Matt asked a question that I sat on for quite a while. I wasn’t sure how to write a reasonably concise answer to a good question, but I’ll try today. First, the question:
I see you don’t believe in Fibonacci ratios, but it seems every book and website says they are really important. I read your analysis on your website and it was convincing, but your stance is so different to the CTA program and all the other technical people out there. You’ve shared stories of your development as a trader and I was wondering Could you maybe talk a little bit more about how you came to the conclusions you have? Maybe seeing the path you walked will help me find more confidence to stand apart from the Fibonacci crowd. Could you tell me what’s wrong with Fibonacci and even more how you came to believe this?
Thought-provoking question, and one that deserves a good answer. First of all, I’m assuming if you are reading this you understand how Fibonacci is applied to trading. At a bare minimum, you should understand retracement ratios, extension ratios, and time ratios. If you are fuzzy on that, just google it (I just opened another tab and my first search found 11.8 million hits) and familiarize yourself with the common practice in today’s technical analysis. As a very short summary, there are two issues here to consider: First, many people believe that the so-called “Golden Ratio” (a number that begins with 1.618) describes many important relationships in the universe and human art. Second, people note that this ratio can be derived from the so-called “Fibonacci sequence” {0, 1, 1, 2, 3, 5, 8, …} and further assume that the actual numbers have significance themselves–i.e., that the number 13, because it is a Fibonacci number, might have some special qualities that 12 and 14 do not. These ideas are extended to financial markets, usually in measuring length and magnitude of a market’s movements in time and price, or in some relation.
I don’t know when I first encountered Fibonacci numbers. I was interested and curious about various arcane schools of thought even as a kid, so I’m sure I had some encounters with the idea before I reached high school. My first serious investigation came in college as I was working on a degree in music composition. Part of the process of learning to write music is learning what people have done before you, and there are various schools of thought about how to understand and analyze a composer’s work. I was working with a technique called Schenkerian Analysis that basically takes a piece of music and reduces it to a few key elements–a way to see the skeleton of the body or the frame of the building. In reading the works of other analysts, I found that people said the Golden Ratio was very important in the structure of many pieces. I probably looked at 100 examples, and then launched into deep analysis myself.
I’ll spare you the gory details, for I spent many months on this project. At first, I was excited because I had unlocked some key to the mysteries of the universe. If I could understand the use of this ratio, then I could improve my own compositions. I could probably use the idea in the computer-generated compositions I was working on, and maybe could develop some alternate tuning systems that would take advantage of different ratios of resonances. What I discovered early on was that the Golden Ratio did not “work”. Sometimes important things fell near the ratio, sometimes (quite rarely) exactly on, but often not at all. There were also inexplicable things, such as very important features coming at some other ratios, while some very minor detail hit a precise Fibonacci ratio–and “pro-Fibonacci” people would call that a win. I scratched my head; maybe there was something I didn’t understand, but it seemed like hanging a work of art on a wall and then marveling over some detail of how the floor tiles hit the wall–probably simply due to chance, and almost certainly not significant.
I then encountered the “measurement issue”: when I talked to people who were supposed to be experts, they were extremely evasive. I remember a conversation with someone who had written an influential book. When I explained that I could not make the ratio work in a specific Beethoven piano sonata, he told me that was because I needed to measure ratios in space on the page; in other words, inches. This, of course, is nonsense. Our perception of music is ordered in time, not physical space. Physical space on a page is arbitrary; I found examples of the same sonata in different editions that were 4 or 20 pages long, and things were spaced proportionally very differently in those different editions. I discovered something that I would later encounter in trading: people would use whatever measurement system they needed to make the theory fit the facts. Once I looked at the problem objectively, I saw that “big things” tended to happen later in a piece of music rather than earlier, usually after the middle and somewhere quite a bit before the end. This, of course, is a dramatic pattern that makes sense in a book, a play, a film, or pretty much any other structure–it’s just common sense. But the idea that 61.8% was some magical ratio in music–that just didn’t hold water. When I started digging into relationships between ratios and musical notes, that didn’t really “work” either. So, after many months of intensive work, I decided that Fibonacci ratios in music were overhyped and simply didn’t represent reality in any meaningful way. Did it make more sense that composers (who, in most cases, were writing music for a living because it was their job) would follow a formula of “big thing happening somewhere after the middle and near the end”, adapting it to the flow of whatever piece they were writing, or that someone was staying awake at night trying to hide a secret code of the universe somewhere in between the notes?
