Debunking the Myths of Technical Analysis 1 – Fibonacci:
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:
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.
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.