Fib Levels or Patience is a Virtue?

There’s no question in my mind that algos trade the Fibs. Keep in mind that there are Fib retracements & Fib extensions and they compliment each other. The 50%-61.8% Fib retracements are more important to my work since they offer good location for trade initiation. I then use a process of Delta Hedging (DH) to reduce or eliminate the initial cost of the trade if price moves in the expected direction. There are numerous posts on this blog explaining the DH or zero cost trading strategy. If price moves against the position I stop out based on chart levels which I determine prior to initiating a new trade. So what are Fib extensions used for? Simple answer: targets! Below is a specific example of how I use both in my trading.

This is a 15 minute chart of /ES which is the S&P 500 futures. I’ll show a series of 4 charts below. They are all the same chart but I’ll be analyzing 4 different segments of the chart. As price was moving I labeled #1 as the beginning of a rally and #2 as the potential top of the rally as it appeared at point #3 on the chart. So, imagine you’re looking at the chart as of #3 and you can’t see any of the chart to the right of #3. Since the rally from #1-#2 has happened I’d set the Fib retracement of that rally on the chart. At #3 I’m not trading long or short since I’m waiting to get long on a retracement to the Fib support zone of #1-#2 at 3814.57-3822.63.

Instead of retracing back to Fib support of the rally from #1 to #2 on the previous chart above, price instead extended the rally to a new high. As price pulled-back modestly towards number #3 on the chart below, I’d still be waiting for a retracement back to the Fib support zone at 3815.43-3823.75. That Fib support level is now slightly higher than the previous support level because the rally has extended higher dragging the Fib support levels up! Now remember, the current time on all of these charts would be a point #3. So, at point #3 on the chart below I still have no trade to be made. I need to be patient and wait for a good setup.

On the chart below I’ve extended point #2 even higher because the rally continued without a retracement back to Fib support from #1 low to #2 high. As of #3 on the chart below I’m still waiting for a good location to initiate a long trade. I’m sure many traders were getting long at point #3 thinking they were missing the rally but that’s almost always a mistake. You have to be willing to miss a rally (or decline) in order to get good trade location! There’s a name for people who trade like that, they’re called disciplined traders! Wait for a retracement back to good location at Fib support (which continues to move higher) to initiate a new trade. So, once again, patience is needed at #3. Sitting on my hands!

The rally continued so I moved point #2 higher again and finally I can initiate a long (bullish) trade at #3 when price retraced back to the Fib support level which was now 3820.21-3830. If the Fib support range is relatively small I’ll initiate a trade at the 50% support level since price doesn’t always reach the 61.8% retracement level. I sometimes will add a 3/4 size position at the 50% level and add the other 1/4 size if price reaches the 61.8% level to net down my cost. Could do it as 1/2 size at 50% retrace and 1/2 size at 61.8% retrace. Customize it to fit your style! The technical stop on this entry would be just below the low of the rally (#1) but if price were to accept value (spend time trading as opposed to a failed breakdown and quick reversal up) below the 61.8% retracement I might stop out there since that would indicate weak buying momentum. If that were the case I’d expect that price could drop down to the 78.6% retracement or even a double bottom low. If that didn’t provide support then new lows would be likely.

So when am I going to discuss Fib extensions? On the chart below!!! 😍 If you follow me on twitter @vegaoptions44 then you’ll know that I constantly preach the If/Then method of price action analysis. In the case of the chart below, after price found support in the Fib support zone I would say If the bulls are strong then they will first hold the 61.8% Fib support level and, if they do that, then they will rally price to at least the 100% Fib extension. That’s the standard I apply to the next potential rally and I’ll compare the actual price action to what should happen. As price approached the 100% Fib extension but didn’t reach it yet, it began to consolidate sideways. That shouldn’t happen if the buyers have strong momentum. The buyers are resting prior to reaching target? What are they tired from? They didn’t even reach target. Bullish consolidation? I think not! It’s more likely that bulls are failing. About 70% of the time a consolidation following a rally is bullish and if price was consolidating above the 100% Fib extension then that would have been more bullish but this consolidation was clearly not bullish!

