Leonardo of Pisa, whose nickname was Fibonacci, lived in Italy in the 12th century. He proposed the sequence of numbers 1,1,2,3,5,8,13,21,34,55,89… to describe the growth of a rabbit population. Each number is derived by adding the two previous numbers.
One remarkable property of this group of numbers is that if you divide one number by the previous one, the ratio approaches 1.618 – anywhere along the sequence. This is called the 'golden ratio'. It has been used in classical architecture, art, and music as being the most perfect to our human senses. It is the number that mathematically describes the natural growth of systems (such as, some argue, the financial markets). Its inverse, 0.618… describes the decay of natural systems.
Often, market prices will extend to a limit, and then retrace part of the move (growth, then decay).
These retracements are expressed in powers of the golden ratio. The first level is 0.618 squared (0.618²), which gives you the significant levels of 38.2%, and 61.8% (100% – 38.2%). The second level is ½ = 50%. The next level is 0.6183 = 23.6% and 76.4%.
Using the Fibonacci retracement tool on trading platforms
Just in case this is new to you, here is a brief primer on using the invaluable Fibonacci tool.
When you pull up a chart, you will see several icons relating to various tools that can be used on your chart. For example, here is an hourly chart of the euro against the US dollar showing a clear high made on October 15th, and the subsequent low made early on October 20th.
I have marked these with purple boxes.
Now, moving to a 30-minute chart (which shows the market in better detail), we can activate the Fibonacci tool.
If you click on the Fibonacci tool icon (purple box), it will activate that tool ready to be applied to your chart. Obviously the exact details will vary according to the software package you have, but this should give you a rough idea of how to use it.
A red line will follow your mouse. I wish to see at a glance where the Fibonacci retrace levels appear, so line up the red line with the level of the top and click. Now, bring your mouse down so that the red line lines up with the Low and click. Here is the chart in detail:
The array of Fibonacci retrace levels will now appear overlaid on the chart.
But there is one important Fibonacci level that my platform does not carry – the 1/3 (33.3%) retrace level. For that, you need your calculator! Simply work out 1/3 of the extent of the distance from top to low, and use the 'straight line' tool (icon next to the Fibonacci icon) and mark that level on your chart.
I shall be using this tool very extensively on my blog, so you will see over time how I use it to pin-point my trades, both in and out.
• For more on Fibonacci theory, see my video tutorial: Trading with Fibonacci levels
Elliott wave theory
Ralph Elliott did pioneering work on stock market movements in the 1930s. He was the first to notice that during a price trend, there was a clear set of five waves: three going with the trend and two against the trend (or counter-trend) waves. Below is an idealised schematic of the overall Elliott wave pattern.
There was also fine-structure within each large wave that replicated the sub-divisions on a smaller scale. And within these minor waves, clear five- and three-wave structures were often visible. You can readily see this 'fractal' nature by clicking on a one-minute chart, then a five-minute chart, then 15-minute, and so on right up to monthly/yearly charts!
Below you can see one of the waves split out. You can see that it also has the five-wave structure rising with the dominant trend, followed by the three-wave correction (A-B-C).
A five-wave Elliott pattern goes in the direction of the major trend, while a three-wave Elliott pattern goes against the trend.
A deep study of Elliott wave theory can get you involved for years, but for my purpose, using the very basic concepts can give me invaluable information on what are the trends, short-term, medium-term, and long-term. That gives me great confidence that I am trading in the correct direction. So, using basic Elliott wave concepts together with the Fibonacci tool, I can get the odds on my side.
Of the multitude of technical indicators available to traders today, momentum is one of the simplest to understand – and one of the most useful to me.
The concept of momentum is quite simple – it is simply the difference between the most recent closing price and the price n periods ago, where n can be any period you choose – I use the standard 12 periods. So on an hourly chart, you will take n to be 12 hours ago. As time moves on, this difference can be plotted, and is shown beneath all of my price charts.
For strong trending bull markets, you will see momentum maintained at high levels (ie prices are rising rapidly), except for the occasional dips which are quickly corrected. Similarly for bear markets, momentum readings stay low.
On your spread-betting platform, you can follow a market in many time-frames.
Let's choose the FTSE 100 on the hourly chart as an example:
(Click on the chart for a larger version)
The market is trending up since the highs and lows are rising. On 4 April, the market made a new high at A. It then backed down, but then rallied and made a new higher high on 6 April at B.
Meanwhile, the momentum reading at B has not reached the higher momentum reading at A. So, price and momentum are diverging – the new high has not been matched by higher momentum, but on a lower reading.
So we can say that the rally to B is on flagging momentum, indicating a potential drying up of buying power, as the bulls have less conviction at B than they did at A. If this persists, we could well see selling overpowering buying, and the market may well reverse downwards.
These divergences are classic tell-tale signs of a potential impending change in trend.
This is especially useful during fifth waves of an Elliott wave five-wave pattern, since fifth waves are ending waves prior to a change of trend.
It is almost a requirement that if I identify a fifth wave, it must sport a divergence with momentum with wave 3.
• For more on momentum, see my video tutorial: Trading with momentum
This is my rule that dictates the maximum level of risk I'll take when I place my stop-loss after taking a trade. So if I start my account at £4,000, the 3% maximum loss is £120. That's 120 points on the FTSE or Dow on a £1 bet.
Move your protective stop to break-even as quickly as possible. Unfortunately, this has to be a judgment call, as there can be no hard-and-fast formula that can be stated. I hope you will see how to apply this as you follow my blogs.
Support and resistance
We often come across these terms in trading. A support level represents an area at which an index or stock price often stops falling or 'bounces', while a resistance level is a price ceiling which an asset has difficulty breaking through. If a price breaks down through a support level, it often becomes a resistance level, and vice versa.
But what are they and why do they occur? Many larger traders do not use stop-loss orders (for many reasons). Typically, they build up a position over time. But if they have guessed wrongly and racked up a loss on paper, then they will be looking to exit the market at the best price they can as soon as they can. So if the asset gets back to break-even, they sell out, relieved to have got out with their shirts still intact. It's a poor way to trade – which is why I insist on careful money management – but I think we can all recognise the situation. We've all bought a share only to see it fall. We then regret buying it, but we still hold on to it in the hope that the loss will be reversed. If the stock then happens to claw its way back to where we first bought it, we're only too happy to get out, there and then.
I have developed a chart-based method that I call 'tramline trading' and it is the approach that I use extensively, in conjunction with the methods above. It is a very easy concept to grasp, and full training videos are available here. Quite often, a market will trade between two parallel sloping lines – I call these the tramlines. Here is a great example in the gold chart:
If the tramlines are sloping upwards, I look for a downward break below the lower line as a possible entry point. Similarly, if they are sloping downward, I look for an upward break above the upper line as a potential entry point. This is used in conjunction with the Fibonacci/Elliott wave analysis.
I am always trying to spot trend changes, and my tramlines often tell me where to enter a trade. But they are also very often useful when trading with the trend.
Prior pivot points (PPPs)
Tramlines are parallel lines that enclose all trading activity within the channel between the tramlines. But before the market enters the trading channel, it will make a series of minor highs or lows.
These points can have a mighty influence on the market as it trades within the channel. In fact, many times, they act as a 'pivot' for one of the tramlines. That's why I refer to them as 'prior pivot points' or PPPs.
Here is a good PPP on the chart for the S&P 500:
See how the PPP has anchored my upper tramline with two lovely touch-points (marked by the red arrows).
That's why it is always a good idea to look for possible PPPs when searching for tramlines.
• For more on prior pivot points (PPPs), click here.