39# Fibonacci Retracements, Fibonacci extensions, Fibonacci Levels:Tutorial II

We now have a model of how the market has behaved in the recent past and can

concentrate on the analysis to anticipate where it may go in the near future. To do

this we need to examine the recent price action in more detail. We can achieve this

with an hourly chart:

 

Breaking the chart down we see that from 24 November to 1 December the market

has been trading in a range between 102.45/40 support and 103.40 resistance with

an intermediate resistance at the 103.00 level. Figures ending in .00, .25, .50 and

.75 have a psychological effect on the market with those in bold being more

significant. This can be seen in the above example where 102.50 also provides a

support zone.

On 1 December the market accelerates a short term down trend which entices

enough sellers on board to overcome the 102.45/40 support level. However at

around 101.90 buying pressure suddenly overcomes the selling pressure at the time

of the European markets opening on 2 December.

 

The shorter term traders, momentum traders and traders entering late, start to bail

out on realising that buyers have entered the market.


This in turn attracts the range

traders back in as the price moves above 102.45/40 and the nett effect is a “short

squeeze” where the shorts are squeezed out of their positions.

 

The squeeze continues up to the short term down trend resistance from where the

market trades a 40 pip range whilst it decides upon the next move. During this phase

buy stops will start appearing above the short term down trend resistance as the

positional traders look to lock in profit and those looking for the breach place buy

orders to take advantage of any breakout to the upside.

 

When the breakout through the short term down trend resistance does occur, it is

swift as the triggering of stops lifts the market through the 103.00 resistance level.

 

103.00 then proceeds to act as a support level with 103.40 as the next resistance

above.

One observation to make note of: When a market breaks out of a range, or some

other pattern such as a triangle, but fails to follow through and reverses, in many

cases it will reverse to the other side of the range, or pattern, that it broke out of.

This is exactly what happened here when the market reversed at 101.90. The

ensuing trend traded up to and through the upper side of the range at 103.40.

 

 

The breach of 103.40 did not have the momentum to sustain further bullish action

and was promptly sold off, triggering sell stops, all the way back to the 101.90 [point

0 on chart] support. Data released that day would have also influenced the price

action and this is discussed in Fundamental Analysis.

 

Price action after point 0 develops in the shape of a triangle or wedge with the high at 1 and the low at 2 producing a narrowing range. The chart below zooms in on this wedge so that it can be seen more clearly:

It can be seen that point 2 is at 102.37 which is close to the 61.8%, at 102.45,

retracement of the previous upleg 0-1. Remember, the deeper retracements occur at

the start and end of a trend. In addition, we have support at 102.45/40 which held

the downleg 1-2. Price action is also making higher highs and higher lows. So this

could be interpreted as the start of trend. Some traders will be entering longs as

close to the short term up trend support connecting 0-2 with stops the other side of

this support. Others will be sidelined waiting for a breakout of the wedge before

entering.

It is at this point that initial target projections from point 2, 102.37, can be made using

Fibonacci extensions of the upleg 0-1, 101.88-103.38. Referring to the third diagram

in this example, it can be seen that these projections come in at:

102.37 + (61.8% x (103.38-101.88)): 103.29

102.37 + (100% x (103.38-101.88)): 103.87

102.37 + (161.8% x (103.38-101.88)): 104.79

102.37 + (261.8% x (103.38-101.88)): 106.27

Most charting applications will have an extension tool that will plot these values for

you, saving you having to calculate them manually.

Before getting carried away thinking that we have found a trend and its potential

targets, we must remember that there is still some resistance overhead at 103.00,

103.40, the upper trendline resistance of the wedge and also the longer term

trendline resistance from 111.43 high of 7 Oct through 107.29 high of 10 Nov that will need to be overcome.

The chart below shows the ensuing breakout to the upside a few hours later:

 

Just before the breakout a smaller triangle/wedge, shown in red, develops indicating

that the market is pausing as it realises that the upper wedge resistance, in black, is

coming into focus around 103.25. Above this is the 103.29 Fibonacci extension and

the 103.40 resistance level.

This cluster of levels provides an ideal location for the placement of entry buy stops

as a) there will be those traders that see the trendline resistance provided by the

upper peaks of the wedge as perhaps a place to short from and will have placed their

buy stop loss orders to the upside and b) many traders will be using similar technical

analysis and thus also be placing entry buy stops there too.

When the smaller triangle is broken out to the upside, there is enough momentum in

the breakout to trigger the stops through 103.25, the area of the trendline resistance

provided by the wedge. Other traders, seeing that the wedge has been breached,

may also have joined the trend buying at market.

To view how trading action from the perspective of a short term trader, let’s zoom in

on a 5 minute chart:

 

 

We can see the:

 

1. horizontal support, in red, at 103.00, 103.40 and 103.60

2. Fibonacci extensions, in purple, at 103.29 and 103.87

3. wedge support and resistance in black.

4. immediate trendline support in red

5. short term trendline support

6. medium term trendline resistance

Notice that immediately after the breakout, there was a pullback to the wedge

resistance from which the breakout occurred. At which point more traders entered

long placing their stops beneath this former resistance anticipating that it would act

as support.

