Leonardo Pisano Fibonacci
Some traders mistakenly want the discount. They do not want to buy rising markets; instead they look for bargains or market retracements as a place to buy:
Consider this email sent Sunday December 14, 2003, from a TurtleTrader student:
In implementing the methodology, what do you do when the market gaps over your next unit entry and after a couple days has not retraced back to give you the entry. There is a good chance that some of that will happen tomorrow morning but only time will tell if we retrace or not.
You want to buy on strength and sell on market weakness. Waiting for a retracement is never a smart strategy. Richard Dennis gives some insight:
Certainly when you have a position with a profit, anytime the market goes up a reasonable amount – say a strong day’s work – after you’ve put on a position, it’s probably worth adding to that position. I wouldn’t want to wait for a retracement. That is everyone’s favorite technique – to buy something strong that retraces. I don’t see any justification in the statistics for that. When beans are at $8.00 and go to $9.00, if the choice is to buy them at $9.00 or buy them if they retrace to $8.80, I’d rather buy them at $9.00. They may never retrace to $8.80. Statistics would show that you make more money buying them and not waiting for a retracement.
Waiting for a retracement is simply another form of losers averaging losers.
Even worse than the basic error of waiting for a retracement are the people fixated on Fibonacci retracements. The Golden Mean will not help you determine entry and exit. The idea that you can use Fibonacci sequences to predict retracements is a favorite ruse of market gurus. It is the holiest of Holy Grails. Read about true wealth systems.
Why Retracements and Fibonacci Both Fail
Dennis’s statistical argument is the complete answer to the retracement question. When soybeans move from $8.00 to $9.00, the trader who waits for a pullback to $8.80 is making a prediction: that the market will retrace before continuing. That prediction may or may not be correct. When it is wrong, the market continues to $10.00 without retracing and the trader misses the entire move. When it is right, the trader buys at $8.80 instead of $9.00, saving $0.20 per unit. Dennis’s point is that the statistical benefit of the occasional $0.20 saving does not compensate for the frequent cost of missing the full move. Buying at $9.00, which feels expensive, captures more of the available trend than waiting for a pullback that may never come.
Fibonacci retracements add a layer of numerology to the basic retracement error. The 38.2%, 50%, and 61.8% levels derived from the Fibonacci sequence are presented as natural price levels where markets will pause and reverse. The appeal is that they provide precise, apparently scientific price targets rather than vague “wait for a dip” thinking. The problem is that markets do not know about Fibonacci ratios. When soybeans move from $8.00 to $9.00, the market has no mechanism for pausing specifically at $8.38 (38.2% retracement) rather than at $8.37 or $8.39 or $8.50 or not at all. Any level that a trader draws on a chart will occasionally coincide with where the market pauses, because markets pause occasionally. Fibonacci levels do not predict those pauses more reliably than any other line drawn on the chart.
The “holiest of Holy Grails” description is precise. Fibonacci retracements satisfy the same psychological need as every other Holy Grail: they provide the appearance of a precise, mathematically-grounded method for knowing exactly where to enter. They feel like knowledge. They are not knowledge. They are the visual representation of the trader’s desire to buy at a discount without the statistical evidence that doing so improves returns.
The student email at the top of the page shows the practical consequence: the trader is considering waiting for a retracement that may not come rather than acting on the signal that is present now. The signal is the entry criterion. A gap above the entry level is the market telling you the move is accelerating. Waiting for it to come back is waiting for the market to be less strong before you participate. Dennis’s statistics say that is the wrong choice.
Frequently Asked Questions
Why is waiting for a retracement statistically inferior to buying at current price?
Because the statistical benefit of the occasionally cheaper entry does not compensate for the frequent cost of missing the full move when the market does not retrace. Dennis found that buying at the current price rather than waiting for a retracement produces better long-run results because the missed moves, when a strong market continues higher without pulling back, outweigh the savings from the occasional cheaper entries.
Why do Fibonacci retracements not work as entry signals?
Because markets have no mechanism for pausing at mathematically-derived ratios derived from a medieval mathematician’s study of rabbit populations. Any price level drawn on a chart will occasionally coincide with where the market pauses, because markets pause at various levels. Fibonacci levels do not predict those pauses more reliably than any other level. The appearance of precision, the exact 38.2% or 61.8% level, is not matched by actual predictive power.
How is waiting for a retracement “another form of losers averaging losers”?
Because both behaviors involve waiting for price to move back toward you before acting. The trader who averages down adds to a losing position hoping it will recover. The trader who waits for a retracement passes on a winning position hoping it will get cheaper. Both are betting that the current price movement will reverse rather than continue. Trend following buys on strength, not on the hope of a reversal.
