Debunking the Myths of Technical Analysis 1 – Fibonacci

By | June 17, 2015

Since I’ve started this site, I’ve received many emails from beginning traders asking what are the best places on the internet to  learn about forex trading. So far, I’ve been directing them to the school over at Babypips, but this will change in the near future as I’m preparing an ‘Education’ section on JLTrader. Looking closer at the curricula on Babypips, I realized that alongside a lot of useful material,  there’s also fluff and mysticism included. I’m referring here to things like Fibonacci, Elliot Wave or harmonic price patterns. To give credit where credit is due though,  they at least didn’t mention Gann. :)

Now, right off, I don’t want to imply that if I personally don’t use something, it automatically means it is ineffective. Far from me this thought. What I want to do is get people to question the rationale behind the technical analysis tools they’re learning about. Just because they come by default with all charting packages and supposed experts mention them day in and day out on TV and on the internet, doesn’t mean they have any value. The fact is that if we’re confronted very often with something that comes from respected sources, we usually stop analyzing it and just take it on good faith.

To give an example, think about horoscopes: you get them on every TV morning show and in most newspapers. But do you really believe that your personality and future events in your life are determined by the position of the sun, moon and other celestial objects ? I mean c’mon, we’re in the year 2015 not 1515.

The most advertised and well known aspect from Fibonacci’s paraphernalia are the retracements, which are used as potential support and resistance areas. Before plotting them on a chart, you first have to find the high and the low of the particular move you’re interested in, like in the picture below:

Fibonacci retracement on USD/JPY

Fibonacci retracement on USD/JPY

As you can see in this example, the starting point of the move corresponds to Fibonacci level 100, and the end point to level 0. Between them there are four levels (some charting packages also have a fifth level, 76.4%): 23.6%, 38.2%, 50.0%, 61.8%.  What they show is how much of the initial move (from level 100 to 0) has been reversed: so for instance, when the price reaches level 50%, half of the original move has been retraced.

So where is the problem ? The concept of price retracement is one that makes sense: every trend will stop at some point and give back some if not all the advance made. But to think you can predict the levels of this back move  by drawing random lines on a chart is laughable. Furthermore, the precision of the numbers, with decimals mind you, is just an illusion that you have any control on the future movement of the price.

Yeah, but they work ! the price just bounced off this or that level, some will say. Well, this is bound to happen when you put four of five lines on a chart. Try it with different lines or leave the default grid on the chart on. The same thing will occur.

The next observation would be: then how are Fibonaccis different from classical support and resistance levels which also don’t work every time.  Well, nothing works all the time in trading – we’re dealing here with probabilities, not certainties. However, resistance and support levels are reactive, being drawn based on past price action. They’re supposed to work in the future because price has ‘memory’ not because of some ‘magical’ Fibonacci numbers.

Support/Resistance in EUR/USD

Support/Resistance in EUR/USD

As you can see in the above picture, the significance of the area around 1.1040 is given by the fact that the price ‘respected’ this level several times. There’s no mysticism or anything strange about it. This is a totally different thing to just drawing a line on the chart and expecting the price to react to it.

To sum up: don’t forget, critical thinking is essential in trading. Always questioning why you do the things you do will not only get you better results, but will also protect you from all the snake-oil salesmen of which the trading world is full.

5 thoughts on “Debunking the Myths of Technical Analysis 1 – Fibonacci

  1. Linz

    Good article! Iv’e been wondering about the same stuff. I’ve even wondered how much popular indicators are self fulfilling prophesy, in as much traders expect prices to bounce off these levels so they do as they are followed. Except of course with big price movements which are economic in origin and nothing else.

    Cheers

    Reply
  2. David

    So you’re saying that there’s a fundamental difference between round numbers and fibonacci levels? If so, I respectfully disagree. Why? Because of the underlying reasons that cause price behavior.

    To simplify for the sake of brevity, market orders drive price to any given level on a chart, while limit orders at a given level effectively create barriers that absorb that drive. If the volume of market orders is greater, price pushes on through that level (and probably hits stoploss orders on the other side). Otherwise, price stalls, and if the volume of orders opposing is great enough, it starts a reversal. Rinse and repeat.

    Markets are essentially collective belief systems that generate this “orderflow”. If enough traders (capable of placing a high enough volume of orders) believe that price will bounce at a level, they will place limit orders at that level, causing price to stall or reverse there — creating a “self-fulfilling prophecy”. Whether it’s a round number, trendline, pivot level, fibo level, prior daily high/low, 200 EMA, area of prior buying/selling, or something else, exactly the same logic applies. Sometimes there will be high enough volumes of limit orders at these levels to turn price around, sometimes not. That’s WHY these levels “work” some of the time.

    The volumes of market orders often vary at different times of the day. During more volatile times, higher volumes of market orders equate to more momentum, and hence these levels are more easily broken; while during quiet times, you can see price simply pinging back and forth between key buying/selling levels, allowing the savvy trader some easy pips.

    But of course FX markets are more complex than this. In addition to self-fulfilling TA, we have algorithmic trading, HFT, the need to maintain triangular equilibrium, stoploss orders, central bank intervention, option expiries, institutional traps and squeezes, macroeconomic drift, response to high impact news events, non-speculative orders, and a zillion other factors that are all simultaneously fuelling the on-going tug-of-war. The net result is apparent randomness — at least most of the time — unless there is overriding opinion, possibly caused by perceived weakness in one currency, and perceived strength in the other, that’s strong enough to create a solid trend in that pair, until that opinion dissipates and becomes ‘priced in’.

    Reply
    1. JLTrader Post author

      Good, thoughtful comment there, David.
      Not necessarily round numbers. It just happened to be a round number in my example – and we could only speculate why that level became an important one (the price action seen on the chart tells/shows us the importance of the level, but leaves us in the dark as to the why). Putting Fibonacci lines on a chart and expecting the price to conform to them seems to me to be an arrogance – you’re kind of ‘dictating’ the price what to do.

      Reply
  3. Christopher

    Although Ganns method sounds mystical, he did make $50 million from his trading, but, no one has been able to properly replicate his methods and success as Gann didn’t leave a blueprint or manual, only a few ideas to his secret and the rest for everyone else to figure out.

    Money talks at the end of the day although I’m not suggesting to try and use anything from Gann because there are too many missing pieces but as far as Fibonacci goes, it can be found in everything, plants, shells, human body features, distance of planets to the sun etc etc BUT, it does not mean you can make money from it in the markets. I have not heard of anyone who has made a fortune ( documented ) from solely using Fibonacci. If someone wants to correct me on that then please do.

    Reply
    1. JLTrader Post author

      I very much doubt that Gann made that much money from trading. More importantly though, there are no credible traders that attribute their success to Gann’s mambo-jumbo. To be fair though, he had some good trading advice in his books (although nothing original or earth shattering), but that was overshadowed by astrology, numerology and all sorts of nonsense.

      Reply

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