use? We want to find a resistance target over the current market price so we must start at the price low. If we start at price low A and drag our mouse up to the price high at B, we will see the 50 percent line falls in the middle of the gap. If you started from the actual market high and dragged your mouse down to the low, you would never see this internal milestone form. That’s why you must start from a price low and consider key swing highs within the range of the decline to find resistance. If the price low selected was the key reversal just past point A, you would have discovered the range high at point B would draw the 50 percent line right on the price highs forming on the bottom of the gap. In intraday trading, I often use this range for an early entry, but I know my stop has to be slightly higher. We will look at stop placement later in the chapter. So Figure 2.10 has introduced the first internal milestone the market gives you to begin to develop the price grid that the market will respect in future price swings. This is only the start.

  Now we want to examine the data to see if the market has shown respect to the subdivisions within our price range in the past. By extending the subdivisions of the range in Figure 2.11 to the left, we can see a few clues, but they are subtle and difficult for a first example. The corrective rally that follows into the 50 percent retracement seems to be confirmation, but keep in mind this only confirms that we took the correct range after the fact. We need confidence at the time we first define the range to subdivide.

  FIGURE 2.11 Centex 3-Day Chart

  Connie Brown, www.aeroinvest.com. Source: Copyright © 2008 Market Analyst Software

  By extending the lines to the left in Figure 2.12 and changing the look-back period of this chart to include data from 2003, we can see several points to discuss where the market has respected these levels in the past. Keep in mind that the range was selected when we could not see this data. The first set of clues that range AB has been correctly identified is the result of the market respect shown at pivots e, d, and c. If you had used the price low just after point B, all these key pivots would have been off an equal amount that the swing low falls under B. As we study the chart further, we see points f and g where strong moves began or were cut off. Point f will have great significance after the next example, but as an introduction to where the market truly starts a strong meltdown or thrust up, these internal milestones will always be important within the data. The point I felt would be hard to start with, when the chart in Figure 2.8 was viewed, is seen at point h. A back-and-fill pattern after h told me the selected range was correct, as the 61.8 percent retracement held the market over a period of many days. I will also notice when all the closes stay above (or below) such an internal line. In my experience, most traders in my seminar look only at the big picture and do not know how to look at the internals of the price data for valuable information. So I know this takes time and some work, because it is very different from how you likely read charts now.

  FIGURE 2.12 Centex 3-Day Chart

  Connie Brown, www.aeroinvest.com. Source: Copyright © 2008 Market Analyst Software

  I have been reading charts a long time using these methods and am very fast at it. The speed come
s from knowing there are a few internal points that the market always uses as critical markers. Gaps are one type of milestone, but there are many others such as strong bars. I’ll cover these next.

  The decline of Centex continues to unfold, and you see the results in Figure 2.13. We sold the directional signal just behind point B and ran the trade into the lows near point A in this chart. How the targets for the decline were created will follow shortly, for now just study the entry levels at B and C into the corrective rally highs. Assume we unwound the trade near the lows at point A, and the indicators show that this market will still develop more of a decline.

  Where do you get back in? Using the price low at point A to start your range, drag your mouse up to point B immediately. This is one of the major internal milestones or clues I was referencing. After the key reversal high just behind B in Figure 2.13, you see three bars showing the market could not exceed resistance at this level. (The mere fact that the bar highs all top near $49 is enough evidence to correctly call this area of resistance from the price data alone.) But from this small area of resistance, you see a strong break that moves the market towards $44 in only two bars. Every time you find the market starting strong trends like this in any time period, use the data to your advantage and define the end of the price range at this level and do not go on to select the price high.

  Range AB is picked, and now we must ask if the three subdivisions within the range AB are major or minor resistance levels. To answer this, we must define a second range of different length, but the start of the range must be from the same low at A. Within the data, I see immediately the place where the next calculation must be made, as another strong bar shows a breakdown at b. The second range uses the same low as A so a marks the same start. The end of the range that we want to subdivide is b. We may not use any bar high that has been retraced in a corrective swing up. Therefore, all the bars that form behind $50 from the $40 low were retraced and cannot be used to mark the end of a price range. The first strong bar that developed is at b. Keep in mind that this calculation is being done before the swing forms from A to c. The entry target is where the two ranges form a confluence zone. Confluence forms on this chart where the 50 percent retracement aligns with the 38.2 percent retracement. Confluence zones form when different Fibonacci ratios come close or overlap from multiple ranges. Confluence zones are price inflection points of major support or resistance. Now we are really making progress because we can answer where the market is going to go next, when the market first starts to roll up from the lows at point A.