Leonardo Pisano, nicknamed Fibonacci, was an Italian mathematician born in Pisa in the year 1170. His father Guglielmo Bonaccio worked at a trading post in Bugia, now called Béjaïa, a Mediterranean port in northeastern Algeria. As a young man, Fibonacci studied mathematics in Bugia, and during his extensive travels, he learned about the advantages of the Hindu-Arabic numeral system.

The Golden Ratio

In 1202, after returning to Italy, Fibonacci documented what he had learned in the “Liber Abaci“ (“Book of Abacus“). In the “Liber Abaci,” Fibonacci described the numerical series that is now named after him. In the Fibonacci sequence of numbers, after 0 and 1, each number is the sum of the two prior numbers. Hence, the sequence is as follows: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610 and so on, extending to infinity. Each number is approximately 1.618 times greater than the preceding number.

This value:1.618 is called Phi or the “Golden Ratio“. The Golden Ratio mysteriously appears frequently in the natural world, architecture, fine art, and biology. For example, the ratio has been observed in the Parthenon, in Leonardo da Vinci’s painting the Mona Lisa, sunflowers, rose petals, mollusk shells, tree branches, human faces, ancient Greek vases, and even the spiral galaxies of outer space.

Fibonacci Levels Used in the Financial Markets

In the context of trading, the numbers used in Fibonacci retracements are not numbers in Fibonacci’s sequence; instead, they are derived from mathematical relationships between numbers in the sequence. The basis of the “golden” Fibonacci ratio of 61.8% comes from dividing a number in the Fibonacci series by the number that follows it.

For example, 89/144 = 0.6180. The 38.2% ratio is derived from dividing a number in the Fibonacci series by the number two places to the right. For example: 89/233 = 0.3819. The 23.6% ratio is derived from dividing a number in the Fibonacci series by the number three places to the right. For example: 89/377 = 0.2360. 

Fibonacci retracement levels are depicted by taking high and low points on a chart and marking the key Fibonacci ratios of 23.6%, 38.2%, and 61.8% horizontally to produce a grid. These horizontal lines are used to identify possible price reversal points.

The 50% retracement level is normally included in the grid of Fibonacci levels that can be drawn using charting software. While the 50% retracement level is not based on a Fibonacci number, it is widely viewed as an important potential reversal level, notably recognized in Dow Theory and also in the work of W.D. Gann.

Fibonacci Retracement Levels as Trading Strategy

Fibonacci retracements are often used as part of a trend-trading strategy. In this scenario, traders observe a retracement taking place within a trend and try to make low-risk entries in the direction of the initial trend using Fibonacci levels. Traders using this strategy anticipate that a price has a high probability of bouncing from the Fibonacci levels back in the direction of the initial trend.

For example, on the EUR/USD daily chart below, we can see that a major downtrend began in May 2014 (point A). The price then bottomed in June (point B) and retraced upward to approximately the 38.2% Fibonacci retracement level of the down move (point C). 

In this case, the 38.2% level would have been an excellent place to enter a short position in order to capitalize on the continuation of the downtrend that started in May. There is no doubt that many traders were also watching the 50% retracement level and the 61.8% retracement level, but in this case, the market was not bullish enough to reach those points. Instead, EUR/USD turned lower, resuming the downtrend movement and taking out the prior low in a fairly fluid movement.

The likelihood of a reversal increases if there is a confluence of technical signals when the price reaches a Fibonacci level. Other popular technical indicators that are used in conjunction with Fibonacci levels include candlestick patterns, trendlines, volume, momentum oscillators, and moving averages. A greater number of confirming indicators in play equates to a more robust reversal signal.

Fibonacci retracements are used on a variety of financial instruments, including stocks, commodities, and foreign currency exchanges. They are also used on multiple timeframes. However, as with other technical indicators, the predictive value is proportional to the time frame used, with greater weight given to longer timeframes. For example, a 38.2% retracement on a weekly chart is a far more important technical level than a 38.2% retracement on a five-minute chart.

Using Fibonacci Extensions

While Fibonacci retracement levels can be used to forecast potential areas of support or resistance where traders can enter the market in hopes of catching the resumption of an initial trend, Fibonacci extensions can complement this strategy by giving traders Fibonacci-based profit targets. Fibonacci extensions consist of levels drawn beyond the standard 100% level and can be used by traders to project areas that make good potential exits for their trades in the direction of the trend. The major Fibonacci extension levels are 161.8%, 261.8% and 423.6%.

Let’s take a look at an example here, using the same EUR/USD daily chart:

Looking at the Fibonacci extension level drawn on the EUR/USD chart above, we can see that a potential price target for a trader holding a short position from the 38% retracement described earlier lies below at the 161.8% level, at 1.3195.

