TraderTalk: Derrik Hobbs on Understanding and Applying Fibonacci Price Zones

This is an edited transcript of a free TraderTalk workshop conducted for TM subscribers and trial users on Oct. 3, 2002, by Derrik Hobbs.

Brice Wightman: Good afternoon and welcome to TraderTalk. Today, we are happy to have a gentleman who is the co-manager and analyst for a publicly traded fund which was listed in the January 2002 issue of Smart Money as one of the best-performing large-cap growth funds. He'll be teaching us about the best Fibonacci strategies and to interview him, we have TM's own Eddie Kwong. It's my pleasure to introduce Derrik Hobbs.

Derrik Hobbs: Good afternoon.

Kwong: So tell me, how did you get into Fibonacci?

Hobbs: I've traded with Fibs for a number of years, many of those years just using single retracements. But just in the last couple of years, I've been turned onto the whole concept of Fib Zones or Clusters.

Kwong: I see... I used retracements for a long time too. I found them to effective. I understand clusters. But can you tell the folks out there what kind of edge they provide you with.

Hobbs: Fibonacci Zones basically give me key price decision areas of support and resistance that I can apply entry techniques against. In our office we talk about if someone were to ask you to jump from a helicopter, would you do it? Heck no! But if that heli was hovering 2 ft off the ground, would you do it?

Kwong: Heck yes.

Hobbs: Knowing where the ground is makes all the difference in making decisions.

Kwong: So you're talking about solid ground that you get off clusters, vs. mushy ground or quicksand if you have fewer Fib relationships.

Hobbs: Bingo!

Kwong: OK, let's start from point A.

Kwong: I used Fib retracements for a long time. When you get your .618 or .50, I find whether it's intraday or daily data, that I get some really good reversals.

Hobbs: Sure.

Kwong: Backed up by other indicators, or simple moving averages, I find them to be very reliable. Why complicate things :-) ?

Hobbs: Good question. Like you said, sometimes a stock bounces from the .50. sometimes from the .618. On a daily chart that could be a few points of difference. So by creating zones, the chart starts to reveal major decision areas that have more importance over others. Example, take a sheet of paper. Pretty easy to rip, but get a stack of paper together, tough to rip. Additional layers create strength.

Kwong: That is logical. OK...let's delve into the theory. After that I will ask you some questions about the current market...and then...
it'll be question and answer time.

Hobbs: Great.

Kwong: OK...you've some charts to show us and I'd you to walk us through how this Fib methodology works and...most importantly how you trade off it. Let me put it this way...People can predict things all day long and even be correct at times...but if you cannot identify entries...none of that matters. So I'd like to also get into the practical process by which you trade, manage positions, etc.

Hobbs: All right. I want to focus on three areas, first looking at the internals of Fib zones, addressing questions people have asked me about the zones. Then I want to discuss real methodology and thinking against those zones, then discuss using zones in different time frames. So let's take a peek at the first chart of QQQ.

Hobbs: This 60 minute chart is our work for today. Coming into today we had two key areas to focus one. There are definitely differences in these zones. One question asked...do the # of levels matter? Most definitely. To be a zone we need at least three Fib levels but the more levels a zone has the more likely price will be attracted to that level. So as you look at the QQQ chart, today we dipped under the first zone. That tells me the next stop will likely be zone #2. Between those zones we have "air"...no other Fib zones.

Kwong: Can you trade off the "air," in others, upon penetration of zone #1?

Hobbs: Most definitely. Some traders I work worth, that's all they do.

Kwong: Shorting...

Hobbs: Wait for a zone to be violated and short into the next zone -- that is one form of trigger.

Kwong: Interesting. Most fib traders I have known of, focus on the reversals but the breakout or breakdown must yield some pretty high momentum moves given that fear and greed would play a role.

Hobbs: I would probably be categorized as a reversal trader as well.

Kwong: Right...I can see that from your columns. Maybe you can elaborate on the pros and cons of each approach before resuming your line of discussion.

Hobbs: OK. With reversals trading, you are typically buying into weakness and selling into strength, so you get that "not so fresh" feeling when putting a trade on and momentum is against you more times than not and usually not immediately rewarded but your stops can be much tighter. At least that's what I've found when a stock is pulling back into a Fib zone, I can enter with stop just below the zone. Now with momentum, you are usually immediately rewarded but stops are little more difficult to manage.

Kwong: I see.

Hobbs: So let's discuss the zone a bit more. Size does matter on zones -- another item to note as you look at the zones, look how far the Fib line extends to the left on the chart zone 2 price level 20.19. On QQQ that is a 1.272 extension of a higher swing. The longer left those lines go, the more significant the decision, because that level has held for a longer time period.

Another thing I like to see in a zone is the inclusion of a 100% price projection of a previous rally or decline. In this case with the Q's, we had a decline of 1.9 pts. I projected that decline from the most recent high and that Fib level comes in at 20.14 down in zone 2.

The other thing I like to see in a zone is the inclusion of a Fib extension like a 1.272 or 1.618. Swings typically terminate at these extension levels -- something to tag onto that, looking at zone 1 on Q, it includes a .786 retracement level of that most recent low to high swing.

Typically, if a .786 ret is violated, we get an extension move to the 1.272 or 1.618 so anyway those are some things to think about when looking at zones: size, extensions, 100% projections, .786 retracement. Now let's talk about letting the zone tell you when to take trades...

