FIBONACCI

IN THE

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The name’s Leonardo, but these days they just call me MONEY. Word?

Leonardo Fibonacci

“Support and Resistance levels either hold or they don’t”

- Jeff Sorrells (Bobokus)

REMEMBER

INTRODUCTION

Fibonacci - Magic, Myths, and the Market

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The use of Fibonacci for analysis of various financial markets is very common and widely practiced. In fact It’s one of the most commonly used trading tools, but to the new trader it’s one of the hardest to understand. The modern age of information and the mass delusions resulting from some of this information, only make it more difficult to understand and actually apply this tool in a new traders arsenal. There are Fibonacci retracement tools, Fibonacci expansion tools, Fibo-nacci arc tools, Fibonacci fan tools and Fibonacci grids. Most of the information you’ll find while searching the Internet will attempt to make you believe that Fibonacci is magical or there is some mystical use behind them, because Fibonacci can be found in nature. I’ll say this now so you can forget all of the mystical and magical properties of using Fibonacci in the markets ... “It’s all rubbish”. There is no magic or mystical properties to using Fibonacci in any type of trading, it has abso-lutely nothing to do with magic but everything to do with helping you make a business decision while trading.

I personally use the Fibonacci retracement tool and have no use for the other Fibonacci tools mentioned earlier. There is no need to use the different tools to accomplish the same goal of being profitable in the markets, we want to keep it simple. The Fibonacci retracement tool is just that, a simple tool to make an analysis from. There is no difference in using the Fibonacci retracement tool over a moving average. Just because many traders use a certain moving average doesn’t make the moving average magical, the same is true with the Fibonacci retracement tool, just because many traders use the tool it doesn’t make it magical either.

How many times have you heard that the use of Fibonacci junk and when it works it is just because it’s a self fulfilling prophecy? I see and hear this a lot and it’s kind of funny to hear traders say that. The only thing I can gather from this is that they have tried to use Fibonacci and failed. Being human we all want the market to be this cut and dry do this and do this and you’ll be profit-able, but it doesn’t work that way. The other side of the coin are the ones preaching the magical qualities of using Fibonacci. Who’s right?

We’ll first look at the ones saying that the use of Fibonacci is a self fulfilling prophecy. The thinking is that the use of Fibonacci is so widespread it will provide common entry and exit points shared by all those using the same tool. To a small extent this has validity, it is self fulfilling to a degree, but that doesn’t mean we can all trade and be 100% correct on all of our trades. Its not that it’s a self fulfilling prophecy, but more along the lines of mass fulfill-ing, you can just forget the prophecy part since this would imply magical qualities that don’t exist. Many of the traders that have tried and failed with the use of Fibonacci didn’t expect any failures in their trades. Once it fails they jump to the conclusion that it doesn’t work because it either didn’t hit the target to the ex-act number, it didn’t bounce, or wasn’t rejected from a level to the exact number, so it must not work. The use of Fibonacci was never meant to work to the exact number, the problem with this view is simply a misunderstanding of the markets and how they work. You have to remember that there are humans that are buying and selling around the Fibonacci levels or and that not everyone will be entering and exiting at the same point. Not only that, there is also a problem with retail brokers who don’t have the same chart data so you’ll find different variations from broker to broker. The result of all this is what I call slop in the market. Even though many traders are using the same tool and looking to buy and sell at the same points, these points can vary anywhere from 10-30 pips or even more sometimes. There is nothing that can be done about this, it’s just the way it is and we as traders have to deal with it.

On the other side of the coin we have traders thinking that Fibonacci contains magical or mystical qualities, the same ones looking for that holy grail or perfect trading system that will work in all market conditions and is easy as sitting in a lazy boy recliner with a remote watching TV. I guess it’s actually a good thing that there are traders with this mentality because someone has to loose in this game and it may as well be them. I applaud those holy grail traders for their persistence in donating to the markets. I hope their quest for the holy grail continues for years to come. Now if you are just starting out in this business do not follow that path, it is paved with pain. Thinking that Fibonacci is magical because we can find it in nature and elsewhere, so it will also work on financial charts and will even hit to the exact number specified, is just silly. “If I could just find that secret way that they are used I’ll be rich.” This in itself is funny, there is no secret way they are used, once you start coming up with your own wacky way of using them…you are the only one using them that way. You are no longer trading with the big money traders and the banks.