I understand that this is nuanced price action analysis but this understanding has served me well over the years. Using the tools of Fib retracements and extensions plus the 8 SMA bands (not shown in this post) are all I really need to find good trade locations and good potential targets. It also allows me to gauge momentum. Speaking of momentum, I often get questioned about why I don’t show RSI or MACD. Do I not think they work? Almost every indicator has some merit and RSI and MACD can indicate momentum but too many traders, especially inexperienced traders, over-rely on them without understanding the underlying price action! Below is the same /ES chart but with the RSI also shown.

Did RSI show the negative divergence as price consolidated below the 100% Fib extension? Yes it did. Did I need to see that to know price had lost momentum? No I did not. I don’t need a derivative of price to tell me what price is doing! If it helps you, fine, but I highly recommend you work on your understanding of price action first! And, by the way, take one more look at that /ES chart below. Did you happen to notice where price topped out instead of the 100% Fib extension? Last month’s HB (Half-Back or midpoint of the price range) was right there. Did I forget to mention that I also monitor the high/low/HB of daily/weekly/monthly/yearly timeframes? Sorry, but there’s plenty of posts on this blog covering that topic as well. So was that just a coincidence that price reversed right at last month’s HB? You can be the judge of that but I highly recommend reading some of the other posts before you decide!

1/7/2023 Update – To broaden your perspective on the very important topic of Fibonacci levels, below is a tweet that I sent on January 2nd (the market was closed) discussing how the same analysis that I just demonstrated in this post for the /ES futures on a 15 minute timeframe applies equally to the daily timeframe of TLT (20 year U.S. Treasury Bond ETF). In fact, the ‘Fibs’ work equally well on any timeframe! Read the tweet and we’ll discuss down below. 👀

TLT was trading 99.85 on January 2nd. I’ll admit I was a little late with the tweet because the buying opportunity had been ongoing over the prior 4 trading days. I hadn’t noticed it because I don’t usually trade TLT so I don’t look at the chart very often. However, the analysis that the tweet was based on held up pretty well, don’t you think? See the current chart (as of January 7th) below. Price did in fact remain above 98.66 and closed yesterday at 105.18 making that Fib support support zone of 100.77-98.66 a good location for a long (bullish) trade, yes?

On the chart above I show why the 110 area is a likely target for the current rally before there’s another likely retracement and another potential buying opportunity. Remember, instead of chasing price, it’s better to wait for it to come to you! After all, patience is a virtue!

1/10/2023 Update – A question in the comment section about trade entry and stop level. I’ve added a chart below describing one method of trade entry using the HB line. Using that method I would’ve taken a long (bullish) trade at candle #1. The trade would’ve had a loss on the following day but price was still within the good location for a buy so why would I sell it there? I wouldn’t. As long as price is above the 61.8% Fib retracement support level I’m comfortable being long. IF price was unable to remain above 98.66 then I would consider exiting the long however I like to give the trade time to succeed. IF price dropped below 98.66 during a session but closed back above that level I would be unlikely to stop out. A failed breakdown below a key level is bullish, not bearish, so I don’t want to be exiting a long trade just prior to a bullish failed breakdown. The bottom line is that I would give the benefit of the doubt to the bulls if price is in a Fib support zone and would need to see clear evidence of a failure in order for me to exit the trade. A close below the support line would be clear evidence of a failure.

3/24/2023 Update – I’m adding 2 charts to try to answer a March 23, 2023 question by the Jaded Lizard. On the second chart below I mention that Fib zones aren’t guaranteed reversal areas. If it was that easy everyone who knew about them would be incredibly wealthy. Fib support and resistance zones are areas where algorithmic traders rest order to attempt to cause a price reversal. IF price doesn’t reverse in that Fib zone or even if it does reverse but the reversal struggles to follow thru, price is sending you an important message! Ignore it at your own trading peril.

In the chart below, price began a reversal where it should have but that move quickly failed and price reentered the Fib resistance zone a second time. If I initiated a short the first time price entered the zone I’d likely have the opportunity to exit that trade for breakeven or perhaps even a small profit on the second entry into the zone. Why stick with that bearish reversal trade when clearly price was struggling to move down? There are plenty of trades available and IF the current trade doesn’t look right I exit it and move on to the next. Read the comments on the chart.

There are many posts on the blog discussing different aspects of chart analysis. Here’s a link to the most comprehensive: Understanding Price Action

Questions or comments? Add them down below. I appreciate any comments, good or bad, because that’s how I know if this post is helpful or not.