Fast forward a few years to where I was learning to trade. I’d had some successes and failures, and realized that I was going to have to study very hard to make this work. I tracked down a bunch of original source material from legends like Schabacker, Gann, and Elliott, as well as a big selection of the modern books written on the subject. In the beginning, I quickly forgot the Fibonacci lessons I learned in music, and was awed by the power of the ratios in financial markets. I read book after book talking about the different ratios and how they described moves, where to put stops, where to put targets, when to predict turns–I saw it worked often. Of course, there were cases where it did not work, but there was also this strong appeal to mysticism in much of the writing: these are “sacred ratios” upon which the “foundation of the universe rests”. How could I ignore such portentous information when I was entering a trade on a currency chart?
A few things eventually shook my belief in the concept. These are, perhaps, best told in bullet points:
- You couldn’t be sure which level would work, but some level always worked after the fact. I began to realize that levels would be violated in live trades; I had dutifully placed my stop a few ticks beyond, but then another level clearly held at the end of the day. There was no way, and no way in the literature, to predict which level would hold. Once I learned about the idea of confluence (see chart above), I realized that we were drawing so many levels on charts that it might just be luck that they seemed to work.
- I began to understand randomness. I had a weird formal education. My quantitative training in undergrad was sorely lacking. While I would not recommend this to anyone, it did leave me with a curious hole to fill: I had to re-think the problem of randomness from the ground up, as I did not have a good understanding of things like confidence intervals and significance tests. From practical trading, I saw that there was a lot of noise in data, but I wasn’t sure how to tease it out. As I was getting a better education, I came up with a stop-gap; I generated many charts of random market data according to various techniques and spent a lot of time looking at them. If I had a better formal education I probably would have thought this was a waste of time, but I experienced so many cognitive errors as I did this. It’s one thing to know them academically, but when you see how easily your perception is swayed and how easily you find patterns in random data, you start to think deeply. Does it invalidate the idea of patterns in real market data? Of course not, but it certainly challenges the claims of “just look at a chart! You can see it works! How can you question it? Look at these examples…” Armed with that first hand experience (and, again that word is critical–it was experiential, not academic knowledge) I became very critical of examples and claims.
- I did some background work on the people making claims for the tools. I won’t dwell on this because I don’t think it’s constructive, but suffice it to say that someone could make a good career out of debunking Fibonacci experts, just like Houdini did with mediums in his day. I realized that we have a tendency to put some aura of greatness around past gurus, who, in many cases, were part time traders who had poor access to data and no analytical tools. Alexander Elder, in his excellent book tells of interviewing the great W.D. Gann’s grandson, and that his grandson said there was no fortune and no profits from his trading in the stock market. When I dug into the current gurus on the internet, I discovered that many trades were done at improbable prices (“How do you always get filled on the bid every time?”), and, years later, one of the big gurus from the early 2000’s told me that all her trading, scalping NQ futures, was on a simulator and she never had a live trading account. Sadly, I had seen hundreds of people try to replicate her methods, with no success. I could go on and on. I wasn’t trying to tear down any idols; rather, I was desperately searching for some evidence that someone was really applying these tools to make money.
- The last straw was adjusted price charts. This might seem odd to newer traders, but when you look at past price charts, those prices may or may not represent prices at which the asset actually traded. Much of the discipline of technical analysis rests on the idea that people have a memory around specific prices. While this may or may not be true, there are different ways that historical charts must be adjusted. With futures, there are at least three common methods (difference, ratio, or unadjusted), and the question of when to roll to new contracts. With stocks, there are issues of dividends, splits, spinoffs, and other corporate actions that may or may not be accounted for on the price charts. You still see this today: ask someone showing a Fibonacci extension on a crude oil chart how their chart is back-adjusted. How many days open interest or volume to roll? How does your chart compare to spot prices? The answer I got from asking many people was either confusion or “it doesn’t matter.” (I have seen this dismissal over the years from many people who use levels in various capacities. I remember explaining to a stock trader who had traded from more than 20 years why SPY prices were so different today from yesterday–in 20 years of using “levels” he had never accounted for dividends.) Simple logic here: if I tell you I have some powerful pills, but it doesn’t matter which pills you take, how much you take–take 1 or 20, or when you take them, is it more likely that it magical medicine or that it does nothing at all?