To be successful in trading you simply have to learn to see the market you are trading with a logical framework, instead of searching for the perfect combination of indicators and holy grail systems so you don’t have to learn how to trade. Isn’t it better to use what has been working for years and years instead of some new “holy grail system.” It isn’t the compli-cated systems or methods that work, it’s the most simple and basic of tools that can help you become successful. For some odd reason learning how to use the simple tools becomes something no one is willing to do. The simple things like basic support and resistance and trend lines are all that’s really needed. Fibonacci is just a way of displaying support and resis-tance points in the markets. Learning to trade is no different than learning anything else, take a musical instrument for example, everyone can learn how to play one but very few will ever actually be any good at it. The same is true in trading,

“We have traders thinking that Fibonacci contains some magical or mystical qualities, they are the same ones looking for the holy grail or perfect trading system that will work in all market conditions and is easy as sitting in a lazy boy recliner with a remote watching TV.”

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anyone can learn, but not everyone will be good at it. Some will pick it very quickly others may take years to learn.

The first thing I try to teach my students is basic support and resistance, its very simple in concept, but because it is so obvious and simple most ignore the fact that it’s the most successful route to profit. Support and resistance is noth-ing more than points in the market where we see the market change direction. These are the natural support and resis-tance points. Figure 1 is an example of natural support and resistance points created by the waveforms price makes.

I didn’t mark all the resistance points in figure 1, I just wanted to point some of them out so you have an idea of the natu-rally created resistance points. In the next chart (Figure 2) support levels created by price movement are marked.

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In Figure 2 I also didn’t mark every single support point, I just wanted to show some of the support points so you can understand where they are. You’ll notice in Figure 2 that support levels continue to be broken and the down trending continues. Good trades will come from price breaking through a previous support or resistance point. Trading the break of support and resistance levels is a trading method all to its own and very common, but we are not talking about break-out trading here.

Understanding this basic concept of support and resistance makes learning to use the Fibonacci retracement tool easier. Fibonacci retracement levels and extensions are just a way of viewing support and resistance to project ahead of price where the next points may be established. Once again it has nothing to do with magic. I’ve used the following analogy often. It’s a simple wholesale/retail mind set, where you buy at a wholesale price and sell at a retail price. The Fibonacci re-tracement tool is just a way of looking for the wholesale price to enter the market at the inner retracement levels and also to display the projected retail price in the form of the extensions. In Figure 3 I’ll demonstrate the inner levels (wholesale region) and the extensions (retail region)

The wholesale region is the inner levels of the fib tool since they are in between the high and low point placed at the high and low of the waveform being measured. The Inner levels are the 23.6, 38.2, 50, 61.8 and some will even use the 78.6 inner level. The object here is knowing that price is moving down in this downtrend and if we wanted to enter, instead of entering blindly, what would be a good price to enter short and trade with this trend? The inner levels give us the points of the wholesale price once price does retrace to these points. Now that we know what the wholesale prices are we want to know what the retail price is for us to target in this trade short. The extensions of the fib tool represent the retail value of a trade short from the inner levels and become our targets. I know some of you may be saying we’ll isn’t this backwards and the answer is no, in Forex this principle works in both directions. Had this been an up trend and price retraces to the inner levels we would be entering long at the inner levels and targeting the extensions above the 100 level instead of the extensions below the 0 level in a short. In Figure 4 we see the reverse of this in an up trend.

Charts Continue On Next Page - >

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As you can see it’s a very simple concept. Another thing to learn about using the Fibonacci retracement tool are the 2 dif-ferent ways they are applied to the charts. The first is measuring the waveforms that develop from these natural support and resistance points created as price moves. In Figure 5 this is applying the fib tool to price movement.

The other method, which is just as popular, is applying the fib tool to a specific time period (monthly, weekly, daily). In this type of strategy you’re simply measuring a period of time to project into the same amount of time ahead of price. Figure 6 is a representation of placing the fib tool based on a time frame of 1 month. The vertical dash lines on the chart represent the beginning of each month so you’re simply looking for the high and low point between these 2 points.

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Next we’ll cover some of the basic rules of using the Fibonacci retracement tool. First let’s make sure you understand what the numbers on the levels represent. The 100 level and the 0 level you simply place at the high and low points of price that you want to measure with the tool. Next is placing the tool in the correct way and its very simple. If price is moving down you start at the high point and pull down to the low. If price is moving up that you want to measure you start at the low point and pull up to the high point. The reason for this is the way the tools levels are displayed in a percentage. In Figure 7 we pull the tool across price movement that is going up and from the high point we want to know how much price retraces in a percentage of the total amount between the high and low point. In this case we see a very common 38.2% retracement and price (bounces).

