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Fundamentals of Technical Analysis and Algorithmic Trading Chapter : Fibonacci Sequence, Elliot waves Theory

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### Fundamentals of Technical Analysis and Algorithmic Trading Chapter : Fibonacci Sequence, Elliot waves Theory

Faculty of Business and Economics

Department of Banking and Finance

SaeedEbrahimijam

Spring 2013

FINA417

Contents

- Fibonacci

Fibonacci Numbers

The Fibonacci Sequence

The Golden Ratio

Price and Time Targets

- Elliot Waves

Basic Elliott Wave Theory

Impulse Waves

Corrective Waves

Fundamental of Technical Analysis and Algorithmic Trading

THE FIBONACCI SEQUENCES

Fundamental of Technical Analysis and Algorithmic Trading

Fibonacci Numbers

- 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144,…
- Fibonacci numbers are simply a sequence in which the last number is added to the previous number to arrive at the next number.

Fundamental of Technical Analysis and Algorithmic Trading

Fibonacci sequences and The Golden Ratio

The relationship that the sequence has to the "golden ratio."

13/21=0.618 61.8%

34/55=0.618 61.8%

34/21=1.618 161.8%

55/34=1.618 161.8%

21/55=0.382 38.2%

13/34=0.382 38.2%

23.6%, 38.2%, 50%, 61.8% and 100%

- Except in the very low numbers, the ratio of any number in the sequence to the next lower number is 1.618 (e.g., 144/89 = 1.61798);
- The ratio of any number in the sequence to the next highest number approaches 0.618 (e.g., 55/89 = 0.61798).
- The number 1.618, known as the "golden ratio," and its reciprocal of 0.618, possess many interesting properties.
- For example, it is the only number that when added to 1 is the same as 1 divided by itself. Another fascinating fact is that 1.618 multiplied times 0.618 = 1.

Fundamental of Technical Analysis and Algorithmic Trading

Why 38 Percent and 62 Percent?

- The two most important are 38 percent and 62 percent.
- Each Fibonacci number is approximately 62 percent of the next higher number (e.g., 5/8= .625);
- hence, the 62 percent retracement level. 38 is the inverse of 62 (100 − 62 = 38); hence, the 38 percent retracement number.

Fundamental of Technical Analysis and Algorithmic Trading

What do those sequences show in trading

- They are very popular among professional traders and are widely used to determine:

“how far price corrections will retrace ? “

Fundamental of Technical Analysis and Algorithmic Trading

Why Fibonacci sequences are significant in the market prices?

- Because it is vastly applied by the traders.
- At last the prices are converge to those sequences.

Note: The Fibonacci method can be applied for all the time horizons from 5min to weekly …

Fundamental of Technical Analysis and Algorithmic Trading

How to use Fibonacci sequences in the charts

- Fibonacci retracements use horizontal lines to indicate areas of support or resistance.
- They are calculated by first locating the high and low of the chart. Then five lines are drawn: the first at 100% (the high on the chart), the second at 61.8%, the third at 50%, the fourth at 38.2% and the last one at 0% (the low on the chart).
- Find MAX and MIN levels Known as, Beginning swing price and Ending swing price
- Maybe you need to go back for daily or weeks.

Fundamental of Technical Analysis and Algorithmic Trading

Trading base on the Fibonacci retracement

- 38.2%, 50%, 61.8%, 78.6% (76.4%)
- The market always correct itself after each strong movement and before continuing the previous trend.
- Wait until point C forms. (BUY or SELL @ C)
- Where is C (Problem???)

Fundamental of Technical Analysis and Algorithmic Trading

SELL @ C

Fundamental of Technical Analysis and Algorithmic Trading

BUY @ C

Fundamental of Technical Analysis and Algorithmic Trading

Fibonacci Price Expansions

162%

Price expansions expand the price range of a price swing by chosen ratio amounts.

The most important ratios for expansions are:

62%, 100%, 162%, 262%, 424%

100%

61.8%

B

ending swing price

beginning swing price

A

Fundamental of Technical Analysis and Algorithmic Trading

Fibonacci Price Expansions

- After BUY @ C , According to Fibonacci price expansions calculation, the price target will be @ point D.
- If retracement Happens @ 61.8%, it will usually continue till 161.8%.

Fundamental of Technical Analysis and Algorithmic Trading

Try to find other reversion signals @ C

Fundamental of Technical Analysis and Algorithmic Trading

Fibonacci sequences convergence

- Some traders use Fibonacci on different time horizons (daily, weekly, monthly,…), so in this situation, coverage of some of the sequences will be more significant.

Fundamental of Technical Analysis and Algorithmic Trading

More examples 1

Fundamental of Technical Analysis and Algorithmic Trading

More examples 2

Fundamental of Technical Analysis and Algorithmic Trading

Time and Fibonacci Numbers

- In addition to the extent of price movements in waves being related by Fibonacci numbers, times in stock market data have also been related to the Fibonacci ratio.
- Tables are often used to show the time differences between important peaks and valleys in market prices that occurred in a Fibonacci number of years, months, or days.

