I was reading back issues of SFO Magazine and found this article. An HWB Trade popped into my head and I realized that floor traders, like the one in this article were why these kind of trades worked so well. Over time these techniques have developed and more and more traders have watched for these levels regardless of price. Here is the article Via SFO Magazine
While I’ve always studied and utilized Fibonacci retracement targets as part of screen-based analysis and trading, I remember well a story that a floor trader friend of mine at the Chicago Mercantile Exchange told me years ago.

He told me that part of his trading strategy was to watch the morning range of the market: from the high to the low or vice versa. Let’s say the market was rallying. From his experience in the pit, he noticed that a good trade was often buying at “halfway back.”

As a trained technical analyst, I was stumped. “Halfway-back…what does that mean?” I asked.

“You know, when the market sells off to its halfway-back point from the high.” Suddenly it hit me. My friend, who was completely unschooled in charts or technical analysis and primarily made his living by scalping extremely short-term trades in the pit, had coined his own term for retracement analysis.

“Oh, you mean a 50-percent retracement!” I said. “What’s that?” he asked.

I went on to explain…but it didn’t really matter to him. He had discovered from his years in the pit that a bull market often retreats halfway back and then rallies again. He didn’t care what it was called…it worked!

The Basic Concept

While there are many ways to utilize Fibonacci numbers, for the purposes of this article we are going to stick to the basics and keep it simple. We’ll outline the fundamentals of Fibonacci retracement analysis and how some traders use it in both long- and short-term trading. Fibonacci analysis can be used on any market and any timeframe. It is just as valid on a monthly dollar/euro chart as on a daily dollar/yen chart or a 60-minute E-mini S&P chart. The basic concept of retracement analysis stems from the fact that markets don’t move in a straight line. When a market is in an uptrend, price rallies, hits resistances, and then retreats (or corrects) before advancing in another up wave. Retracements can help pinpoint how far a market will correct before resuming its prior trend.

Fibonacci retracements pinpoint specific areas between price highs and price lows that potentially could be good spots to enter or exit a trade. Traders could trade with the existing trend or attempt to catch a counter-trend corrective move using Fibonacci retracements: you choose.

Don’t Sweat the Math

While there are many variations on Fibonacci retracements, the three basic levels are 38.2%, 50% and 61.8%. Don’t worry. One does not have to be a mathematician to understand or utilize Fibonacci retracement targets in trading! These days, just about every charting package offers Fibonacci retracement lines programmed right into the software. A trader just clicks on that option and drags the cursor from the price high to the low – or conversely, from the low to the high – that he wants to measure. Presto! “Magic” lines will appear on his screen. And surprisingly, more often than not, prices appear to gravitate toward the 38.2%, 50% and 61.8% mark.

Pick Points Carefully

Many people might say, “Oh, those Fibonacci numbers don’t work.” One problem that beginning technical traders may encounter that may detract from the efficacy of this strategy is picking the right points from which to draw the lines. The first criterion for using Fibonacci retracement targets is that there must be a well-defined trend with a series of higher highs and higher lows (or vice versa). It can be an uptrend or a downtrend; it doesn’t matter. Don’t forget, traders can draw retracement targets across all timeframes from an intraday chart to a monthly chart.

Now that you’ve got a trend, pick the right points. Traders need to pick a valid low to high (or vice versa) in which to draw the line. Look at the chart. Where did the rally (or sell-off) begin? That’s where the first line is drawn. For an uptrend, draw the lines from the most important swing low to the most important swing high. See Figure 1 for an example of how to draw the lines. From that important swing high, prices will likely correct and retrace.

Trading Targets

Once a correction is underway, counter-trend traders could use those Fibonacci targets as potential exit points, as they represent a point where the market could run out of steam. Or for those who missed the starting point of the rally, the retracements could offer a low-risk entry point to join the uptrend.

Take another look at Figure 1. In late October 2004, March coffee futures launched a strong bull move that peaked out in late December. One could draw a Fibonacci retracement of the move; from Point A to Point B. From top to bottom, the first line on the chart is the 38.2% of the move; the second line represents 50% of the rally, and the third line delineates 61.8% of the upmove.

