We have talked about cycles and how they repeat themselves. There have been many examples of booms/busts throughout history and there will be many more.
One of the most famous events was the "South Sea Bubble" which occured in 1720. Quoting ...Markets go up and down over time and there are many reasons for a change in direction. Economic news, market sentiment, geo-political events, the attitude of the market makers and manipulation are all factors that govern the current direction of the market.
The markets move in cycles and in particular at the larger time frames these cycles are the key drivers for market direction. In the shorter time frame, markets can be manipulated and economic news can distort the picture, but generally markets will move in the larger cycles.
Is there any way of predicting when a cycle (or market move) will end and the direction change?
Yes there is.
Back in the 12th century in Italy, a mathematician called Leonardo Bonacci first brought to the attention of the world a unique series of numbers that were named the Fibonacci sequence. The numbers had been know about before but Leonardo was the first to introduce them to Europe.
The sequence begins with the number 0 and 1, and the next number is always the sum of the previous 2.
How does this work? Let’s create the sequence.
0,1,2,3,5,8,13,21,34,55,89,144,233,377
and so on.
What’s so special about these numbers? Well if you take 2 consecutive numbers and you divide the lower number by the higher you will get the value
0.618
If you divide the higher by the lower you will always get the value
1.618
This a fixed ratio which becomes more accurate as you go higher up the fibonacci sequence.
This ratio has a special name, it is called “The Golden Ratio” and it is found throughout nature, architecture, space, phsyics, medicine; you name it, and the golden ratio has some part to play. Of course this means that the ratio also appears in the markets.
More information about the background and meaning of Fibonacci numbers and the Golden Ration can be found here
http://en.wikipedia.org/wiki/Fibonacci
http://en.wikipedia.org/wiki/Golden_ratio
How Does Fibonacci Work In The Markets?
We have said how markets go up and down and that they work in cycles. When a market has reached a top it will subsequently drop and as it drops it will pass through certain levels which correspond with fibonacci levels. It is as these levels that the market is likely to turn back up again. This is called a retracement.
How does a retracement work?
A retracement is where you take the distance between a high and a low (or a low and a high) and retrace that move. You can see it in the picture below:
If you look at the picture we have drawn a retracement between a recent high and low, and then back again. The retracement levels are at fibonacci values and you can see that there are direction changes at levels 38.2%, 61.8% and 78.6% which are well known fibonacci values.
What are the best fibonacci values?
The most well known fibonacci levels are 38.2 (0.382), 50.0 (0.5), 61.8 (0.618), and 100 (1.0). There are the ones that most people are aware of, but there are others.
For example if you take the value 0.618 (the golden ratio) and take the square root of it, you will get 0.786. If you repeat this process you get the folling list.
0.618
0.786
0.886
0.941
These are all levels that can be used in the markets. In particular watch out for 0.886 and 0.941. These levels can lead to new directions in the market which can lead to huge moves.
Fibonacci Extensions
Now fibonacci levels are not just used in retracements, they are also used in extensions. How does an extension work?
This time a recent high and low is also linked but the retracement goes back above the high and is extended upward into the future.
Now with extensions the fibonacci level goes above 1. So you get figures like 1.382, 1.500 and 1.618. Ther series goes on forever as can be seen in the diagram. Here we have a major change in direction at 2.618.
In my longer term analysis over weekly chart etc we can take these fib levels above 3,4,5 etc.
So fibonacci levels are very powerul numbers, but remember they are just indicators. Don’t make a trade until you get a confirmation of a change in direction after the fact. In many cases the chart will pass straight through a level and head for the next one.
Use other tools to confirm a trade. If you get signals from more than one tool at the same time then that will provide a higher probablility.
Once again I will raise the point. Trading is all about probabilities, and you need to get them on your side.
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