Fibonacci Corrections and Multiple Fibonacci Tools

Trading signals based on Fibonacci corrections become more valid as more tools confirm a turning point in the market. All Fibonacci trading tools are devices for reflecting investor behavior. That is why it is easy to combine them.

We are looking for clusters of confirmations of trend reversals. To get the full picture, we add Fibonacci extension levels as well as support and resistance lines to our starting trading device, the Fibonacci price corrections.

The three main Fibonacci retracements 38.2 percent, 50.0 percent, and 61.8 percent are nothing more than the converted Fibonacci ratios 0.618, 1.000, and 1.618. When looking for trend changes, we can combine the calculations if the necessary swing sizes exist (see Figure 6.10).

Figure 6.10 Price band based on Fibonacci correction and Fibonacci extension combined.

Many combinations of Fibonacci price corrections and extensions are possible. The rationale behind the calculation of the target prices that determine the price band is the following:

• The correction level calculated using the Fibonacci ratio 61.8 percent is reached just below point C. If we take the distance between point B and point 1 and multiply it by the Fibonacci ratio 1.618, we reach a price target that is a little bit above point C.

• The precalculated price targets often do not overlap completely. As long as the price band formed by the target prices is very narrow, we find an ideal Fibonacci target level, for the price target is calculated twice by the Fibonacci figures 1.618 and 61.8 percent.

Figure 6.11 is a bar chart example of the S&P 500 Index between November 2001 and November 2002 that combines Fibonacci price corrections and extensions.

Figure 6.11 is a bar chart example of the S&P 500 Index between November 2001 and November 2002 that combines Fibonacci price corrections and extensions.

Traders often ask whether they can predict price movements with the Fibonacci ratio. The answer is that we cannot say in advance whether a precalculated price target will ever be reached. But what we can say is that as soon as a price target precalculated by the combined Fibonacci figures is reached, the chances for a trend change are high.

Although the best price targets are those at which the Fibonacci levels 1.618 and 61.8 percent overlap, these perfect targets are rare. Fibonacci extensions are calculated using the ratios from the PHI series: 0.382, 0.618, 1.000, 1.618, 2.618, and so on. If we calculate large enough swing sizes, smaller ratios for calculating Fibonacci extensions become more important in combination with Fibonacci price corrections.

If we take the latter argument into account, the analysis shown in Figure 6.11 on the S&P 500 Index becomes easier to understand. In our example, we have applied the ratio 0.382, instead of 1.618. The price band on the chart, therefore, is based on the following calculations:

• The Fibonacci correction level of 50 percent between point A and point B leads to a target price of 975.00 points in the S&P 500 Index.

• The Fibonacci extension level of 0.382 leads to a target price of 963.00 points in the S&P 500 Index.

Because we focus on large swings that last over months, we cannot expect to find price targets calculated at ratios of 1.618 (extension) or 61.8 percent (correction) to be easily reached.

In our example, we have calculated the first wave of a long-term S&P 500 Index market movement. If it holds true that we have finished the first and second wave of a 3-wave price pattern, the S&P 500 Index is currently in the third wave. The next price target is the high of wave one at 966.00.

If the market price moves continuously higher, the correction levels of 50.0 percent and 61.8 percent become critical price targets that traders should watch carefully. In the event of further rising prices, new price extension levels based on swings that have not yet been realized may be used for additional calculations.

Whenever Fibonacci price correction levels of 50.0 percent or 61.8 percent are reached on large swings, we might not enter the market right away based on daily price data (and use a sophisticated entry rule instead). For short-term traders, however, especially those with an intraday perspective, these price goals are extremely important (see Figure 6.12).

Figure 6.12 S&P 500 chart from 05-02 to 11-02. Short-term turning points.

Thus far in this chapter, we have encouraged readers to wait for additional confirmations of trend reversals once Fibonacci correction levels have been triggered by candlestick patterns, 3-point chart patterns, or other Fibonacci devices. Short-term traders, however, who only want to scalp a few basis points at very low risk, need to pay attention to the following price targets:

• At point E, the total distance from points A to D is corrected by 50.0 percent, followed by a strong price move in the S&P 500 Index.

• At point F, the total distance from points D to E is corrected by 61.8 percent. The market price in the S&P 500 Index reverses instantly to the downside at point F.

If we switch the perspective after this intermezzo from short-term back to long-term, we finally set the focus to profitable combinations of Fibonacci price corrections, Fibonacci extensions, and PHI-ellipses.

Figure 6.13 shows a perfect buy signal for a long-term investment immediately after the lowest low in the S&P 500 Index is made late in September 2002.

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Figure 6.13 S&P 500 chart from 05-02 to 11-02. Long-term turning points.

Figure 6.13 S&P 500 chart from 05-02 to 11-02. Long-term turning points.

New lows or highs (especially in large swings and double bottom or double top formations) are always possible indications of major trend reversals. Investors should be highly alert for a trend change if other tools and parameters confirm the turning point.

The price extension in Figure 6.13, calculated as the total distance from the high at 965.00 to the low at 868.00 multiplied by the Fibonacci ratio 1.000, leads to a target price of 772.00. The lowest low in the S&P 500 Index is at 775.00. One can hardly get closer. (The lowest low in the range from 750.00 to 800.00 in the S&P 500 Index could have been calculated many months earlier, based on other price swings. We come back to this in the next section.)

Once the double bottom is made, our entry rule applies. The breakout of the outside line of the PHI-ellipse confirms the trend reversal. The buy signal is filled market on open on the day of the breakout.

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