Observations of Fibonacci relationships in the Forex Markets and the use of Fibonacci tools in Technical Analysis
by Fan Yang CMT
FXTimes Chief Technical Strategist

In our previous article, we explored Fibonacci relationships, specifically the golden ratio (1:1.61.8) or phi, as it appeared in nature. We also came to an understanding that whatever application we now make in the financial markets require a stipulation that market behavior resembles nature; that as market’s progress (grow) or regress (decay) from one position to another -  that the movements are based on human behavior, led by market psychology and different trading emotions.

When the market is moving, we can see retracements and expansions. The retracement of a swing means the move against the direction of the swing. An expansion of a swing means another swing in the same direction after a retracement. Let’s take a look at some forex market movements in the recent past to see if we can see any patterns in significant retracements and expansions.

Fibonacci Retracement

Retracement is another word for a correction, or a reversal attempt, which is a move against a prior bull run or bear run. He we had a rising wedge in the EUR/USD broken to the downside to start a correction attempt. Let’s take a look at the measurements of different parts of this retracement.

The EUR/USD is seen in the above 4H chart consolidating, with a bearish tilt after hitting a high near 1.4540. Note that the first wave down was caught at the 38.2% retracement level. A second came down to the 50% level, and a third came down to the 61.8% retracement level.

Zooming in to the 1H chart, and looking at the first swing down followed by a pullback, we see that the pullback extended past 61.8% retracement, but was immediately rejected. The 1.4450 pivot was another resistance factor. And the market was more focused on that then the 61.8% retracement level.

The second swing down after that pullback from the previous image is also capped by a pullback. This pullback is also rejected immediately after cracking the 61.8% retracement level.  The market continued lower after the rejection from above 61.8%, as the market also tested the 200SMA. Also note that we  had a bearish divergence with the RSI after it tagged 70 (overbought level in a ranging market).

Extended Fibonacci Retracement:

Fibonacci retracement can extend further than 100%. The example below shows the EUR/GBP after a correction decline is complete. When we measure the completed correction, and look at its retracement levels, you see that after breaking above 61.8%, we can start to consider the possibility of a continuation. In this case, the continuation materialized, and the market “extended” the retracement of the decline to 138.2% before the market topped off for another correction decline.

Reinforcement of Fibonacci Retracement Levels:
It may not be prudent to simply depend on the fact that a market is at the fibonacci level to forecast a reversal. There are other signals or factors that can help reinforce the strength of the fibonacci retracement level. As we saw from the above examples, other technical signals like divergence or presence of  say the 200-period moving average can also help determine possible retracement completion. What else strengthens fibonacci levels as support or resistance?

1) Fibonacci and other Pivotal Cluster: If a level is 61.8% retracement of a swing, and also 50% retracement of a larger swing for example, this retracement level will more likely become a pivot. This is because the more fibonacci ratios line up, the more chances the market will see and acknowledge it.

2) Harmonic Retracement Patterns: Simply put when the market retraces in an ABC manner, and the C=A, it can be classified as a harmonic retracement, especially if B wave was also a fibonacci retracement of wave A. If at completion of this ABC move, otherwise known as an “ab=cd” correction, we are at a fibonacci retracement level, we invite a reversal against the direction of this ABC, or ab=cd move, and back to the direction of the trend before the ABC corretion.

Here is an example that includes both clustering, and harmonic patterns.

This screenshot of the USD/JPY 4H chart from May to July shows both clustering of fibonacci retracement and completion of harmonic retracement patterns. Starting with the first (a) wave which ended right below 50%, then a (c) wave which went to 61.8% . These green retracement levels are based on the decline from the May 31 high. If taken from the higher May 19 high. The (a) and (c) waves ended at 38.2%, and 50% respectively.

Note that at the end of (c), we are at a “cluster” of 50% and 61.8% retracement. Also, notice that (c) and (a) have wave equality, and therefore completed a harmonic retracement pattern. A sharp decline did materialize, but this was just a bear trap for further consolidation.