- The whole thing died, for me, when I realized that it rested on vague appeals to authority. I knew this all along, but once I had been around the block a few times, it was even more obvious. The Emperor had no clothes. No one will ever provide you with a quantitative proof of Fibonacci levels working. (I’ve made this challenge many times, and I will renew it here. Show me something good and I will publish it and admit I’m wrong. Show me something possibly flawed but still substantial, and I’ll publish it for discussion. It’s possible my thinking on this subject is wrong, and I would love to expand my thinking in another direction. Despite me having said this hundreds of times, I have yet to receive a single shred of actual work done on these ratios.) The last apology for ratios I read was a few weeks ago when someone said that you could just look at charts and see they worked and a lot of his friends, who were medical doctors, said Fibonacci ratios were really important in the body and in art.
So, that’s my journey, and that’s why I place no emphasis at all on Fibonacci levels. Here’s the real key: you do not need them. That’s the point. It’s not that I’m trying to tear down anything or simply show you that something doesn’t work; it’s that I’m showing you that this is probably confusing baggage and noise, and does not add any real power to your analysis. Why not focus your attention on things that do work?
Your answers may be different from mine, but that’s my journey and that’s why I don’t use these tools in my trading in any capacity. If you want to dig deeper, I published some of my quantitative work on Fibonacci levels in the posts below. No, this is not, nor is it intended to be, a disproof of the theory, but it does offer a simple replacement that is supported by the data: look for retracements to end at about 50% of the previous swing, with a very large margin of error. We might wish for more precision, but that is all I have been able to find in the data. Good news, though: it’s enough.
- Start here for background, and click the links for some basic numerical literacy
- I share some of my efforts to quantify the ratios in this post.
- This post and this post share some results from a deep look at a lot of market data.
Incredibly helpful post. Thanks so much for taking the time to write this all down.
Thank you 🙂
Adam – I read your piece What’s wrong with Fibonacci? And found myself shaking my head. Where I agree with you that Fibonacci retracements and extensions work some time but not all the time, I found the tone of the entire response to be a bit unusual. I have to apologize that I have not read your tome on Technical Analysis, but the response above seems to lack a basic understanding of one of its basic tenets. The primary role of Technical Analysis is to identify a trend. The thought is if you can find a trend then you can continue to invest or trade with it until the trend changes. That of course leads to the desire to find where a trend will end and reverse. This is where Technical Analysis seems to be most misunderstood and where I take issue.
What I found confounding is the thought that Fibonacci’s should work consistently in determining the end of trends, and your statement that you found no consistent evidence of that (although no data is presented). Technical Analysis is not a magic bullet, and does not teach that this will be the case. There are two basic tenets of Technical Analysis missing here.
The first is that Technical Analysis is not about Certainty, but Possibility. It is about finding points of Reflection not Inflection. There are many types of Technical Analysis that ‘work’ sometimes and not others. Classical patterns like Triangle breaks, cup and handles and head and shoulders will sometimes work to determine a reversal and a target and sometimes will not. Japanese Candlestick patterns will sometimes work and other times will fail. And Fibonacci retracement ratios and extensions are no different.
The second tenet is that of confirmation. This is the requirement that the result of any analysis that gives one of these points of Reflection be confirmed as a meaningful price level. A reversal is not a reversal until it starts moving in the opposite direction. No Technical Analyst will front run a Fibonacci level or pattern break or candlestick pattern without confirmation.
Technical Analysis, when used properly can be a powerful tool set. It can assist with when to protect profits or lighten positions. It can give strong entry points and exits. And it can help with assessing risk management, position sizing, and reward to risk analysis. There is nothing wrong with Fibonacci analysis, when used in the proper context. As a point of Reflection or a possible reversal point. Please don’t expect that any type of technical Analysis can be relied upon to be modeled into a system. It cannot and was not ever intended to predict the future.