For those versed in pattern recognition, a double-top formation developed on this daily chart in late December, which was a warning signal that the bulls were running out of steam (and a potential sign to take at least partial profits on longs). From those highs, traders can see that Mar coffee did indeed pull back and correct, as all markets need to do from time to time. The contract retreated to just around the 38.2% mark, seen in the circled area in Figure 1. This proved to be a successful stalling point for the corrective retreat, and as of this writing in late January, prices have renewed their upside momentum.

Trading Spots

How could traders have used Fibonacci retracements in this example? As mentioned earlier, traders can use them in a trend or counter-trend manner. The first obvious counter-trend strategy could have been to trade the corrective pullback. Several technical negative indicators had developed (not all shown on this chart). The bearish double top was seen in price, bearish divergences had developed on momentum readings, and prices began to fall. Traders looking for a short-term move could have attempted to sell after the failed double top. Right away, traders would have a first objective with the 38.2% retracement.

Sometimes markets need to correct even more and will continue lower until the 50% or the 61.8% mark. All three of those levels could be used as valid targets for counter-trend trades.

It is important to remember, according to basic Fibonacci analysis, that as long as the 61.8% support level holds, the prior trend (in this instance the uptrend) will remain intact. This simply means that a market can retrace as much as 61.8% of the move but still be in an overall uptrend (or downtrend). Classic Fibonacci analysis says that if the 61.8% support area (in an uptrend) is seve
rely violated, the uptrend is over. In that case, traders can set their objective for a retest of the low (or the first point that is drawn off the Fibonacci lines).

Confused? To clarify, let’s pretend that Mar coffee shown on Figure 1 failed to hold the 38.2%, 50% and 61.8% support lines on its corrective pullback. Instead, coffee futures plunged through the 87.90 cents per pound zone (61.8%) in January. That would have confirmed an end to the uptrend and would have targeted a retest of the late October low around 75.00 cents.

Confirmation

Technical traders often talk about the need for confirmation. This is an important theme within technical analysis and simply means that one should not look at one chart or indicator in a vacuum. For example, technical traders often will look for confirmation across timeframes. For example, does that support or resistance point pop up on the hourly chart and the daily chart? If so, it is likely a more significant price point for the market.

Confirmation also refers to the concept of utilizing several different technical indicators in tandem. Let’s say three of your favorite technical indicators all flash buy signals – that confirmation increases the odds of a profitable trading opportunity. With this in mind, it is not advisable to rely strictly on Fibonacci retracement targets for entry or exit points. They are an excellent tool when used in conjunction with other confirming technical indicators. A few that work well with Fibonacci numbers are stochastics, relative strength index and candlestick chart formations. The idea is if positive readings are seen on those tools around retracement levels, the trade idea may be looking good!

Why Does It Work?

There are some who scoff at the concept of Fibonacci numbers, calling them superstition or just plain old hoo-hah. Some even say they become a self-fulfilling prophecy. Make no mistake about it, though. They are widely used in the technical community, and that reason alone makes them important to watch. Wouldn’t you like to know the key levels that other traders may be considering for entry and exit points?

Simply, the Fibonacci retracements are based off a number series: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55…etc. (notice that the sum of any two consecutive numerals equals the next higher number). Leonardo Fibonacci, the son of a Pisan merchant, in the 13th century discovered this number series and its various properties. The percentage retracements actually are ratios of this number series. Scientists have found that Fibonacci numbers and ratios tend to appear randomly (or maybe not so randomly throughout nature) – for example, in the number of petals on a flower and the number of spirals in a pinecone.

So what does this have to do with the financial markets? Well, there are those that say markets move in waves. Momentum rises and swells like the tides. Perhaps there is a relationship. Don’t take my word for it. Check them out for yourself. Form your own opinion. But as my old floor trader friend said, he didn’t care why it worked; he just observed that it did.