Tuesday, April 1, 2014

Fibonacci keys and the E-mini S&P 500

By Jeff Greenblatt

Many traders are familiar with the Fibonacci numbers sequence and some of its applications and it has been the subject of many technical trading books. The better books often concentrate on the well-known Gartley pattern or Elliott Wave relationships.

However, it’s common for traders to get confused with Fibonacci relationships because they try to put the strategy in a box and make it work with an Elliott count that is only designed to be a guide. Others only know Fibonacci from the retracement tool available in trading software packages.

Serious Fibonacci study, however, goes much deeper than software tools or relationships that just scratch the surface of analytical potential. Here, we’ll cover some common relationships that you can use to trade on any chart in any time frame, providing a foundation for advanced study.

Cross time frame trading

If you believe Fibonacci and Gartley are tied together, you will be missing many opportunities. Fibonacci relationships can be used for stocks, futures and forex charting. What works on an intraday chart will also work on a daily or weekly time frame. But there are a few things you need to know to become proficient and profitable if you seriously want to use this method.

First, there are different relationships between price legs. The most common revolves around the golden spiral relationships. The golden spiral is commonly known as the 0.618, 1.618 or 2.618 ratio. For ease, we’ll call it either the 61, 161 or 261 relationship.

For many people, navigating around the intraday E-mini patterns is too complicated or a mystery because the patterns move so fast. Wayne Gretzky wasn’t the fastest, strongest or biggest player on the ice, but he is the greatest scorer in the history of the NHL. Why is that? Most of the players would follow the puck. Gretzky anticipated, correctly, where the puck would go. While everyone else chased the action, Gretzky usually ended up in the right place at the right time. By understanding the Fibonacci relationships any trader can also learn to be in the right place at the right time, slowing down the action.

“High target” (below) shows us a 180-minute view of the E-mini S&P 500. On this chart, we are looking for a good target for the high. A common target is the point where the first leg off the low (in this case A) has a 61/161 relationship to the secondary low, which is B. In other words, A will be 61 of B-C and B-C is 161 of A. As you can see it’s not exact but it’s very close.

With Fibonacci, many times close enough is good enough. This is what confuses many. Some people shy away from trading with Fibonacci simply because they are not comfortable with this concept. They are looking for pinpoint, textbook precision that quite frankly is not there in many cases. In trading, there is no such thing as perfection.

Traders must learn to manage risk. Sometimes the legs will give you that close to a perfect 61/161 relationship. Other times, it will be slightly off. A 61/161 relationship might really be a 0.625/1.60, or it might even be 0.59/1.68. Let’s say you have one leg that is 9.5 points and the other leg in the sequence is 16 points. That is obviously not 61/161, and the actual calculation is 0.593/1.68. If the trader is going to make Fibonacci work, he will have to get used to this kind of imperfection.

“Projecting the low” (below) is an example of a very close approximation—close enough, in fact, to call it a 61/161. The actual calculation for A is 12.25 points and BC is 20.25 points, which is a 0.6049/1.65. A tick either way would make it perfect. If you are getting the idea that the real-world use of Fibonacci is part art and part science, you are correct.

How legs relate

An important variation is the relationship of the first leg (F) to the last leg (LL). Many times in any time frame, the relationship between the first leg to the big move will be imperfect. It may be 61/161 or off the tracks, so much the golden spiral relationship isn’t even in play. In this situation, we have a fast moving three-minute environment that resembles a five-wave impulse pattern, where the move off the secondary low to the high before the high would be something Elliotticians consider the third wave.

Here, F can also be considered the first wave and LL the fifth wave, but it’s the relationship that’s important. In this case, F and LL are each equal at 3.75 points apiece (see “Equal waves,” below). A variation would be a relationship where F and LL would be either 61/61 or 161/61 to each other. If the trader just concentrates on the relationship of the first and last leg, he could improve his batting average for picking tops and bottoms substantially.

As noted previously, the pattern isn’t going to give you the 61/161 relationship all the time. To this point, you’ve seen relationships measured between A and the move off the secondary bottom or top. An important variation is where A will be approximately 61 to the entire range. That means you take the measurement of the A leg and compare it to the entire move.

In “Taking measure” (below) the A leg measures 0.59 or 59% of the entire move. The 59% relationship is just about far enough to consider it close enough for a golden spiral. Any more than that, and it becomes too much of a judgment call. Also, what confuses traders about a move that has a relationship of either 61/161 between the legs or the A to the whole is whether we consider 61 to the whole complete. That is, should we take a trade going the other way if all the market shows is a 61 to the whole?

The answer to that question depends on overall market conditions. For pure trading strategy, picking tops and bottoms is not generally a winning strategy. If you look back at the five-wave sequence, you’ll see the A wave is generally the smallest move. It also will retest the absolute pivot before the big move materializes.

What that means is if the trader is good enough to pick the high or low six out of 10 times, he is only batting a little better than 50-50. What that also means is he gets stopped out a lot and is setting himself up to trading the smallest move in the sequence. That’s why lots of traders never progress beyond the breakeven point.

When the trend ends

Perhaps the most consistent application of Fibonacci is to let it tell you when a trend is complete. Once you get your calculations, you look for a retest of the high or low or a secondary high or low. Trade that leg and your chances of being con-sistently profitable go up exponentially.

It really doesn’t matter if you are trading a 61 relationship from the B secondary pivot or a 61 relationship from the absolute high or low. What you are looking for is a retest of that pivot that will lead to the biggest move in the sequence.

There are variations. One can retest a high or low, but tests of gaps are important as well. Gaps are tricky because the trader has to deal with the uncertainty of whether the price action fills the complete gap or only part of it. The idea is to have a strategy of what to do before the price action gets to the gap. As the price action enters the gap, look for the Fibonacci relationships and see if a reversal materializes by virtue of a reliable candle reversal formation.

Traders also struggle with countertrend bounces. The same principles apply. In this case, the first leg off the bottom is 159 points and the entire range is 261 points (see “Bearish set-up,” below). You can’t expect to get much more textbook than that. The ratio of 2.618 to 1.59 is 1.64. The best strategy is not shorting the actual peak but waiting for a retest and then entering just below the topping candle. At that point, sellers are starting to take control, and the probability is high the trade will work. On a secondary high, chances are also good it will lead to the best part of the move. The move off this YM secondary high is 330 points. Hindsight is always 20/20, but the number of quality red bars characterizes the move.

Fibonacci is an excellent tool with a variety of uses. These days, the environment is challenging considering high-frequency traders have an edge down to a millisecond. Fibonacci, however, can describe the underlying structure to all markets. Just like The Great One waiting for the puck, if you correctly anticipate where the biggest part of the move is going to materialize, it won’t matter if a bigger, faster trader is quicker after the move begins.

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