Greg Harmon, CMT CFA
President and Founder, Dragonfly Capital
Greg,
First of all, I’ve always respected your writing and work. I’m honored to have your voice here, and I thank you for a comment that significantly advances the discussion.
I guess my thinking is this: any tool we apply to market data needs to speak to *probabilities*. You said that technical analysis was not about certainties, but possibilities. To my thinking, possibilities are not useful because anything is possible in markets at any time. Anything that has happened, and even things that have never happened are possible. Crude oil could go directly to $500 without a downtick, or it could go to $0.01 without an uptick. The stock market could cease to exist tomorrow. The EURUSD could go to 4.00. These things are possible, but they are exceedingly unlikely.
So what matters is probabilities, and I would argue that any useful tool (technical, fundamental, macro, or other) must say something useful about the probabilities in the market. Otherwise, it adds no information—it’s essentially the same as flipping a coin. No one would think to make market decisions by flipping a coin, but what if we are using tools that are no better than that coin flip? That’s an important and scary question to ask. The only thing that matters is that our tools can show that something is more probable, over a certain timeframe, than something else. That has been the core of my approach to market analysis.
Your comment broadened the scope of the discussion to the whole of Technical Analysis, but the post was specifically about Fibonacci ratios—that I have been unable to find an empirical edge in Fibonacci ratios and proportions in the market. Contrary to your comment, I did provide data—a lot of data. The links at the end of the post go to other posts in which I outlined the methodology I used and I show results from looking at several hundred thousand swings in various markets. Though this isn’t a conclusive test, it’s an interesting and broad perspective on the question.
What I’ve tried to do in all my work and thinking about markets is to attempt to truly understand the edge and probabilities by taking a scientific and skeptical approach. As I said, this means asking some hard questions: how we know this works? How does it work? How do we know what we think we know? What if we’re wrong? Of course, humility is important and this approach means that I can never disprove something; that’s not how this works. It’s certainly possible that something was wrong with the way I tested it and I need to look at it a new way, or that I simply missed something. I’m always open to those possibilities, but this perspective invites (demands) a focus on the data and a critical mindset.
So, that’s where I’m coming from and that was the spirit in which I offered the original post. I hope to encourage more discussion and thought in this direction, and, again, thank you for your time in writing the comment on my post.
I don’t use Fibonacci, but I’ve heard some proponents who use them talk about “Fibbonacci clusters.” They measure multiple swings over a set period of time, and look for areas of confluence where Fib levels tend to cluster or overlap. Then they look at the swing highs and lows in price and draw support and resistance lines. If they have S/R lines, and a cluster of Fibonacci all lined up at a certain level, they will trade off of that level. That would be hard to backtest, but maybe there’s some slight edge to it.
Also, it might have been Gann, or Wyckoff that apparently traded the “halfway back” strategy successfully using certain rules.
Greg, first of all, I’d try to comfort you: it’s perfectly normal what happened, you are not alone, most humans experience a range of uncomfortable feelings (fear, anger) when our dogma-fueled beliefs are questionated. Unfortunately for Adam, looking at your charts and seeing how many lines/divine signs/indicators/etc you have there, it was very difficult for Adam to criticize anything without hurting you in some sense.
The solution for you Greg would be either 1) stop identifying yourself with your faith, and don’t fall on this vicious path “Adam asks what’s wrong with Fibonacci” -> “I am a Fibonacci true believer” -> “Adam asks what’s wrong with me” or 2) stop reading articles that call into question different assumptions and stick with Fibonacci jihadists articles (for instance, allstarcharts – another random walker down Wall Street).
Greg, maybe you don’t know Adam and his work, but really this tone of educating him on platitudes like ‘sky is blue’, ‘grass is green’ and ‘TA can be a powerful tool set’ is inappropriate.
Another thing that seems you don’t get right Greg, is that the burden of proof is always on the person making the claim. So, if you say that Fibonacci ‘works’ in some way, it’s your part to show us the proofs and not on Adam’s side to prove that the claim is false (even if as others already said here in the comments, Adam published the results of his investigations).
