Over the years, people have asked me a range of questions about Fibonacci levels, such as:
Aren’t they just support and resistance levels that people like, making 61.8% and 38.2% self-fulfilling yet arbitrary numbers?
Isn’t the golden ratio of 61.8 found everywhere in nature and perhaps is a mystical key to unlocking the secrets of the universe?
Isn’t Fibonacci a large bow-tie pasta best served with pancetta and a light pesto sauce?
The answers are 1) sort of, but not arbitrary; 2) Whoa, hippie! All around in nature yes, but let’s not get carried away; and 3) no, you’re thinking of Farfalloni.
Though most trading software lets you draw Fibonacci retracements, the key to using them is to understand the psychology behind them, specifically: memory and the need to take just enough but not too much risk.
Since Fib levels often lie very close to major lines of support and resistance, let’s look at those. Resistance is a price above which the market has trouble going. It might poke its head up there, but it ducks quickly back down. It means that the herd (and I mean that in the nicest way possible) is reaching for a higher price, but is so far not ready to be there.
Every time it gets close, it gives in to the need for security and sells, locking in profit. The herd’s need for security in a risky situation is greater than its need to venture to new levels of profit.
What do you do when you find yourself in a risky situation? Try to get home as quickly as possible. And if you can’t get all the way home, at least to get back to the last safe spot you remember.
A lot of other people were there. You’d been there before so even if it was still a dangerous place to rest, at least you knew what the danger was.
Support and resistance lines are nothing more than levels where the herd remembers having spent some time. “Hey, I remember 1675 in the E-mini! I spent a lot of time there, sometimes several bars in a row, before moving back up or further down. A lot of others were there, too. Good times.”
So why do we remember those levels and not others?
Whether you believe that something in us seeks the golden ratio and that we are programmed for it, just as the Fibonacci sequence guides the number of flowers on a petal, the shape of a nautilus shell, and many other aspects of nature; or you believe it’s just group-think, you can’t deny that the numbers are real. Markets do stop there more often than they stop at other random numbers.
The most common price levels typically end in 3 and 7. Day traders often buy a price ending in 7, hold it through the higher round number (ending in 0) and place a limit order to take profits at the next 3. 7 and 3 add to 10, giving us the well-known 10-Handle Rule.
There’s more such math, which mystical types enjoy playing with, but let’s leave at this: Magicians know that when asked to pick a number between 1 and 10, most people will choose seven, especially if they’ve been giving some simple subconscious suggestion. Of those who don’t pick 7, the majority of them will pick 3.
The difference between 3 and 7 is 4; the difference between 7 and the next 3 above it is 6. Multiply by 10 and you get 40 and 60. Or roughly 38.2 and 61.8. The market moves in Fibonacci steps.
Risk and safety
Popular psychology coach (he doesn’t like “motivational speaker”) Anthony Robbins identifies six human needs that govern our behavior. Two of these are our competing needs for certainty and uncertainty. He talked about them in his brilliant TED talk a few years ago. (While you’re at the site, if you’re having trouble sleeping, you can check out my TEDx talk on “A New Capitalism” on ted.com. It’ll work better than Ambien.)
As I’ve said before, the thing that gets bought and sold in any market is really risk. We buy when we want to take on more of it and sell when we want to protect our profits or remaining account balance by getting out. We buy risk when we want more uncertainty and sell risk when we want more certainty.
On your next trade, instead of asking yourself whether you’re long or short the underlying commodity, ask yourself whether you’re long or short risk.
We see this struggle for a risk-certainty balance in the common phenomenon of resistance becoming support. What was a line enforced by people saying, “Don’t go any higher! It’s too dangerous,” becomes a line that says, “Use this as your launching pad and keep going up. If it gets too scary, you can always come back down here. Or you might try that nice rest stop about 61.8% of the way back here. Lots of people rest there.”
The opening range is a magnet
You may notice that after the market has reached well outside the opening range, it starts to lose momentum. People aren’t so eager for more risk and want to get out with a profit. At some point after each successive rally or selloff, the market tries to return to the opening range. Sometimes it goes back so fast and furious it even overshoots and heads in the other direction.
Other times, it starts to head back, but doesn’t make it all the way back to the opening range. When it starts to do that, draw a Fibonacci retracement on the initial move. More likely than not, the market will pause at 61.8% and maybe also 38, 50, and 76.4%. That’s not to say it will stay there. But rarely does a market simply race past 61.8% without pausing to pay its respects.
Why? Let’s put it all together. It pauses at 61.8 before deciding to reverse course again or continue back to 100% because the herd remembers 61.8% as a place where lots of traders gathered, offering lots of opportunity to sell and buy.
Whether it’s because we are drawn by some force the way bees are drawn to the particular honeycomb that they call home, or simply because everyone else remembers it as a good place to pause, it is real.
And in a place as risky as the market, any place you can find some temporary shelter is a place you remember and are tempted to return to.
Now look at this chart and think about the psychology it reveals. 1700 is a big milestone. The market needed a place to pause and catch its breath before attacking the summit. And what levels did it choose to pause at? And what level is a 61.8% level both in a one-week range and in a one-day range? Seems like as good a place as any to launch a rally from.
Before you go long just remember one more thing about Fibonacci levels: they also make good spots at which to place your stops. You have planned your stops, right?