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Looking at Lines, Part 2
In this second of a two-part series, we’ll be taking a look at Fibonacci and the line tools in eSignal that are based on that theory. (See a previous article for Part 1.) In addition, we’ll review the text notation icon and the rest of the toolbar.
Figure 1: The Line Toolbar (Part 2)
As you may recall, each line tool has a right click function available to allow the customization of the default preferences in eSignal. This is even more important when we get into the Fibonacci tools because up to 12 different price levels can be drawn with varying colors and values.
Fibonacci Theory
Before we get into the remainder of the eSignal line tools, it is important to understand the underlying principles of Fibonacci ratios and how they apply to the financial markets.
The Fibonacci sequence wasn’t actually discovered by Leonardo Fibonacci; it was first published back in 200 BC in India. Fibonacci did popularize Fibonacci and the ratios that are derived from the sequence in his written works. He also took notice of how many processes in nature have similarities, such as the way stems and branches grow on trees and how a nautilus shell expands from the center outward.
The sequence itself is created by starting at 0 and 1 and then by adding the two numbers to derive the next number in the sequence:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89,…
The actual Fibonacci ratios are calculated by taking the higher number in the sequence and dividing it by the previous number. Additional ratios are derived by reversing the order in which the numbers are divided or by changing the divisor to the number that is two numbers back. For example:
89 / 55 = 1.618181…
55 / 89 = 0.617977…
89 / 34 = 2.617647…
34 / 89 = 0.382022…
This provides us with the primary ratios commonly used when applying the Fibonacci tools to the advanced charts in eSignal.
Fibonacci Retracement
When a trend occurs, inevitably, a reversal against that trend results. The Fibonacci Retracement tool attempts to discover the possible price levels where support or resistance may be found. Typically, the 0.382 and the 0.618 ratios are used for this purpose; however, other popular values are 0.25, 0.50 and 0.75.
Figure 2: Fib Retracement on the Russell 2000
As seen in Figure 2, the Russell 2000 had a strong up trend from mid-March to the end of May 2007. At that point, the buyers could no longer sustain the momentum and the prices backed off. Once that pattern is seen, the retracement tool can be drawn to predict where the small down trend might subside or reverse. In the previously described case, a double bottom was formed at 820.00, right at the 38.2 percent line, before finally breaking that support level at the time of this writing.
Fibonacci Extension
This drawing tool is based on similar principles as those of the Fibonacci Retracement, but instead of measuring how far the pullback on a trend will be, the Extension tool attempts to estimate how far a trend will continue upward after the pullback. The common ratios used with this tool are 0.618, 1.618 and 2.618.
To apply a Fibonacci Extension, you will use 3 clicks. The 1st is at the beginning of the original trend, the 2nd is at the end of that same trend, and the 3rd is at the end of the pullback. The ratios are applied to the distance between the 1st and 2nd clicks and, then, the 0.000 line is extended to where the 3rd click is placed.
Figure 3: Fib Extension on the Russell 2000
In Figure 3, we’re using the same trend. However, if we back-track in time a bit, the majority of the trend was from March to early May. At that point, the index backed off close to 38.2 percent and, then, continued its way up. If you were in a long position at that point, how would you know where to get out? That is what the Extension Tool is attempting to assist with. You can see that, within approximately 1 point, the 61.8 percent line predicted the top and eventual double top of the Russell 2000 index.
Fibonacci Circle
Thus far, we’ve looked at price relationships with the Fibonacci Ratios; however, another tool in eSignal takes into account the x-axis. The Fibonacci Circle tool applies time to the concept of trend analysis. How long will it be before the next trend reversal takes place and at what price? Those are the questions that the fib circle is attempting to answer. Numerous ratios are commonly used with this tool; they are 0.382, 0.618, 1.000, 1.382 and 1.618. Even Gann ratios are used, such as 0.25, 0.50, 0.75, 1.25, and so on. However, this is beyond the scope of this article.
Let’s take a look at another example.
The Fibonacci circle is often fit into place using the major pivot points as the center of the circle and the last known pivot as Figure 4 demonstrates. The screen shot in Figure 4 shows how the circle is drawn from the center of a very crucial point in July 2006 for the Russell 2000 and then extended outward until the 1.000 line meets up with the previous major pivot at Point A. Once the circle has been applied, you can see numerous points along the way that acted as support or resistance.
For example, Point B had a triple touch against the 0.618 line before continuing its strong trend upward. Point C provided similar resistance with the 1.250 line while Point D at 1.618 was a very clear turning point for the market, dropping the index approximately 70 points down to Point E, which met support at the 1.250 line.
Figure 4: Fibonacci Circle and the Russell 2000
Fibonacci Time
The Fibonacci Time tool is used a bit differently than the other tools we’ve used thus far. It may seem simple on the surface, but, actually, it’s attempting to predict the length of future time cycles. A time cycle is the length of time it takes for one trend to complete. This may seem to be what we’ve been measuring all along, but, in fact, a time cycle is actually measured from one major pivot top to the next major pivot top. (Previously, we were measuring from bottom to top or vice versa.) All the common ratios still apply here (1.382, 1.618, 2.618), but we’re just measuring the 0 percent to 100 percent a bit differently.
Figure 5: Fibonacci Time & the Dow 30
In the weekly chart of the Dow Industrials in Figure 5, we can see how the Fibonacci Time tool was able to estimate that, based on the 41-week cycle from May ’06 (Point A) to Feb. ’07 (Point B), the next major cycle was 138.2 percent from that time at Point C. In the next few weeks, we can watch to see if the 1.618 line will play a role here.
Text Tool
Just as a successful student takes plenty of notes, a successful investor also benefits from jotting down his or her findings. However, instead of writing things down on paper, you can use eSignal’s Text Tool to put notes right on the charts. Many equity traders look at a relatively high number of symbols. To have the ability to keep your personal research organized, symbol by symbol, directly on the charts, is invaluable.
Figure 6: Taking Notes on a Chart
Zooming In and Out
On occasion, you may want to take a closer look at a chart. The zooming features of an eSignal Advanced Chart easily allow you to select a region to investigate the finer details of bar structure or how the price has reacted to a particular support or resistance level. In order to zoom in, simply click on the magnifying glass with the plus icon, and then draw a box (click and drag) on the chart around the region you wish to zoom into.
Interacting with Lines (Erase / Move / Copy)
When using the line tools in eSignal, you’ll sometimes want to change some aspect of a line you’ve already drawn. We haven’t mentioned it thus far, but you can simply right click on any line to interact with it. A menu will pop up that allows you to choose to Edit, Copy or Remove that line.
Another way to do this is via the icons that are near the end of the Line Toolbar. The Eraser is handy when you need to remove a number of lines quickly while the Move tool is great for making adjustments to the placement of a line that has already been drawn. The Copy icon is useful when drawing parallel trend channels, as seen in the following Figure 7.
Figure 7: Drawing a Parallel Trend Channel
Magnet
Drawing trend lines or placing Fibonacci levels often involves exacting precision. In order to precisely place a line anchor specifically on the top or bottom of a specific bar or candle, you either need a very steady hand or can simply use the Magnet tool. The Magnet is a toggle that will snap your mouse cursor to the nearest high or low point along a bar when drawing a line.
How close you need to get is determined by the Snap Length. This is a setting via the right click of the magnet icon, and it determines how close you need to be before the mouse will automatically move to the High or Low.
I hope this look at all the different ways the line tools can be used in eSignal will help you use them more effectively.