Fundamental of Technical Analysis and Algorithmic Trading

Time and Fibonacci Numbers

- Elliott himself used the example of the 34 months between the peak in September 1929 and the bottom in July 1932 and the 13 years between the peak in 1929 and the low in 1942 (see Figure 20.12).
- Although others also have seen a relation between Fibonacci time counts and important events,

Fundamental of Technical Analysis and Algorithmic Trading

Fibonacci Time expantion

Fundamental of Technical Analysis and Algorithmic Trading

Fibonacci ratio in speed line

- Modem methods have included marking the Fibonacci ratio numbers of 38.2% and 61.8% and drawing the speed lines through them. As retracements do not seem to follow a consistent percentage, it seems doubtful that much merit should be applied to speed lines, but they are often seen in the literature on technical analysis.

Fundamental of Technical Analysis and Algorithmic Trading

STOP LOSS with Fibonacci

- It is a pre calculated price before entering to a trade.
- Stop Loss is applied for exiting fro the market when the market acts in the opposite of your expectations.
- One suggestion is using the resistance and support line which are consistent with the Fibonacci sequences as S/L value.
- In FOREX, Each pair has a specific behavior that should be considered in determining S/L.

For example USD/CAD, USD/JPY have quick movements and noise than the price of USD / CAD, USD / JPY Which causes further S/L limit to be calculated.

- MOVING S/L strategy:

Keeping the obtained profit is very important. One of the methods used is when your trade enters to profit, change the S/L to reduce your risk.

Note: You should keep S/L away from market price fluctuations not to be affected by the market noises.

Fundamental of Technical Analysis and Algorithmic Trading

ELLIOTT WAVE THEORY (EWT)

Fundamental of Technical Analysis and Algorithmic Trading

Introduction

- Devised by Ralph Nelson Elliott, the Elliott Wave Theory (EWT) is an attempt to define a structure to the stock market, and by implication, other trading markets.
- EWT is based upon the notion that the market behaves in an irregular cyclic manner.

Fundamental of Technical Analysis and Algorithmic Trading

Introduction

- The terms called waves, in fact, are explain how people behave.
- These waves show: volume, market psychology, and optimistic and pessimistic wave’s movementsand corrections and Furthermore, the measurement level of patterns.
- One of the things that we see in the financial markets, is the changes in investor psychology in the form of displacement (change) in prices.

Fundamental of Technical Analysis and Algorithmic Trading

The main research of Elliot, he examined changes and mutations in 11 different patterns of waves that occurred between the price data were examined.

- Then named them.
- The explained how those patterns are related to each other and explained how these waves are also present in pattern with larger dimensions.

Fundamental of Technical Analysis and Algorithmic Trading

Wave theory can not tell us complete and certain market future. It is only what is probably happening, and the target range is used for changing.

- The Elliot wave analysis is not appropriate for Gold market.

Fundamental of Technical Analysis and Algorithmic Trading

Basic Elliott Wave Theory

- Elliott's theory describes the market structure as a nested series of waves of various length and size. A wave is a sustained price move in one direction as determined by the reversal points that initiated and terminated the move.
- A wave cycle is composed of two waves—an impulse wave and a corrective wave.
- The impulse wave is in the direction of the current trend;
- the corrective wave moves against the trend's direction. During a bull market, the overall trend is called a "motive impulse wave" (upward price movement) and ends when a downtrend begins, signaling a major change in market direction.

Fundamental of Technical Analysis and Algorithmic Trading

The Rules tell us that:

Impulse (divided to sub waves):

- Market moves by 5 waves (motive waves) and corrects itself with 3 or 5 waves(counter market movement) before the a larger trend starts.

Fundamental of Technical Analysis and Algorithmic Trading

The details of these subwaves are as follows:

• Wave 1 is an impulse or a leading diagonal.

• Wave 2 can be any corrective pattern but a triangle.

• Wave 2 does not retrace more than 100% of wave 1.

• Wave 3 is always an impulse.

• Wave 3 is larger than wave 2.

• Wave 3 is never shorter than waves 1 and 5.

• Wave 4 can be any corrective pattern.

• Waves 2 and 4 do not overlap in price.

• Wave 5 is an impulse or ending diagonal.

• Wave 5 retraces at least 70% of wave 4.

• In the fifth wave, a diagonal, extension, or truncation indicates that a major reversal is to occur soon.

Fundamental of Technical Analysis and Algorithmic Trading

Fractals and Elliot wave

Fundamental of Technical Analysis and Algorithmic Trading

Wave 1:

- Wave one is rarely obvious at its inception.
- When the first wave of a new bull market begins, the fundamental news is almost universally negative.
- The previous trend is considered still strongly in force. Fundamental analysts continue to revise their earnings estimates lower; the economy probably does not look strong.
- Sentiment surveys are decidedly bearish, put options are in vogue, and implied volatility in the options market is high. Volume might increase a bit as prices rise, but not by enough to alert many technical analysts.