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In the next example Figure 8 we measure price that is moving down, but his time price retraces past the inner levels re-tracing more than 61.8% which is a sign for a reversal of direction.

Which brings us to another general rule while using the Fibonacci retracement tool and that is the less price retraces the stronger the movement prior to the retracement is. The more it retraces the weaker the previous direction is and retracing more than 61.8% is an early sign of the market possibly reversing.

So as you can see the Fibonacci tool is really very simple to apply and use, maybe you have a little better understanding of what its levels actually mean and how you can apply the logic to using them now.

FIBONACCI FRAMEWORK

Set Up Your Fibonacci Framework And Trade It

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I’ve had many traders ask why I use multiple fib tools and the answer is very simple, it goes back to the basic principle that the Fibonacci tool is way of displaying support and resistance points. Well when you think about that for a second, if you’re only using one tool, is that tool showing support or resistance levels? Don’t know the answer?

See if you can figure out why more than one tool is needed in the next few examples. In these examples I don’t have the 23.6 or the 78.6 inner levels since personally I don’t use them or base trade entry’s from those points.

Here a movement up in price is measured and once price retraces, we see that the support levels from this move up ini-tially hold.

Why did price go short after it made the bounce from support then not continue up? Let’s measure the retracement that occurred and where the bounce from support occurred to see what we find.

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What we find now is that after measuring the retracement that occurred we’ve generated resistance levels to price that it must break in order to continue up from the bounce. In this case the resistance levels created by the retracement of the move up hold price and its levels become selling points based off the price action after price tests its resistance levels. We see that Fibonacci can be used to draw a picture of support and resistance levels in relation to current price and the use of a single tool will only give you a one sided view of the support and resistance points to price.

So now let’s apply this to a chart and find the support and resistance levels in the market currently. To start we want to get the bigger picture and begin with the higher time frames. Let’s establish the overall trend which we find with the Euro is an up-trend. Since price is moving up we can apply the support levels to price by placing a fib on this movement we now can see the support levels in Figure 11.

In Figure 12 we simply add the resistance levels to the retracement that has occurred and we have both the major support and the major resistance levels in relation to current price from the Monthly time frame.

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As you do a top down analysis in your charts, each time frame will be measured in the very same manner just on a smaller scale, so you simply follow this procedure until you get to the time frame you want to trade from. The reason you need the higher time frame levels is that the higher the time frame you’re drawing them on, the more significant its levels are compared to the smaller time frames. From here you simply move to the Weekly then the Daily, the 4 hour and down to the 1 hour time frame if you choose. Just remember the lower the time frame the less accuracy and the more market whip you have to contend with meaning the more false signals you will get.

This is your Fibonacci framework which can now be traded from. As you spend time in the market your framework be-comes your market lens and you know ahead of time how the market is likely to behave within your framework.

EVOLUTION OF A TRADER

Now that you have a profitable trading framework it is time to BECOME a trader...

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Welcome New Trader, Please Leave Your Money At The DoorThere is a common misconception that traders have and it is fueled and then fed on by the trading industry, or more spe-cifically those in the industry that make their living not from trading, but from selling false hope to traders. A large por-tion of new forex and equities traders are under the impression that it is easy to be a trader. A quick google search on various trading related searches will quickly make you realize how so many are led astray and believe it is as easy as the marketers proclaim. I recently came across a post on a prominent traders forum, the question from the poster was this (word for word):

“Hey Guys, There Is A New Forex Trading Robot - ______.com, anyone hear of them?”

I’ve omitted the address, but I did go to the site and shockingly (*sarcasm) it was no longer there. There seems to be a bit of debate online, in paranoid circles, on whether or not we should be afraid that robots will one day take over our jobs, then eventually the world. Well I don’t really have much to say about that, but I can tell you that if you ever see anything about a Forex Trading Robot, you should be afraid. Grab your money and run for your life! The sad fact that people actually pay for stuff like this makes it all the more easy for those with negative intentions in the industry to continue feeding naive new traders counter productive crap and downright scams.

