The mass psychology of traders and investors causes waves on price charts. Optimism of the crowd changes to pessimism and back to optimism. This is the basis of Elliott wave theory. It is also the basis of the Fibonacci projection system. The challenge is to interpret these waves for profit. Charles Lindsay gave direction on how to trade this in his 1991 book, Trident a Trading Strategy. It is said that this method goes back to the 1970’s or even the 1940’s.
The fibonacci extension method is based on finding useful pivot points in wave patterns. The pivot points start at point 1 with the low of the beginning wave, 25.93 in the example. Pivot point 2 is at the top of the first up wave at 26.49. The next wave is down ends with pivot point 3 at 26.27. Some charting programs have a drawing tool for this. The chart above was done on Thinkorswim. You can also calculate the levels yourself as described later.
In the example chart, some news or events caused a wave of optimism from the low of 25.93. We chose 25.93 to 26.49 as the first wave, since it only had slight interruptions along the way. There is no requirement to choose just one possible pattern. We could have chosen the secondary low of 26.18 on January 15 as point one. It takes practice to select the best 1, 2, 3 points to meet your goals. You can look for quick, small gains on intraday charts, or zoom out to monthly charts to look for patterns that may take years to complete.
The Fibonacci projection is calculated by simply taking the difference in price from point 1 to point 2 and adding that to the low price at point 3. You can take 25% of that up leg as the buy point.
Buy signals are triggered as price penetrates the first fibonacci level at 23.6%. We use 25% as a clear breakthrough buy point as Lindsay did. The theory is that due to mass psychology and the magic of fibonacci numbers, once the 23.6 level is exceeded, the 50% level is most of the time reached also, and the 75% and 100% level are more likely than not.
In the example chart the price easily slipped past the buy point, paused at 50% exactly and looks to be on the way to the 100% level. The Fibonacci levels act as magnets, attracting and repelling price.
There are various ways to trade this. The one useful rule is to use a beginning stop just below the number 3 point. We like to put in an order to sell half at the 50% level. When that is triggered, we can raise stops to the buy point to lock in gains. Then either sell the rest at a higher target, or sell half the remaining at a higher target and continue the rest with trailing stops.
Lindsay recommended using 50% and 75% (the actual fibonacci level is 78.6%) as sell points and/or use trailing stops to see how high it can go. Taking profits at 50 and 75% gives a higher percentage of winning trades than waiting for 100%, but limits profit potential. Each trader must determine their own targets. A combination of partial profit taking at specific levels and letting some ride with trailing stops can be useful. There is nothing but good about taking a safe bite out of every up leg. Not being greedy is the key to a successful and sustainable trading career.
The second chart below was done on StockCharts.com, but is the same chart two days later. Stock Charts doesn’t have the same fibonacci extension tool. They use a different definition of the term. This chart shows two manually calculated additional alternative wave counts that could have been useful for trading.
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