And Greg if for you TA is about possibilities, you can forget it right here and right now, I will tell you all that TA can tell you: everything is possible.
Regarding these CMTs, CFAs, BLABLAs, I don’t know about other fields, but in the scientific community, designations are so much less important than the data behind some one’s ideas.
I will close with a Jason Zweig’s statement if I may: Sooner or later, the markets always punish investors who do the right thing for the wrong reason.
I’m not sure there is a need to disparage Greg for his views. We all have opinions and are all probably successful in our own rights. Adam, I appreciate your thoughts here. I use fib analysis in my approach to the markets. My opinion is that markets are uncertain, complex and adaptive, and probabilities are only probabilities until the market changes. I try to find robust tools to help me understand the growth and retracement cycles (trends) of the market. Fibs have helped me in this regard, but it is not just simple retracement and extension ratios. I think anyone would be hard pressed find a quantitative, systematic way to use them. I’ve found it’s much more nuanced than that. The analogy I would use is someone who uses flow of the market (tape reader), or market psychology. It is hard to use hard data in those endeavors, but there is definitely a rhyme to the markets that can be teased out. That’s how I view fibs. Every market is different, you have to tease out the right markers and as Gregg mention use confirmation. This really becomes a broader question of whether or not you believe technical analysis works or not and whether you are a systematic or discretionary trader. Even in quantitative or statistical analysis you are using the same basic premise as TA, that there is some underlying, stable pattern that can be exploited. In a uncertain, complex market, none of us know if we are right or wrong ex ante or ex post. To say we KNOW is truly a misnomer and to claim we are right or wrong is obtuse. Adam’s journey is not everyone’s journey. It could be the case that people out there that have data, but don’t want to share it because it is proprietary. Those are just my thoughts.
Brad Jantz, CMT, CFA
Greg, I believe you are misled by the different tone and scope of this piece giving a much more personal insight into Adam’s journey. If you simply follow one or two of the links he provided to previous posts, you’ll see how most and probably all of your concerns and objections were previously addressed. Everybody is aware that nothing works all the times, trading is about “possibility” (or rather probability?) and not certainties etc. – but the bottom line is that there should be some trace of evidence that the probabilities at or near Fib levels are skewed in some way and that there is something at least slightly deviating from random walk.
In any case, I sense a lot of passion in the discussion. People using Fib levels seem to find them really helpful and I believe that if those people are profitable and happy using them, they are probably better off to keep using them, be there a statistical proof or not. Trading is more than just applying statistics (unless you are a pure quant).
Now having a few Fib lines on your chart may give you some edge neither Adam nor anybody else so far was able to find – or it may give you simply some guiding lines that make your brain more comfortable and confident with your approach and make you follow through on your plan?
In the end it does not matter.
Thank you. You posted that literally as I was writing my comment, and you said what I needed to say in half the words I used!
Adam, excellent post.
Great post from Adam and the discussion here. Adam is very clear that he is looking for statistical evidence that Fib levels works. And we are clear up to now we have not seen any. The supporters of Fib levels however claim that they manage to make money in markets using Fib levels. I personally know one trader who make his fortune in trading and he uses Fib levels as part of his trading decision process. So, who’r right, who’s wrong? Or is this even the correct question at the first place? Maybe Adam has not found the evidence that it exists or traders who make money in market are not aware that FIb levels in purest sense actually make no contribution to their success? At the end of the day, it doesn’t matter, as pointed out by irdoj75. Trading methodology is a system which include your beliefs and trading styles. In a system, there are some good components and bad components, it is not so easy to distinguish which is which and removing one may affect another. Michael Marcus once said, ‘when you try to incorporate someone else’s style, you often wind up with the worst of both styles’.
I’m with Adam on this one. My problem with Fibonacci levels has always been that users are very precise about which numbers are specifically Fib (61.8 and not 62 and certainly not 61 or 63) but not precise at all about when they matter. If a stock goes to the 60% level before falling that is a win for Fib, if it goes to 70% before falling below 61.8% that is a win. You can start measurement over the most recent daily move, unless you should have used the longer term monthly move unless you should have used from the most recent retracement.