The Web of The World Wide WebThe age of easy access to information now seems to have a negative flip side. The same easy access that can sometimes seem like a godsend, also allows a pile-on of bad information or content of little value which can lead you astray. Many older traders did not have to go through this as they were mentored by another successful trader or forced to learn through long tiresome study of charts and the live market. The common path for an aspiring trader these days is to pop open their web browser and begin searching for information to apply immediately in their live account. The problem is that their search often leads them to destinations which are infected by viruses of bad ideas, negativity, indicator obsession, and other road blocks to lead the knowledge seeker off their path. Even many of the books sold these days are filled with recycled concepts or hacked together strategies which the authors do not even use. The problem with this new found easy access to information, at least when it comes to the trading profession, is that trading remains a discretionary field, there is no clear path to success. The problem with this new found easy access to information, at least when it comes to the trading profession, is that trading remains a discretionary field, there is no clear path to success. There is no series of text books and exams that will graduate you as a trader. The same easy access to information that may be a godsend for other fields of study, can be a curse in our profession and might even make it harder to achieve success than it was 20 years ago. Add to this the continual barrage of sites with guru’s who fuel the idea that trading is easy, then financially feed off those same people they have sold this idea to. At the end of the day what many of them offer is a gross misrepresentation of what it takes to trade for a living. Trading is far from easy. You know you have become a good trader when your are trading with profitably with ease, but that does not mean it is easy. At a certain point you will be at a stage where you are calm and at ease when entering and exiting trades, but the reality is it is still hard work and must be treated as a career.

The effect of much of the bad information you come across is that it leads many traders start off overly optimistic. Now don’t get me wrong, having a positive attitude and being optimistic is a great thing, but not when the foundation for your optimism was built to crumble. Would-be new traders start by jumping right in to the live market after getting a hold of some set of indicators or “secret” set of moving averages and they are quickly punished for their naivety. Being led astray is not the fault of a new trader, In fact many now successful traders went through this learning process. It only becomes your fault if you continue to allow yourself to be led astray. A break from this cycle, and your first step back on the road to success, comes when you realize that the majority of those piling on this information will not help you nearly as much as you can help yourself. You help yourself by beginning to think for yourself and accepting the reality that you cannot just decide to “Be” a trader, rather you have to decide to “BECOME” a trader.

BECOME A TraderThe faster a new trader can make the mental shift to “I am going to become a trader” the faster they will get to the goal line where you can say “I am a trader.”

To be a trader is easy, all you need is an account with money in it then you enter the market and start trading. To become a trader is more work. Becoming a trader involves you going through an evolution from the starting point of little knowl-edge to the point of having a tradable framework, knowledge of the behavior of the market you trade, and a cool head while taking wins and losses. To Become a trader you must:

“The problem with this new found easy access to information, at least when it comes to the trading profession, is that trading remains a discretionary field, their is no clear path to success.”

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THE STEPS TAKEN TO BECOME A TRADERBegin With HumilityEmphasize Equity ManagementCreate Your Market LensOperate Like a SurgeonMaintain Your MindExpect The Unexpected

BEGIN WITH HUMILITYThis is very important when you are starting your trading career. You must come to terms with the fact that you are a small fish in a big ocean. The big fish will happily enjoy you as a little snack. When you enter the Forex market most of the liquidity is coming from big banks and experienced traders. Don’t for a second start off by thinking that it will be easy to take these big traders money out of the market. What you have to learn is to swim along side the big fish, catch the same currents they do, don’t swim against them or they will eat you up in passing.

A funny misconception is that these big traders must have access to some holy grail strategy or use some secret indicator, but this is plain and simply not true.

Online you can find access to daily bank analyst reports on currencies. Analysts at the biggest banks in the world generate these reports which are then sent off to their trade desks for the banks traders to consider. In these reports you will find simple, but proven technical analysis techniques - most commonly horizontal support/resistance, identification of trading ranges, Fibonacci, and fundamental themes. Begin by accepting that the other participants are highly experienced in the market and then learn to trade like them. They make money because of experience, not because they hold a holy grail or secret indicators.

EMPHASIZE EQUITY MANAGEMENTIt is crucial that as a beginning trader your emphasis is not on how much you can make, but rather how you can properly manage what you have. This is most likely to be the downfall of traders. It would be common place to see a starting trader risk their entire account on one or two positions. This is not the way to a sustainable trading career and this is not how the professional traders you are up against in the market manage their risk. At some point in your trading career you will likely have a string of bad trades. A reasonable number might be 10 losing trades in a row. Are you managing your equity in a way that you can survive this?

