Trading What I See

I’m not sure whether to call today an inside day or not. It waited until the last three minute bar to poke its head above yesterday’s high, but I can certainly call it an uneventful day. Which makes it a nice time for a little review.

Many times a week I talk about Fibonacci extensions, usually with at least a minimal explanation of what they are. Today I want to go over them in more detail. The market was nice enough to provide examples of the three most common measurements.

A Fibonacci extension is sometimes called an Alternate Measurement, because what you are doing is comparing alternate swings. In other words, the two swings are consecutive movements in the same direction. At the beginning of today’s chart we would measure the length of the swing from “X” to “A” and compare it to the swing from “B” to “C.”

Sometimes you’ll hear traders talking about an A-B-C move, and this is what they mean. Another way of describing it would be an Up-Down-Up move, or the reverse, a Down-Up-Down move. The Fibonacci part is the stopping point at what I am calling “C.” There is a surprising consistency when you compare the “A” and “C” movements.

A common ratio is when the two moves are equal (100%.) We’ll often call this a Measured Move, and you can see this in the yellow Fibonacci extension marked on the chart. Often (but not always) the “C” move will have less momentum than the “A” move, and this leads to an oscillator divergence that I’ve marked in the lower pane. I like to take trades where a divergence occurs at one of the common Fibonacci extensions.

The second common measurement is when the second move (in the same direction) is 0.618 times the first move. I’ve market that in magenta. The B-C leg is 0.618 times the C-A leg. And again it ends with a Stochastic divergence.

When I see a Measured Move I think of the market as being in balance — about equal upwards and downwards pressure. When the market stops at a 0.618 extension I feel that shows a strong potential for a reversal, and today that was from down to up.

The measurement shown in blue is the third most likely ratio, with the “C” move being 1.618 times the “A” move. This obviously shows a bit more strength than either of the other ratios.

There are two more Fibonacci ratios that appear in these extensions. If price doesn’t stop at 1.618 it is likely to move on to 2.618. And a truly strong move will usually end at the next ratio — 4.236.

Of course sometimes the market becomes perverse and figures out some entirely non-Fibonacci level to turn, but that doesn’t happen as often as most people think.

If you look carefully, inside the marked moves on this chart you can see smaller A-B-C moves, and many of them are also these same Fibonacci ratios. When you have different sizes of Fibonacci measurements all pointing to about the same place on your chart, we call these Fibonacci clusters. When this happens it creates even better trades.

Just remember, you shouldn’t use Fibonacci levels as entry points by themselves. You need some additional kind of trigger. And sometimes a Fib level just means a pause rather than a reversal. But used correctly, Fibonacci extensions will give you one more type of market edge. And that’s what we need to trade profitably.