Pattern Based Indicators
There is large group of charting techniques that, for brevity, we’ll call pattern based . These identify regularly occurring patterns within charts. Two methods that are covered here are Elliott waves and Fibonacci.
Elliott Wave Theory
The Elliott wave for example, uses the idea that when the price is trending it usually does so in a series of predictable waves. Elliott showed that trend legs could be broken down into five waves in the primary trend direction, followed by three waves in the corrective direction. The waves in the primary direction are the impulsive phase, while those in the opposite direction make up the corrective phase.
Elliott wave proponents use these cues to time their market entry and exit points. The main problem is that identifying the start and end of each wave is often not as straightforward as the examples shown in textbooks. This makes the technique more subjective than one that waits for a crossover signal . Automated Elliott wave indicators are available and can make the task easier and less subject to interpretation. More on Elliott wave theory .
Fibonacci is another method favored by currency traders. This can be broken down into two methods. Fibonacci retracement , the most well known, is used to find potential retracement lines on a chart. Retracement happens when the price pulls back, or retraces, in the opposite direction.
The theory is that the Fibonacci levels define probable new lines of support and resistance. These can work at any scale both in time (horizontal axis) and in price (vertical axis). For example, suppose the price moves from B to A. The retracement levels would then give potential turning points. They act as resistance as the price moves up, and support as the price moves down.
The retracement levels are 24%, 38%, 50%, and 62%. Most charting packages will calculate these levels for you once you define a top and bottom to your range.
Fibonacci extension is less commonly used, but the idea is the same. When the price breaks out of a range, Fibonacci levels extend out by using the top and bottom points of the previous range as reference points.
There is a mathematical theory underlying Fibonacci numbers, and why they work in financial markets. In my opinion, it is not important or helpful to know about this in order to use the technique. The important thing to know is traders pay attention to Fib retracements, and probably because of this, they become in part self-fulfilling in that traders expect price reversals at these points. More on Fibonacci retracement .