Using Fibonacci Levels to Detect Range Bound and Trending Markets

Why we shouldn't buy breakouts

The FX-market oscillates on a regular basis between range bound and trending markets. In range bound market conditions, traders typically adopt a simple buy low, sell high approach, where as trending market climates call for traders to trade with the trend. However detecting whether the market is currently in a range bound or trending environment can be tricky, and costly if applied inaccurately. With that said, the Fibonacci levels can provide a valuable insight to the current market climate and the appropriate trading approach.

The first chart below shows a significant rally to the upside, as the trend reversed direction, the market then passed through all 3-commonly used Fibonacci levels; 38.2%, 50%, & 61.8%. Due to the fact that not one of our Fibonacci levels established our new support, we can extrapolate that a trend is not probable. It is important to keep in mind that trends exist when there is an uneven distribution of buyers and sellers, forcing the market to new high/low prices. However due to the fact that the market fell back below every Fibonacci line, indicates that the buyers were not in fact in control of the marketplace. Finally note how the market then accomplished a 'slightly' new low before reversing once again back to the upside. If we were to sell short the market at its slightly new low price, we would have certainly exited the trade at a loss.

We may now see how the market rallied back to the upside, and found a new (lower) resistance at the 50% Fibonacci level; measured now from our recent high to low prices. Due to the fact the market's progress was then halted at a specific Fibonacci level tells us that at that moment in time, the sellers had in fact gained control of the marketplace as they will not allow the buyers to force us back to recent highs, and an ensuing downtrend is now more probable.

These observations also teach us a valuable lesson against the practice of buying new highs or selling new lows. Conventional wisdom dictates that if the market accomplishes a new high price, the short (stops) will be triggered, in turn will compel the market to even higher highs. However upon careful study of the two aforementioned charts, we learn that if a new trend is intact, the market 'should have' found a new support/resistance level at one of the previous Fibonacci lines. After the first rally to the upside was complete, and as the market retreated back to recent lows, the fact that the market did not find a new (higher) support at one of our Fibonacci levels tells us that the buyers were not in fact, in control, and a relatively equal distribution of power remained between the buying and selling forces which have a greater chance of keeping us in a perpetual range bound market environment. On the other hand, due to the fact that the market found new lower resistance at a Fibonacci level indicates stronger selling pressure, and a greater likelihood of a new trend to the downside will now emerge.

Adam Rosen, FX PowerCourse Instructor
FXCM