Fundamental of Technical Analysis and Algorithmic Trading

Wave 2:

- Wave two corrects wave one, but can never extend beyond the starting point of wave one. Typically, the news is still bad. As prices retest the prior low, bearish sentiment quickly builds, and "the crowd" haughtily reminds all that the bear market is still deeply ensconced.
- Still, some positive signs appear for those who are looking: volume should be lower during wave two than during wave one, prices usually do not retrace more than 61.8% (Fibonacci) of the wave one gains, and prices should fall in a three wave pattern.

Fundamental of Technical Analysis and Algorithmic Trading

Wave 3:

- Wave three is usually the largest and most powerful wave in a trend (although some research suggests that in commodity markets, wave five is the largest).
- The news is now positive and fundamental analysts start to raise earnings estimates.
- Prices rise quickly, corrections are short-lived and shallow.
- Anyone looking to "get in on a pullback" will likely miss the boat.
- As wave three starts, the news is probably still bearish, and most market players remain negative; but by wave three's midpoint, "the crowd" will often join the new bullish trend. Wave three often extends wave one by a ratio of 1.618:1.

Fundamental of Technical Analysis and Algorithmic Trading

Wave 4:

- Wave four is typically clearly corrective.
- Prices may meander sideways for an extended period, and wave four typically retraces less than 38.2% of wave three (see Fibonacci relationship).
- Volume is well below than that of wave three.
- This is a good place to buy a pull back if you understand the potential ahead for wave 5.
- Still, fourth waves are often frustrating because of their lack of progress in the larger trend.

Fundamental of Technical Analysis and Algorithmic Trading

Wave 5:

- Wave five is the final leg in the direction of the dominant trend.
- The news is almost universally positive and everyone is bullish.
- Unfortunately, this is when many average investors finally buy in, right before the top.
- Volume is often lower in wave five than in wave three, and many momentum indicators start to show divergences (prices reach a new high but the indicators do not reach a new peak).
- At the end of a major bull market, bears may very well be ridiculed.

Fundamental of Technical Analysis and Algorithmic Trading

Wave A:

- Corrections are typically harder to identify than impulse moves.
- In wave A of a bear market, the fundamental news is usually still positive.
- Most analysts see the drop as a correction in a still-active bull market.
- Some technical indicators that accompany wave A include increased volume, rising implied volatility in the options markets and possibly a turn higher in open interest in related futures markets.

Fundamental of Technical Analysis and Algorithmic Trading

Wave B:

- Prices reverse higher, which many see as a resumption of the now long-gone bull market.
- Those familiar with classical technical analysis may see the peak as the right shoulder of a head and shoulders reversal pattern.
- The volume during wave B should be lower than in wave A.
- By this point, fundamentals are probably no longer improving, but they most likely have not yet turned negative.

Fundamental of Technical Analysis and Algorithmic Trading

Wave C:

- Prices move impulsively lower in five waves.
- Volume picks up, and by the third leg of wave C, almost everyone realizes that a bear market is firmly entrenched.
- Wave C is typically at least as large as wave A and often extends to 1.618 times wave A or beyond.

Fundamental of Technical Analysis and Algorithmic Trading

Impulsive or Motive Waves - Moving with the Larger Trend

Fundamental of Technical Analysis and Algorithmic Trading

Diagonal – also known as a Diagonal Triangle: Leading (LD) and Ending (ED)

Fundamental of Technical Analysis and Algorithmic Trading

Corrective Waves - Moving Against the Larger Trend

- ZigZag
- Double and Triple Zigzags (DZ and TZ):
- Flat
- Triangle (Contracting and Expanding)

Fundamental of Technical Analysis and Algorithmic Trading

The rules for a converging triangle are as follows:

• Wave A is a zigzag or a flat.

• Wave B is only a zigzag.

• Waves C and D can be any corrective pattern except a triangle.

• Waves A, B, C, and D move within the bounds of the channel lines between A to C and B to D.

• Bounds converge (one may be horizontal), and the intersection of the bounds occurs beyond the end of wave E.

• Wave E can be a zigzag or a converging triangle.

• Either wave A or B is the longest wave.

• Wave E ends in the range of wave A.

• Wave E moves within or closes within the bounds.

Fundamental of Technical Analysis and Algorithmic Trading

Expanding triangles, although relatively rare, have generally the same rules. The exceptions are that for the expanding triangle:

• Wave B is smaller than wave C but more than 40% of wave C.

• Wave C is smaller than wave D but more than 40% of wave D.

• The intersection of the bounds occurs before the formation of the triangle.

• Wave E is longer than wave D.

• Wave E ends outside the territory of wave A.

• Either wave A or B is the shortest wave.

Fundamental of Technical Analysis and Algorithmic Trading

Degree or Time Frame:

- Submicro – minutes to hours
- Micro - hours to days
- Subminuette- days to weeks
- Minuette- days to months
- Minute - weeks to months
- Minor - weeks to quarters
- Intermediate - months to quarters
- Primary - months to years
- Cycle - quarters to years
- Super cycle – years
- Grand Super cycle – decades or longer

Fundamental of Technical Analysis and Algorithmic Trading

Elliott waves and Fibonacci

- Elliot technique expects that all the correction waves happen near the Fibonacci numbers 38% , 50%, 62%.

Fundamental of Technical Analysis and Algorithmic Trading

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