Lessons from the Pros

In a recently released study by researchers at the prestigious Cass Business School in London, Roy Batchelor, Professor of Banking and Finance, and researcher Richard Ramyar take great pleasure in debunking the “myth” of Fibonacci. In their work, titled ”Magic Numbers in the Dow”, they analyze the movements in the Dow Jones Industrial Average from the years 1914 through 2002.

Their rigorous studies concluded that Fibonacci retracements have no effect whatsoever on price movement in the DJIA. Are they right? Not really, they’re just barking up the wrong tree. Maybe the best way to explain their conclusion is through my own experience.

I used to trade on several equity desks on Wall Street, and I can tell you that even the mere mention of Fibonacci often evoked laughter and ridicule. “You’d might as well try to find trades using a Ouija board,” laughed one trader. And I laughed right along with them, because at the time, I didn’t know any better.

When I switched from stock trading to Forex, I brought those anti-Fibonacci prejudices along with me. After a short while, I was surprised to observe that in the Forex market, Fibonacci worked frequently, it and worked well. Despite my preconceived notions to the contrary, I found Fibonacci to be an extremely effective tool for trading Forex.

The fact is this: Fibonacci doesn’t work well on the Dow because it is not a part of the “culture” of stock or index trading. Stock traders don’t generally use Fibonacci, and therefore it doesn’t work in the stock market. This is because Fibonacci works as a self-fulfilling prophecy, much like the use of Pivot Points in the futures market.

When you think about it, Pivot Points are a random calculation – the reason why they work is because so many futures traders use the same calculation, and therefore they come up with similar support and resistance levels. If enough traders place their orders at the same pivot point level, that pool of orders can cause the price to stop falling (or rising) when it reaches that level. This is the essence of a self-fulfilling prophecy.

Fibonacci operates in much the same way; currency traders commonly use it, and it is a big part of the Forex trading “culture”. So when a major trend begins to falter, Forex traders all around the world locate the major retracement levels – 38.2%, 50%, and 61.8% – and frequently, a large number of orders will accumulate at those levels.

These orders are not only placed by individual traders, but also by the major banks, institutions and hedge funds – the “big boys” of the Forex trading world. If enough orders congregate at the same Fibonacci retracement level, they form a barrier, causing the exchange rate to bounce when it reaches that level. 

Figure 1: AUD/JPY bounces off of the 38.2% Fib level in November of 2006. Source: FXtrek IntelliChart(TM) Copyright 2001-2006 FXtrek.com, Inc.

For example, in mid-November of 2006, the Australian Dollar/ Japanese Yen (AUD/JPY) currency pair, after rallying for about 400 pips, began to retrace from its peak (see Figure 1). After falling for five consecutive sessions, support kicks in at the 38.2% Fibonacci retracement level.

Why does AUD/JPY choose to reverse at this particular point? It could be a coincidence, but I’ve observed this type of price behavior in the Forex market too many times to ignore this phenomenon.

It’s likely that traders, seeking an entry point in anticipation of a resumption of the uptrend, chose to locate their entry orders at the 38.2% Fibonacci retracement level. The combined buying power of these orders is what makes it a viable area of support. This is just one of many examples of a currency pair bouncing sharply from a key Fib level.

In another recent example, the Great Britain Pound/ U.S. Dollar (GBP/USD) currency pair raced higher by more than 650 pips from October 11 through November 10, 2006 (see Figure 2). In this case, instead of finding support at the 38.2% Fibonacci retracement, the currency pair falls clear through to the 50% retracement, where it bounces for three consecutive days. 

Figure 2: GBP/USD finds support repeatedly at the 50% Fib level in November of 2006. Source: FXtrek IntelliChart(TM) Copyright 2001-2006 FXtrek.com, Inc.

The idea that Fibonacci “doesn’t work” on the Dow Jones Industrial Average should come as a surprise to no one who has traded both the equity and Forex markets. This technique is primarily used to trade reversals in the Forex market, where it is an ingrained part of the trading culture, and thus an effective candidate to create support or resistance levels through a self-fulfilling prophecy.

Perhaps our friends in academic world need to make one key distinction before studying the effectiveness of Fibonacci, and here it is: the next time you plan to do a similar study, be sure that you are analyzing Fibonacci in the correct trading market. Put that in your pipe and smoke it, professor!

Watching the U.S. Housing Market

In October, U.S. Housing Starts tumbled to their lowest point in over six years, falling 14.6% from the previous month, according to Commerce Department data released on November 17, 2006. This shocking news could have serious repercussions for the U.S. economy, for interest rates, and for the U.S. Dollar.

Softness in this sector could lead to significant erosion in the U.S. employment picture. Consider the negative effect of a weak housing market on construction jobs, on real estate sales jobs, on loan officers, insurance workers, and even on employees of stores like Lowe’s or Home Depot.

Consider also the tremendous amount of money that pours into tax coffers from the sale of real estate. The effects of a pronounced slowdown in the real estate sector would be far reaching indeed.

Traders who follow the housing market will want to pay particular attention to the following reports:

1) Construction Spending

2) Existing Home Sales

3) New Home Sales

4) Housing Starts

5) Building Permits

And remember, it’s not just the headline number that you need to consider – keep an eye on the “numbers behind the number”. For instance, Construction Spending figures will be broken down into residential, business, and government spending.

Traders will pay special attention to the residential segment of the Construction Spending number, because it will have a more direct impact on the residential housing sector – the sector that can have the greatest impact on the U.S. economy.