We all remember the scene…
A mad scientist watches his protégé accelerate his time-travelling DeLorean up to 88 miles per hour. Seconds later, it’s sent back to the future, leaving nothing but its fiery tracks behind. A lone Dr. Doc Brown celebrates in the street.
The ability to travel through time has always shared the dream pedestal with flying, living forever, and super-human strength.
What if you really could travel to the future to see how the market will behave? What if you could be relatively accurate in forecasting the future movement of a certain currency pair you were? Can you imagine how powerful and valuable this ability would be?
Believe it or not, it is possible to predict the future somewhat by looking at the past. This ability comes to us, not via a modified DeLorean, but by simply understanding how a tennis ball bounces.
Realistically, there is no Holy Grail of trading, nor all-knowing Oracle of currency… and don’t get too excited about the time machine either. However, it really is possible to “kind of” tell the future, or at least enhance the accuracy of your forecast.
If you are relatively new to trading, you may have heard the intimidating terms “Fibonacci Retracements” and “Fibonacci Extensions”. Well, before your eyes begin to glaze over as if your flux capacitor suddenly surged to 1.21 gigawatts, let me quickly explain what this term means.
Leonardo Fibonacci was a 12th century mathematician who discovered that specific proportion patterns, or ratios, are found in the world of nature.
The Fibonacci sequence consists of the following numbers: 1, 1, 2, 3, 5, 8, 13, 21, and so on. Here is the recursive formula for the Fibonacci sequence:
F(1) = 1
F(2) = 1
F(n) = F(n – 1) + F(n – 2)
So, each consecutive number in the series is figured by adding the previous two numbers in the sequence.
Now that this is all clear as mud, let’s move right along…
Remember that the market moves in waves. It waves up and down, ebbing and flowing, in one general direction. These waves, in themselves, are components of even bigger waves on larger time frames. In trading, when we talk about “retracement”, what we’re basically saying is that the price is starting to change directions counter the current trend, or wave direction. This is a correction that occurs before the price again changes directions back to the current trend and continues to move in that direction to the “extension”, which marks the potential point for the next retracement.
By noting how far the market retraces, we can take this ratio of retracement and use it to figure out how strongly the market will return once it recovers from the correction and resumes moving with the current trend.
See? Understanding fibs aren’t so scary now, are they?
Let’s finally find out what this has to do with bouncing tennis balls and traveling to the future to maximize your trade performance.
Imagine that you are holding three fuzzy Wilson tennis balls… and, of course, you’re standing on stilts. Yup, stilts.
You raise the ball over your head and thrust it downward with a decent amount of force toward the ground. As the ball hits the ground, you watch the ball bounce back up just above your head.
Next, you get off the stilts. People are beginning to notice.
Time to bounce another ball. So, you do, with the exact same force and direction toward the ground as before. Keep in mind that you are now about five feet shorter without the stilts. This time, the ball bounces back with much greater speed and easily breaks the height reached of the previous ball.
Ok, Marty, time for the finale.
You walk over to a table that is about waist high. Let’s bounce that last ball. Same force, same direction. What happens this time? Oh yeah! That baby flies higher than Balloon Boy Falcon!
What do we learn from this little experiment? Well, pretend that those tennis balls represent the current market price for a currency. As we raised each ball over our head, this is like the price moving upward in a bull trend. Throwing the ball downward represents the market retracing. The bounce back up is the market returning to its current trend. Remember how high the ball bounced? That peak is what we call the Fibonacci extension.
So, the conclusion is: the shallower the retracement, the higher the extension. Just as the ball bounced harder and faster when it was thrown closer to the ground, likewise, when the retracement covers less distance (like throwing the ball when closer to the ground), the extension is likely going to be farther away (the height of the ball’s peak travel). Once we figure out the actual retracement ratio, we can predict with relative accuracy where the extension will be. We are essentially going forward in time and figuring out at what point the price is likely to possibly pull back. By placing our exit order just shy of this extension point, we are maximizing the profit that we can safely pull before the price changes direction once again. Great Scott! Imagine the possibilities!
With this new understanding of the Fibs, you are now on your way to becoming a more competent trader. In our next article, we will get into the nitty-gritty details of this wonderful “time-machine” we call Fibonacci, as well as a strategy to help you to maximize your profits while minimizing your risk.