Over the past two years I have been working on a trading tool called the Price Action Pro, which incorporates some of the most commonly used tools for technical analysis. Many traders tend to invest much effort in using well-known utilities and methods such as support (demand) and resistance (supply) areas, price pivots and Fibonacci retracement levels. I think that there is tremendous value in these tools, especially if you practise using them on a consistent basis to the point where understanding and using them becomes second nature. In this post I will discuss some of the ways these tools can be used.
Support (demand) and resistance (supply) areas
These price sensitive areas, especially the concept of supply and demand, have been around ever since people began trading goods – and the concept is simple: the more people demand given goods or services, the higher the price will climb. Equally, the higher the price of the goods or services, the less the demand. In real-life, contrary to trading, when an item such as a television is at a bargain price, people will rush to buy it. In trading on the other hand, traders often start buying after seeing confirmation that the asset is indeed attracting higher prices. And the opposite is so for supply. The question is, when do you know roughly when to buy or sell? Ideally, when price reaches a level of supply (demand), if the support is substantial enough, people will buy. This is a combination of a few things the one being herd mentality and the other being the way a market maker establishes a market place for clients to engage in the market. The second is one that requires an understanding of how the markets operate on a fundamental level. Ideally, in order to qualify a valid area of supply or demand you need to see the level show some strength, which is easiest seen when price reacts very strongly at an area of supply (demand) or resistance (supply), often resulting in very large moves, or when price is capable of moving through historically respected areas of support (demand) and resistance (supply) with great force. For more information on this, please see the references section at the bottom of this post.
Price pivots have been used to decades to help determine price sensitive price areas, for many markets. The are calculated using a very simple formula and here is the example taken from the Price Action Pro:
// Central Pivot dPP = (dHigh + dLow + dClose) / 3; R1 = (2 * dPP) - dLow; dR2 = dPP + (dHigh - dLow); dR3 = dHigh + (2 * (dPP - dLow)); dS1 = (2 * dPP) - dHigh; dS2 = dPP - (dHigh - dLow); dS3 = dLow - (2 * (dHigh - dPP));
The best thing about price pivots is that they are 100% objective in contrast to support (demand) and resistance (supply) areas, which can take time to see. Many charting platforms will show these to you, MT4 with the Price Action Pro is just one of them.
Fibonacci retracement levels
The Fibonacci number sequence was brought to the west by Leonardo Pisano Bigollo (1170 – 1250) also known as Fibonacci. Fibonacci was best known for his use of the Fibonacci numbers in his work, Liber Abaci (Book of Calculation). The magic of the Fibonacci numbers and their role in trading is something that has occupied me for some time now, and will be the focus of this article. Most traders who are familiar with the Fibonacci numbers are likely more acquainted with the ratios that result when they are divided with each other, and how they are applied to trading. Despite how some may feel about the Fibonacci numbers and their use in the financial markets, the evidence stacked up to support the use of Fibonacci numbers, makes it difficult to ignore them.
These levels are, like price pivots, calculated using a little maths, making them 100% objective, the calculation of which can be summed up via the following expression:
Fn+1 = Fn + Fn-1
This results in a sequence of numbers that starts at zero and continues on forever. The following is the sequence of the first 15 numbers:
0 1 2 3 5 8 13 21 34 55 89 144 233 377 610
In order to obtain the Fibonacci ratios we know and use in trading, we must divide the numbers with one another. It’s best to start with one of the larger numbers in the sequence such as 34, as this will ensure a greater degree of decimal point accuracy. If we perform the required division using 34 as a minimum value, we get the following:
34/55 = 0,618 34/89 = 0,382
This is how we get the standard Fibonacci ratio values. In order to get the deeper Fibonacci retracement levels, we must obtain the square-root of the value 0.618 (The golden mean – 1) as follows:
√(0,618) = 0,786
So now we have the following values:
0,786 0,618 0.382
Some of you may be wondering where the 50% and the deeper 88% retracement levels are. The 50% Fibonacci retracement has nothing to do with the Fibonacci number sequence but can be obtained when performing the same division operation on the smaller numbers in the sequence, 1 and 2 (1/2 = 0.50). This value was added, as it made perfect sense to have a mid-way reference point between the high and the low. As for the 88% retracement level, this can be calculated by taking the square-root of the 79% Fibonacci retracement value calculated previously:
√(0,618) = 0,786 √(0,786) = 0.88656641037
And this process can also continue on forever:
Rn = √(Rn-1)
What about the external retracements and extensions? The Fibonacci retracements 127%, 162% and 262% immediately come to mind as some of the more significant external levels: the square root of the golden ratio (1.27), the golden ratio (1.62), the golden ratio + 1 (2.62), as well as the deeper, more extreme level (4.235):
√(1.618) = 1.27200628929 55/34 = 1.618 (golden ratio) 89/34 = 2.618 (golden ratio + 1) 144/34 = 4.235
The most important thing to remember is that the closer these technical levels are located to each other the better, you simply want to see a confluence. They will likely rarely line up accurately but when they are close to each other then there is a very high likelihood that price will respect them, at least on the initial test of the level. I think the best approach is to study each of these topics individually until they are fully understood before moving on to the next, and I strongly recommend beginning with support (demand) and resistance (supply).