And no, of course Fibs don’t have to work every time to be useful. But it would be helpful to know how often they are right to on order to determine probabilities in trades. Without strict rules this is impossible.
The tldr; version is ‘correlation doesn’t equal causation’
A good part of the sound and fury associated with defending Fibonacci is that newer traders hope it’s supposed to be the answer to their main question when they look at a chart which is ‘Tell me what to do?!’
Coupled with the ‘magical/secret’ aspect (Are we still in the Middle Ages?) taking on perceived orthodoxy is a waste of time. If that’s what it takes for people to gain the confidence to enter a trade then more power to them. Let them get on with it and at least they can blame something other than themselves when it fails…
If Fibonacci (as taught) is true then “Prices will react at arbitrary lines that happen to be drawn at ratios associated with previous highs and lows.” Say that sentence out loud a few times and it will start to make less sense as you repeat it.
I reckon that if you persistently apply the same process, refine it based on feedback, practice good risk management and (most importantly) gain a large enough sample size over time you can probably make any indicator or tool work… Which is why trying to copy how someone else trades usually ends in failure ’cause you’re missing the 80% of their experience that sits below the communicable water line.
It’s human nature to seek an easily transferable view of how markets move/behave but believers (and vendors of systems) are only fooling themselves. We spend millions of dollars trying to predict the weather while still getting it wrong so why do people think they can succeed by attacking the markets with nothing more complex than a ruler?
Hi Adam,
I am a big fan of your work. As a life long discretionary professional trader, like you I have extensively researched many relationships over the years. There are two important points I have discovered pertaining to “fibs”.
First, fibs work best in the absence of interference by other price patterns that either conflict with or dilute focus on measured levels (as opposed to levels derived by prior discrete price behavior). This eliminates the majority of candidates. While I could write a book about the possibilities, generally this is evident in price moving at a measured pace until reaching some clear key price level such as a prior swing high or low and then moving explosively through it. This creates expectations by the market at those levels about future behavior of losers covering/exiting and winners adding.
Second, fibs work best when they represent logical price behavior. For example, in a directional market, 50% (not a fib but mentioning it anyway) is great because if your thesis is that price will make a higher high before it makes a lower low then this is the retracement point at which mathematical expectancy turns positive, a concept systematic traders fully embrace. This argues why 61.8% and 38.3% might worker in weaker and stronger trends, although I do not use them. I do extensively use 23.6% and 100-23.6 = 76.4% for similar reasons. With 23.6% I am betting that price moves to at least the midpoint of the range before taking out the low, and likewise the other way. This also alludes to the type of price structure particularly appropriate for this approach, mainly one in which the move up from the low or down from the high is particularly sharp, implying good buying or selling pressure there. Again, without any other distinct level against which to manage a trade (point one above), these levels are as good as any and I believe there will generally be some number of fib traders placing trades there.
One might argue that I am basically using 25%, 50%, and 75%, nothing magical about fibs. However I find more times than not that price reacts within ticks to 23.6, 50, and 76.4 so for that reason I default to these levels.
Your comment is entirely correct if applied in a blanket manner over all price swings – apparent randomness. However if properly filtered I have found the results to be quite favorable (as can be said of course about any trading approach).
Adam,
Thank you for this post. I think it takes us closer to the reason why fib levels “work” and why there are millionaires who made their millions using them: positive expectancy.
If you cut your losses short and let your profits run, then almost any indicator or method “works”. It’s been ‘proven’ that even coin flips work. If I take a method such as fib levels, that work about 50% of the time, and I cut my losses short and let my profits run (or at least are bigger than my losses) then my naturally biased mind will interpret fib levels as the source of my profits, even though the real source is positive expectancy. Thats why fib levels work, and will ALWAYS “work”. They work randomly 🙂
Rodrigo,
With all possible respect, I have to tell you that what you’ve written here is absolutely wrong. If you don’t have an edge, then cutting your losses short will not work. What will happen is your win ratio adjusts so that the end result is about zero. (“about” is needed because of statistical noise.)
This is one of the most common misconceptions with newer traders, and it is fatal. If you don’t have an edge, cutting your losses short will not provide that edge. A little testing and/or thinking about the math in a random walk context will show you why.