If you take the (a)(b)(c) waves together as an A wave, and then B as the bear trap decline, what comes after is another correction rally. Without breaking down the internal moves, we see that a wave C completed at a cluster of 61.8%, and 78.6% retracement. These did not exactly match, and the market respected the 61.8% retracement level.

Another bear trap in D was completed, which was followed by a wave E, which actually violated the 61.8%/78.6% retracement cluster, before the REAL bearish continuation swing developed.

From here, what we can learn is that fibonacci retracement levels are stronger when they are clustered, and when they are at end of a retracement pattern. We also should note that an abc retracement is not always the end of it. In the case above, we ended up with an ABCDE wedge correction.

Finally, we see that fibonacci retracement levels aren’t magical, and sometimes you need to give the market some elbow space. Also, you may want to combine other aspects of analysis such as candlestick and momentum to help confirm that a retracement pattern is complete, and that a continuation is developing.

Fibonacci Expansion:

The idea of using wave ratio to project another swing in the same direction is that although the past does not always dictate the future, the future can be anchored from the past. So if we had a 100 pip move and then a pause. When the market continues, another 100 pips move for example can be anticipated. This is a conventional swing projection. However, we don’t always have wave equality.

Sometimes a swing that is capitulating a previous sharp swing may be 50-61.8% the strength of the sharp swing. Or a sharp swing may be 161.8% the length of an initial swing. Let’s take a look at some fibonacci expansions in the forex markets.

Here is the AUD/USD after it bottomed out in 2008. We marked 4 points, ABCD (not Elliott Wave labels). The AB rally had a sharp correction in BC, but the CD rally shows acceleration. After the market surged upwards, a fibonacci expansion tools shows that the market ended a rally at 161.8% expansion, near 0.8185, before a relatively significant correction, which in this case was sideways with a slight bearish tilt. It should be noted that this was a cherry-picked example, and that the market does not always follow expansion ratios. In fact, more often it does not, and the ratios are just a way to put things in context, to give you target suggestions, not to predict where the swing will end. The most conventions projection is the 100% , swing projection, or some would say a measured move. If the market pushes above 100% without a sign of correction, then we can anticipate expansions of 138.2%, 150% to 161.8% as the next targets.

Another way of assessing the fibonacci expansion is that if a market is in a corrective move, a second swing should not be greater than 161.8%. So in the example above, the fact that the market eventually passed 161.8% expansion suggests that the rally was not a corrective rally. If a follow through swing is indeed greater than 161.8%, it is likely in a trend in that direction.

This is not always the case, as evidenced by the USD/JPY below:

Here despite a sharp move during August 3rd, that was greater than 161.8% expansion of the August 1st rally, the USD/JPY pushed lower. The rally was simply a correction the underlying downtrend in the USD/JPY.

It should be noted however, that this sharp rally was caused by an intervention by the Finance Ministry of Japan. Anytime you have a sharp move that comes out of intervention, panic, rioting, or any risk event that may induce highly emotional trading (fear of intervention), we may get exaggerated moves. In fact, traders know that the word intervention is something to fade against because it shows such underlying conviction of the market in a trend that central banks need to step in. Most of the time, the intervention is brief, and is like spitting into the wind.

Fibonacci ratios should not be a predicative tool, but an anticipatory one:

After enough observations of the market, you will realize that yes, there are times when the market lines up with perfect fibonacci retracement or expansion ratios. However, fibonacci ratios lose practicality when used as a predictive tool. For example, most of the times, the market will NOT give you a 61.8% retracement, so it would not be prudent to always look for this retracement ratio. Markets also don’t always give you 100% expansion, or 161.8% expansion when it accelerates. It is more useful to look at these fibonacci levels and assess how the market reacts there. If indeed there is a sharp turnaround from the 61.8% retracement level, you can then say that the market acknowledges this fibonacci level, and is likely to return to the previous trend.

The Use of  Fibonacci Tools In Technical Analysis – Part I