 

It is also evident that the market was aware of the overhead medium term trendline

resistance coming in at just under 104.00, as well as the 100% Fibonacci extension

at 103.87, by the choppy manner in which it reached that level through the

intermediate resistances. This is a longer term trendline and is thus not likely to be

broken on a first attempt. This becomes clear when we see some immediate profit

taking when this level is reached. Other traders will have seen this as an opportunity

to short as the risk is defined by placing the stop loss above the medium term

trendline resistance. This would have helped accelerate the fall from 103.99 to 103.62.

However, we can see that the former resistance level at 103.60 is now providing

support. This is further strengthened by the immediate trendline support and the fact that 103.61 is 38.2% of the rise from 103.00 to 103.99. Short term,intraday,traders may use this as a base to initiate speculative longs with a tight stop beneath 103.60 support, for a renewed assault on the medium term trendline resistance. 

Summarising the situation as seen in the above two charts:

 

Extensions 61.8% and 100% have been met, with the 100% coinciding with

the medium term trendline resistance.

Immediate trendline support is strengthened by presence of 38.2%

retracement of the rise 103.00 to 103.99 coming in at 103.61 and horizontal

support at 103.60

Immediate trend is up and this direction will be favoured by the intraday

traders for a fresh attempt through 103.90 zone with a potential targeting the

161.8% extension at 104.79.

Other traders may look to the hourly chart and decide to trade long on a break

of, or a break and pullback to, the medium term trendline resistance

There will also be those traders taking the short side either at the medium term

trendline resistance or on a break through the immediate trendline support.

Let’s now look at the possible entries that would have been used en route to the

161.2% target of 104.79. 


 

a.

Low risk entry for intraday trading with a stop the other side of the immediate

trendline support. Risk to the upside is the 103.87 extension could act as

resistance and have still to breach medium term trendline resistance.

b. As per a.

c.

Enter on breach of medium term trendline resistance. This would have seen

both intraday traders and positional traders enter the market as the break is

visible on both the shorter [eg 5 min] and longer [eg 60 min] timeframe charts.

Stops would have been placed beneath points b, 103.70, and a, 103.60,

depending on the timeframe of the chart used.

d. Visible on intraday, shorter timeframe charts.

Enter on pullback to medium

term trendline resistance, now support, with immediate trendline and 103.87

extension providing additional support. Upside risk is that high at 104.30 acts

as resistance.

e.

As per d. with the addition of lower high at 103.20 providing potential

resistance.

f.

Visible on intraday, shorter timeframe charts. Enter on break of triangle

resistance with a stop beneath e. and medium term trendline now acting as

support around 103.90

g. Visible on both intraday and the longer timeframe charts.

Enter on break of

previous high at 103.40. Stop beneath previous swing low at e.

Subsequently, the target level, 104.79, is breached with the high being 104.98. From

here there is a spate of short term profit taking which sees the price come back to the previous high at 104.30, now acting as support at h.

 

Notice that at h. and i. further buying interest entered the market. This would have

been the short term “buy on dip” traders looking to capitalise on any further rise.

They would have bailed out on the breach through point j. You can also see that

point j. did not give way immediately. It is on the immediate trendline support and is

also on the line made through h. and i., the short term triangle support. This may

have enticed speculative buyers but they would have soon exited their positions.

The breach through j. confirmed that the immediate trendline support had given way

 

The market can be seen to be coming off the highs at this juncture. This is often the

case after a 161.8% extension has been achieved. It does not mean that the overall

up trend is necessarily over, just that the market may need time to consolidate. This

can be seen more clearly on the hourly chart below:

 

 

In the picture Fibonacci Retracements, Fibonacci exstensions, Fibonacci Levels: Tutorial forex system in action.

 

The chart shows that:

 

price action moved sideways between points 3 and 3a in a 115 pip range over

103.83-104.98.

the low of this sideways action was supported by 38.2% retracement, 103.79,

of the rise from the lows. This is a normal, healthy retracement within a trend.

We wouldn’t question the strength of a trend until approaching a 61.8%

retracement or unless the peak (lows in the case of a down trend) of leg 0-1 is

being threatened.

the low of this sideways action is supported by the former medium term

trendline resistance now acting as support. The rally just before point 4 was a

result of traders seeing a confluence of support at 103.80 and either entering

longs or exiting short positions thus causing a squeeze higher.

additional support comes into effect at point 4 strengthen the existing support.

The support at 103.80 is now considered sufficient enough, by the market, to

define the risk for going long. The rally from point 4 is rejected at 3a, the top

of the range where it is quickly sold off.

by point 4a there is a clear short term trend in place from point 2 through point

4 and persuades more traders to enter the market at point 4a with a stop

beneath 103.80, or even tighter at a point just beneath the trendline at point

4a. in the region of 104.20. This is the reason for the bounce off point 4a.

the 161.8% extension of leg 4-3a supports the view that the overall target of

106.29 is attainable. 

 

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