If what I wrote is wrong, then Fibonacci levels have an edge. A huge edge if traders are becoming millionaires with it. I seriously doubt that.
Van Tharp has a section in his book about random entries. (“Trying to beat random entry”- Trade Your Way to Financial Freedom, pg. 200). He explains how Tom Basso and later himself tested a simple rules system with random entry and it made money on 100% of the runs. (note ‘runs’ not ‘trades’) It had about 38% winning trades, which is on par for trend following systems. And this is not the first time ive heard of studies with random entries being profitable. I’m pretty sure they were not Hugely profitable, but profitable nonetheless.
It is true that without an edge, you will not win, as you point out. But the edge in this case (and in many others that we don’t suspect) the edge is in the Exit and in Money Management.
I also want to point out something: Several defenders of Fib levels and other Technical indicators point out that they “wait for confirmation”. So in essence what they are doing is trading a BREAKOUT and not the Fib level. And breakouts may very well have an edge.
I think what Adam’s pointing out here is that money management cannot compensate for a total lack of edge. I’ve made the same false assumption you have, years ago. I don’t have the hard numbers to back it up, but I can illustrate:
Imagine flipping a coin to decide buy vs sell, and from that point, you elect to have a 1% stop-loss and a 3% profit order, giving you a 3:1 reward. A money management edge, right? Wrong. 🙂 It doesn’t take into account that in typical data (i.e. over the long term) you won’t get 50% success at all here: you’ll tend to reach your stop-loss 3x more frequently than your profit, because it’s that much easier to hit, for net zero.
adam is correct , cutting your losses short (after random entry) absolutely will not work except by chance and knowing this you walked away from the roulette table after an early winning streak.
Van Tharp here is just an appeal to authority because there are catastrophic flaws in his material on position sizing,expectancy , stop loss use.
How do I know?
I used that simple idea, ran tests of millions of backtests changing the various variables, sampling replacement, stops size, on a data set.
It looked great but when I traded it in the real world it quit immediately.
Later I found out the data set was just plain wrong and didn’t reflect real futures pricing.
btw: I also tested if going the opposite direction would work, because if you found a sure way to lose money it stands to reason that doing the opposite could be profitable. again only on paper and clearly an artifact of bad data.
Now, I quantitatively know better : even if the data set I used wasn’t bad the system as described in his book would only be successful by chance and no money management scheme except quitting after a big run or win will work.
Thank you, Adam, for your rigorous, evidence based approach to trading. I really appreciate what you share with us.
I can relate to this post through my own experience…
When I was a new trader, I found my way to Elliott wave analysis and its BFF, Fibonacci ratios. A contrarian by nature, I bought into the notion that these Elliott wave guys had tapped into a mysterious property of the universe that could explain any kind of human activity. They seemed to be able to explain every market move, and the extent of the move (after the fact, of course), by wave counts and fib ratios.
Try as I might to make it all work real time, though, I just couldn’t. I joined an online EW group, where great debates would rage about wave counts, structures and fib ratios. I tried and tried to force recent market moves to fit a Fibonacci scheme, and some would, some more or less would, and other market swings seemed to ignore the any “Golden Ratio” number altogether.
I then had a revelation while eating my lunch in my car in the parking structure at work. This structure had no continuous outer walls–instead it had five or six thick steel cables strung horizontally between the supporting vertical columns, spaced about a foot apart (the cables were a foot apart, not the columns). In the distance, in my line of sight were a grove of trees and some buildings, and as I looked out through the steel cables I remarked to myself that this scene looked kind of like a stock chart. I could see in this “chart” that the tops of some of the trees and buildings almost exactly touched the line of one of the horizontal cables, just like price on a chart hitting a support level and retracing. It happened a surprising number of times in this little 10 foot wide scene I was looking at. There I sat, chewing my sandwich, questioning a big part of my approach to trading.
A couple of days later I went to my charting software and just randomly added a bunch of horizontal lines, not caring at all where I put them. You can guess the outcome. If I went back far enough–and I didn’t have to go back very far–I could find a place where every single line looked like support or resistance. This made me take a hard look at all types of support and resistance in terms of my own confirmation bias, and one of the results of that look was that I stopped considering Fibonacci ratios in my trading.