The Bottom Line

Fibonacci retracement levels often indicate reversal points with uncanny accuracy. However, they are harder to trade than they look in retrospect. These levels are best used as a tool within a broader strategy. Ideally, this strategy is one that looks for the confluence of several indicators to identify potential reversal areas offering low-risk, high-potential-reward trade entries.

Fibonacci trading tools, however, tend to suffer from the same problems as other universal trading strategies, such as the Elliott Wave theory. That said, many traders find success using Fibonacci ratios and retracements to place transactions within long-term price trends.

Fibonacci retracement can become even more powerful when used in conjunction with other indicators or technical signals. Investopedia Academy’s Technical Analysis course covers these indicators as well as how to transform patterns into actionable trading plans.

Despite the overshadow of trade tariffs, industrial stocks remain underpinned by a lower corporate tax rate (35% down to 21%), a push for increased infrastructure spending and a strengthening U.S. housing market. Economic data also shows increased industrial activity. Industrial production, which measures the value of output from manufacturers, mines and utilities, is up 5.1% year over year as of September 2018. The sector should additionally benefit from early investor rotation into value names, robust profit forecasts and increased buyback activity.

Senior analyst at Wolfe Research Nigel Coe told Barron’s that he believes industrial stocks can maintain strong growth momentum while the Federal Reserve’s policy remains loose and supportive of growth. However, he cautioned that companies in the sector need to grow into their earnings multiples – forward earnings currently sit at 16.7 times as of October 2018. Price action also suggests that industrial stocks are at key support levels. Three leading exchange-traded funds (ETFs) in the sector have all bounced at critical technical areas on their respective charts. Let’s further analyze each fund.

Launched in 2006, the iShares U.S. Aerospace & Defense ETF seeks to track the performance of the Dow Jones U.S. Select / Aerospace & Defense Index. The fund invests in companies that manufacture, assemble and distribute airplane and defense equipment. ITA charges investors an annual management fee of 0.43% and has returned 9.3% year to date (YTD) as of October 2018. The recent pullback found support on the uptrend line the connects the early May and late June swing lows. This $200 support level on the chart also finds support from the 200-day simple moving average (SMA), making it a high-probability buying area. A stop-loss order could be placed just below the candlestick that reversed on the trendline/moving average.

The Invesco DWA Industrials Momentum ETF, also created in 2006, aims to provide similar returns to the DWA Industrials Technical Leaders Index. The ETF’s portfolio holds U.S. industrial firms that are showing strong relative strength and price momentum. As of October 2018, the fund has a -4.69% YTD return and charges a 0.6% management fee. PRN’s chart appears to be forming a double bottom – the most recent swing low found support near the early May swing low at the $57 level. Short-term momentum looks to be moving back to the upside, with the relative strength index (RSI) crossing back above 30. Stops should be placed slightly below double bottom pattern to protect trading capital.

Formed in 2013, the Fidelity MSCI Industrials ETF attempts to replicate the performance of the MSCI USA IMI Industrials Index. It holds companies that cover the broad U.S. industrials sector. The fund has a low expense ratio of just 0.08%, well below the 0.5% category average. Performance wise, FIDU has returned -1.33% YTD. Although FIDU’s share price is trading below the 200-day SMA, it found strong support from the uptrend line that commenced in early May. The recent bounce at the $37.5 support level has moved the RSI out of oversold territory and occurred on above-average volume. Traders who take a long position should protect it with a stop below the most recent swing low.

Indicators, such as moving averages and Bollinger Bands®, are mathematically-based technical analysis tools that traders and investors use to analyze the past and anticipate future price trends and patterns. Where fundamentalists may track economic data, annual reports, or various other measures of corporate profitability, technical traders rely on charts and indicators to help interpret price moves.

The goal when using indicators is to identify trading opportunities. For example, a moving average crossover often signals an upcoming trend change. In this instance, applying the moving average indicator to a price chart allows traders to identify areas where the trend may run out of gas and change direction, which creates a trading opportunity.

Strategies frequently use technical indicators in an objective manner to determine entry, exit, and/or trade management rules. A strategy specifies the exact conditions under which traders are established—called setups—as well as when positions are adjusted and closed. Strategies typically include the detailed use of indicators (often multiple indicators) to establish instances where the trading activity will occur.

While this article does not focus on any specific trading strategy, it serves as an explanation of how indicators and strategies are different (and how they work together) to help technical analysts identify high-probability trading setups.

Indicators

A growing number of technical indicators are available for traders to study, including those in the public domain, such as a moving average or the stochastic oscillator, as well as commercially available proprietary indicators. In addition, many traders develop their own unique indicators, sometimes with the assistance of a qualified programmer. Most indicators have user-defined variables that allow traders to adapt key inputs such as the “look-back period” (how much historical data will be used to form the calculations) to suit their needs.

