The Great Fibonacci Debate

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The Great Fibonacci Debate
I have a great question from a reader this week about Fibonacci. Fib strategies have become very popular, but today there are so many permutations and variations on this basic theme that sometimes the useful aspects of this technique get lost in the shuffle. This question opened the door for what we might call the "Great Fibonacci Debate". Read on!

Q) Hi Ed, I have a few quick questions about Fibonacci arcs. Do you think they have any value, and do you use them? To me it seems like a working idea (Fibonacci numbers) is being taken a step too far (like calculating an RSI on an RSI). I’ve always thought, the more lines you draw on a chart, the more chance you have of the price being around one of the lines.

With the arcs sometimes the price "stalls" above or below them, but I can overlay a drawing my 3 year old son made and find the price stalling around his lines too :) And of course, the examples found in books and on the web are chosen as examples because they prove the author’s point.

As you said, because their use is so widespread, it becomes a self-fulfilling prophecy. The use of Fibonacci arcs doesn’t seem so widespread, and I’m not sure whether they work because of some "mystical" order in the universe or not...Thank you in advance for your answer.


A) You are right on the money. I agree that Fibonacci is a self-fulfilling prophecy, in other words it works because people believe it will work. For example, let’s say that some traders believe that Fibonacci works, maybe even big traders like institutions, banks, and hedge funds.

If these traders believe that EUR/USD will hit resistance when a leg of the downtrend retraces 38.2%, some of them will place sell orders at that exact point. If enough sell orders accumulate at that level, a wave of selling pressure will be unleashed on the currency pair if and when the 38.2% level is reached. Perhaps that is what happened in late October, as EUR/USD rocketed straight up to the 38.2% retracement of the move that began in mid-September and promptly reversed (see figure 1)


CLICK HERE FOR THE FULL SIZED CHART

Is this a coincidence? It could be, but isn’t it kind of strange that a movement of about 2500 pips would choose that exact location to stage a major reversal? I was highly skeptical of Fibonacci techniques when I first learned about them, but I have seen so many cases like the one above that I’ve become a believer myself.

Now if I’m correct in my assessment that Fibonacci works because it is self-fulfilling, then it makes sense to use it in the form that is used by most traders. You’ll notice that in my examples, although I often display additional levels, I use only the 38.2%, 50%, and the 61.8% Fibonacci retracement levels ñ that’s all. I don’t use Fib extensions, Fib arcs, or Fib Trendlines.

I stick with the major retracement levels because that’s where I believe most traders focus their attention. After all, we don’t want our order sitting out there alone; on the contrary, we want as many "friends" as possible entering the same trade at the same time as we are. A large enough quantity of buy or sell orders, bunched up together in a strategic location, could change the direction of the exchange rate.

So what about Fibonacci Fans? These are trendlines that are created from Fib retracement levels. Now I don’t necessarily believe that Fib Fans are used as widely as Fib retracements, so I don’t use them. On the other hand, take a look at the recent action on the daily chart of USD/CAD; after staging a huge rally, the pair pulls back to its 61.8% Fib Fan line before finding support.

Again, this could be a coincidence ñ in fact I believe it probably is a coincidence, because I don’t believe that huge numbers of institutional traders are using Fib Fans as a part of their analysis (see figure 2).


CLICK HERE FOR THE FULL-SIZED CHART

Finally, there are Fibonacci Arcs, Fibonacci Extensions and the rest of the ever-growing Fibonacci family of indicators. Fibonacci Arcs are curved lines that anticipate support and resistance in the same way that Fibonacci Fans do. I don’t use them personally, because I don’t believe that they are widely used by institutional traders.

It’s helpful to keep the following in mind ñ software that provides Fibonacci Arcs and hundreds of other indicators to Forex traders have only been widely available to the general public for about fifteen years, since the dawn of the internet boom. Yet somehow, traders made money before all of this fancy software became available. Could it be that traders made money over the years by keeping things simple, without all of the bells and whistles that are available today, and that modern day traders are turning the simple act of trading into an overcomplicated mess? HmmmÖ

In recent years, it has also become trendy to use Fibonacci settings on moving averages and Bollinger Bands, among other things. In my opinion this is just ridiculous; it’s not as if these numbers contained some magic key to the universe, so let’s not treat them that way. In summary, if you’re new to Fibonacci, take it slow and stick with the basic stuff, like Fib retracements, and good luck!
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