That was many years ago, but to this day, every so often I’ll throw a fib retracement/extension grid over recent short and intermediate term market moves. Hope springs eternal, you know. My reaction is usually the same–nah!
thank you for a great comment and good insight here. the story of the trees and cables is a good one.
Great post and a great debate in the comments section.
The pro-fib guys are slightly missing the point in Adam’s work. As already mentioned, he has provided statistical tests on why he thinks Fibs don’t work, outlined the premise for the tests and at the same time acknowledges the possibility that there could be limitations to the scope of these results (blind spots?) and anyone who thinks he’s missing anything, is invited to provide evidence to the contrary.
This is exactly how we should be approaching any tools we use in the market. For me, this is real insight and education in the trading development process. As mentioned below, the burden of proof is on the claimer (or as I like to put more strongly: Anything you are told about a market’s “tendency to do something”, you should assume guilty until proven innocent).
Interestingly, the arguments for fibs seems to fall along the wordy response – They work some of the time or in the right context, they can be a powerful tool, I find them helpful. The bottom line is, they should survive a robust test and if you want to apply specific filters – test them too.
The easy catch for me, is when somebody says something like in a strong/weak trend, the retracement should be only 38.2%/61.8% respectively. A comment like this simply does not understand the hindsight bias that plagues most guru claims (a bit like: if the market is ranging buy the bottom of the range/sell the top, if the market is trending trade with the trend – if it were that easy) and you simply have to question the ability of the claimer to make any objective observations about the market if they can’t even see a very simple blind spot.
To balance it out, re: comment by DB knowing a trader who makes lots of money using fibs – in a way, you can’t argue with the bottom line. If somebody’s making lots of money using fibs – whether the fibs have any edge or whether it just helps them be more decisive over a more subconscious but profitable part of their process – that person’s not gonna really care, and if it were you or I, we’d probably wouldn’t fix it either.
There is a lot of wisdom in the “if it works, don’t fix it” idea. If it works, and if it continues to work (monitor your ongoing performance)… then you have something. I could still make the argument that there might be value in trying to tease out where, exactly, the edge comes from… but “if it ain’t broke, don’t fix it” certainly has some validity too!
Personally, I’ve always appreciated AlphaTrends/Brian Shannon’s view that all of these indicators are _potential_ support, nothing is known until after the fact. Being aware of potential scenarios helps in trading.
If one assumes Algos/HFT programs incorporate Fibo levels in their trading, would your analysis be different if limited to recent timeframes or to heavily traded stocks rather than classes of assets? Alternatively, has the attention to Fibo killed its effectiveness or reinforced it?
Similarly, have you analyzed pivot levels’ support/resistance levels (R1,R2, S1, S2…) for statistical proof ?
Great stuff Adam, keep at it!
Yes those “floor trader pivots” were one of the first things I started looking at, and I was puzzled when I couldn’t find an edge… because my whole mindset was that these things HAD to work because I’d seen them work so many times in real time. It took me quite a while to shift my thinking around to truly be objective.
Also, check your assumption: Algos/HFT incorporate Fibo levels? Do you know this to be true? All the evidence I have suggests otherwise… quant-minded people aren’t terribly excited by magic levels… this is much more in the realm of the visual/subjective chart reader.
Thanks you Adam for an interesting topic. My view on Fibonacci is to recognise that a lot of people believe in the Fib levels and use that information to trade. When a forex pair has had a good run and has rolled over then I use the Fib to understand where Fib believers will likely place orders and pressure price to resume the impulse trend. Once there is a turn at a Fib level I look towards ensuing price action to determine my entry. If price continues into the reaction then wait for the next Fib level. So in summary use the Fib levels to see what others might do and benefit from the ensuing price action.
I too have been wondering about Fibonacci levels being a self-fulfilling prophecy in the shorter timeframes where smaller-scale trading is more apparent. Somewhere around the 3 to 60 minute bars…
Dear Adam
I agree with all your writing , except your comments on Volume on p 107 of your book.Heres some trivia of fibs about Pluto.As you mention, perhaps you are not using Volume correctly. Maybe the same applies with fibs?
Kind regards
bobc
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