A moving average, for example, is simply an average of a security’s price over a particular period. The time period is specified in the type of moving average, such as a 50-day or 200-day moving average. The indicator averages the prior 50 or 200 days of price activity, usually using the security’s closing price in its calculation (though other price points, such as the open, high, or low, can also be used). The user defines the length of the moving average as well as the price point that will be used in the calculation.

Strategies

A strategy is a set of objective, absolute rules defining when a trader will take action. Strategies typically include trade filters and triggers, both of which are often based on indicators. Trade filters identify the setup conditions; trade triggers identify exactly when a particular action should be taken. A trade filter, for example, might be a price that has closed above its 200-day moving average. This sets the stage for the trade trigger, which is the actual condition that prompts the trader to act. A trade trigger might occur when the price reaches one tick above the bar that breached the 200-day moving average.

A strategy that is too basic—like buying when price moves above the moving average—is usually not viable because a simple rule can be too evasive and does not provide any definitive details for taking action. Here are examples of some questions that need to be answered to create an objective strategy:

• What type of moving average will be used, including length and price point used in the calculation?
• How far above the moving average does the price need to move?
• Should the trade be entered as soon as the price moves a specified distance above the moving average, at the close of the bar, or at the open of the next bar?
• What type of order will be used to place the trade? Limit or market?
• How many contracts or shares will be traded?
• What are the money management rules?
• What are the exit rules?

All of these questions must be answered to develop a concise set of rules to form a strategy.

Using Technical Indicators

An indicator is not a trading strategy. While an indicator can help traders identify market conditions, a strategy is a trader’s rule book and traders often use multiple indicators to form a trading strategy. However, different types or categories of indicators—such as one momentum indicator and one trend indicator—are typically recommended when using more than one indicator in a strategy.

Using three different indicators of the same type—momentum, for example—results in the multiple counting of the same information, a statistical term referred to as multicollinearity. Multicollinearity should be avoided since it produces redundant results and can make other variables appear less important. Instead, traders should select indicators from different categories. Frequently, one of the indicators is used to confirm that another indicator is producing an accurate signal.

A moving average strategy, for example, might employ the use of a momentum indicator for confirmation that the trading signal is valid. Relative strength index (RSI), which compares the average price change of advancing periods with the average price change of declining periods, is an example of a momentum indicator.

Like other technical indicators, RSI has user-defined variable inputs, including determining what levels will represent overbought and oversold conditions. RSI, therefore, can be used to confirm any signals that the moving average produces. Opposing signals might indicate that the signal is less reliable and that the trade should be avoided.

Each indicator and indicator combination requires research to determine the most suitable application given the trader’s style and risk tolerance. One advantage of quantifying trading rules into a strategy is that it allows traders to apply the strategy to historical data to evaluate how the strategy would have performed in the past, a process known as backtesting. Of course, finding patterns that existed in the past does not guarantee future results, but it can certainly help in the development of a profitable trading strategy.

Regardless of which indicators are used, a strategy must identify exactly how the readings will be interpreted and precisely what action will be taken. Indicators are tools that traders use to develop strategies; they do not create trading signals on their own. Any ambiguity can lead to trouble (in the form of trading losses).

Choosing Indicators to Develop a Strategy

The type of indicator a trader uses to develop a strategy depends on what type of strategy the individual plans on building. This relates to trading style and risk tolerance. A trader who seeks long-term moves with large profits might focus on a trend-following strategy, and, therefore, utilize a trend-following indicator such as a moving average. A trader interested in small moves with frequent small gains might be more interested in a strategy based on volatility. Again, different types of indicators may be used for confirmation.

Traders do have the option to purchase “black box” trading systems, which are commercially available proprietary strategies. An advantage to purchasing these black box systems is that all of the research and backtesting has theoretically been done for the trader; the disadvantage is that the user is “flying blind” since the methodology is not usually disclosed, and often the user is unable to make any customizations to reflect their trading style.

The Bottom Line

Indicators alone do not make trading signals. Each trader must define the exact method in which the indicators will be used to signal trading opportunities and to develop strategies. Indicators can certainly be used without being incorporated into a strategy; however, technical trading strategies usually include at least one type of indicator.

Identifying an absolute set of rules, as with a strategy, allows traders to backtest to determine the viability of a particular strategy. It also helps traders understand the mathematical expectancy of the rules or how the strategy should perform in the future. This is critical to technical traders since it helps to continually evaluate the performance of the strategy and can help determine if and when it is time to close a position.

Traders often talk about a holy grail—the one trading secret that will lead to instant profitability. Unfortunately, there is no perfect strategy that will guarantee success for each investor. Each individual has a unique style, temperament, risk tolerance, and personality. As such, it is up to each trader to learn about the variety of technical analysis tools that are available, research how they perform according to their individual needs, and develop strategies based on the results.

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