The solution is using simple formulas to calculate your maximum risk per trade and total risk in the market at any one time. Doing this is not difficult, but you must have the discipline to follow through with it on each and every trade.

CREATE YOUR MARKET LENSMany fail to realize that when you open your charting software and pop on the latest hot indicator or charting tool you’ve heard works so well, you are extremely unlikely to see much success from it. This is because an indicator on a chart does not provide you with a market lens to trade from. Your market lens comes from experience. It comes from knowing how the market behaves around your chosen framework.

There are many traders that are profitable with various indicators or tools such as fibs, pivots, price channels, etc. But the tools they have chosen are not what is making them profitable. A common theme between successful traders is that they have the experience of seeing how the market behaves around their chosen tools and framework, day in and day out. The only way to achieve this is to stop jumping between tools and select those that are based on logical reasoning, under-stand how they work, then spend time in the market experiencing them.

OPERATE LIKE A SURGEONIt should be your goal to take your pips out of the market with precision, the same precision a surgeon must use with his scalpel. Traders who don’t treat each trade as a business decision by calculating their risk and defining entries and exits, open themselves to big losses when a trade goes bad.

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EOnce again it is a novel concept which you will hear again and again, but for some reason it is difficult for many traders to exercise the discipline to follow a plan for each trade. Instead what often happens is what I call the “Lazyboy Trade.” The trader sees a potential set-up, Decides on some arbitrary sum to buy with a quick guesstimate, then carelessly gets in the trade without analyzing risk and having an exit strategy. The Lazyboy Trade may work out a few times solely because of luck, but eventually the trader wakes up from a nap to find themselves under water in a position and that’s the end of their trading career. Now there’s nothing wrong with trading from your Lazyboy, but be sure you never partake in the Lazy Boy trade and you must exercise discipline each day to keep your account healthy.

MAINTAIN YOUR MINDEntire books have been dedicated to the subject of psychology and its role in trading. That doesn’t mean they are all go-ing to help you, but you should take this as a sign that the subject is not to be ignored. Like a professional athlete must maintain their fitness at a level that allows them to compete at the top, we must maintain our mind because it is relied on each and every day to trade at the top of your game.

This comes down to a few things. First you must understand the role psychology plays in trading. Second you must make it your aim to never stop learning. You cannot get yourself to a certain level and then become complacent. Your entire career in this industry will be a learning experience. Until the day you stop trading you must be prepared to learn lessons from the market and be willing to do R&D and testing of newly gained knowledge, just as a business would Invest in R&D.

EXPECT THE UNEXPECTEDI’m writing this at the end of 2008 which has been quite a wild year in the markets. We’ve seen bank runs followed by bail-outs, brokerage bankruptcy’s, government intervention in free markets, housing bubbles exploding, and a global delever-aging of the financial system of historical proportions. At the beginning of the crash it seemed like every other week the market was being saved by rumors of Warren Buffet buying out struggling companies. Now we see pundits questioning the savvy of the oracle himself as he loses large sums on the same derivatives he once criticized as a bad idea and sees his prized AAA credit rating for Berkshire being threatened. Did anyone expect to see that?

These are indeed interesting times, but there is one thing every investor needs to learn. Expect the unexpected and do not get wrapped up in the euphoria of those around you. There will always be bubbles, crashes and threats to your profit-ability, but as long as you maintain and objective outlook and think for yourself you will have a feast when there is famine for those who are caught up in the hype.

Allow Yourself To SucceedBy putting in the effort to BECOME a trader you allow yourself the opportunity to one day evolve from saying “I am going to become” a trader to “I am a trader.” And that is the ultimate reward.

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To say “I am a trader” is a great privilege and achievement, it means you have done something that around 95% of those who tried could not.

Congratulations to those who can make this statement and for those just beginning this journey start your evolution by allowing yourself to BECOME a trader.

BOBOKUS TRADE KINGS CLUBIn the Trade Kings group here at Bobokus.com we go into much greater detail of using Fibonacci and more advanced strategies of applying them to trading. We also expand into other logical methods of trading and format our education in a way that short term and long term traders can learn to profit. We hope one day you will join us and we can help advance your trading into the next level.

- Jeff Sorrells

Forex Trader & Founder - www.bobokus.com

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