Kwong: If I am reading the first chart correctly we closed down at zone 1...is that correct?

Hobbs: Yep, closed right on it.

Kwong: Would you guess then that a reversal could be in the cards at Monday's open?

Hobbs: Based on this chart I would be more inclined to think we hit zone 2 first before making a reversal to the upside.

Kwong: I see...why is that?

Hobbs: The zone is larger down there acting as a magnet on price. Hitting that zone would be a symmetrical high to low swing with the previous high to low swing but bottom line, I can't trade what I think. if the market goes up from here, we have the justification with Fibs to back it.

Kwong: Derrik...OK go ahead with your other thought.

Hobbs: So moving on to (WMT | Quote | Chart | News | PowerRating)...people ask...when should I take the trade against these zones? What's nice about trading with these zones is that the zone pretty much tells you when to take it and get out. If your money management rules allow you to risk 10% on a trade and in the case of WMT, we are running up to this resistance zone from 51.50-52.93. When can you take the trade? Of course we have some rules along with it but the first step is knowing how much you can risk in a trade. It's also important that if you take a trade against a zone that you be able to risk to the top of the zone.

With WMT for example, it didn't reverse at the bottom of resistance, it traded half way into it before reversing. If the zone is setting up in the direction of the trend of the time frame chart you are looking at, it is legal to take trades against that zone without a trigger, in my book at least. However if we are trading counter to the trend, I only take a trade against a zone if I get a trigger against it. Finally, when trading with Fibs, it make sense to know what higher time frames are saying.

On the next chart of SPY, I focus a lot of my trading on daily charts so when I look at this weekly chart, I see that we are sitting on a key support zone so I'm not real comfortable taking short trades when I'm sitting on this higher time frame support zone. Now...these zones are simply decision points but what this weekly chart tells me is that if we can not hold this support zone we could expect a very fast 10-15% drop into the next weekly zone. So knowing those higher time frame zones are key!

Kwong: OK...Derrik is going to take questions now.

Question: Is there a way to calculate dynamic support and resistance clusters other than using Dynamic Trader software?

Hobbs: Most definitely. Most charting software like Qcharts offers these tools and if you are not into buying software, it is quite easy to set up a spreadsheet. Basically you would have two inputs: the swing low point and swing high point. The difference between those two points would then be multiplied by each Fib ratio and added or subtracted from the swing high or low, depending on the direction of the trend.

Question: Is there a relationship between your Fib numbers and Elliott wave? They seem to be linked in many circles and not in others.

Hobbs: I like this one :) Yes there is. In fact many times in my columns, you'll see me refer to a two step pattern or a Gartley or butterfly pattern. These are simply patterns that reflect waves. Robert Miner's book gives a great description about each wave, abc or 12345 and what fib ratios are involved with the termination of those waves. I use waves as a confirmation, not as the focus of my trading. If I can confirm a wave C is complete against a zone, it strengthens my zone and my trade but yes...Wave and Fibs go hand in hand.

Question: What is your trigger for counter trend trades against a Fib cluster?

Hobbs: First...glad to see that you listened about waiting for triggers on those counter trend trades. I am a pattern recognition guy. For example, if I'm looking at a 60 minute chart hitting a support zone but a long trade would be counter to the main direction, then I'll drill down to a 5 or 15 min chart and look for basic patterns like double bottoms, reverse H&S even better.

In fact I mentioned in my column yesterday (HON | Quote | Chart | News | PowerRating), we hit 60 min resistance. I drilled down to 5 min chart and there was a bearish Gartley pattern. Great trigger. Some people that use my service use a 5/15 ma cross. Others use Stochs or other OB/OS indicators.

The point here is: Be consistent. Take a trigger you like to use and has a good track record and stick with it. Matching a decent trigger (doesn't have to be great) with Fib zones can get you in the winners circle 6-7 times out of 10 on trades but doggone it, manage those 3-4 losers wisely, because you will have 'em. Fibs are not the Holy Grail, just an edge. Enough rant, next question :)

Question: How do you determine which swing points to use? Also, which ratios do you use?

Hobbs: Ah yes...the trusty swing points. I have a couple of rules I use. I have an "8 bar" rule for swing lows there can not be a new low within 8 bars to the left and of course no new lows to the right. Also if a swing low meets the 8 bars left rule but the swing low point is similar to the previous swing low point. I don't use it. Regarding ratios for retracements, the numbers .382, .50 .618, .786, 1.272, 1.618 2.00, 2.618 -- those are the bread and butter #'s for me.

Wightman: Does the 2.618 number come up often? It goes out a ways.

Hobbs: It comes up more often in intraday trading than on daily swing trading but when it is in the mix within a cluster or zone, it gives more strength to that zone as a swing extends further, the higher likelihood for reversal is similar concept to volatility bands. I'm thinking about making Fibotility Bands :)

Kwong: (Laughs) Brice...I do think we are running out of time.

Wightman: Well Derrik, we sure appreciate your time. If you'd like a 7-day free trial to Derrik's daily stock and ETF report, click here.

Hobbs: Thanks, Brice.

Kwong: It was very cool talking to you today.

Hobbs: Enjoyed it.

Wightman: Have a nice evening everyone.

Hobbs: Yes, good night! Have a Fiberrific evening!