Harmonic trading techniques use Fibonacci ratios to quantify the extent of relative price action. The two most important Fibonacci ratios directly derived from the Fibonacci sequence are the 0.618 and the 1.618. These numbers are the primary ratios of harmonic trading techniques and are used to derive the secondary and tertiary ratios of harmonic price pattern recognition.

For this article, I will illustrate a simple technique of using 1.618 extension price movements with the Relative Strength Index (RSI).

1.618

The 1.618 projection is a significant Fibonacci number because it usually indicates exhaustive price action. Often, when a stock exceeds 1.618, it usually represents extreme price action that is difficult to sustain. When the 1.618 projection has been exceeded in this area, I know that a trade set-up is developing. Because the 1.618 represents price action that is too extreme, reversals that occur beyond this area will usually happen quickly. As a rule of thumb, I usually wait for a stock to hit a 1.618 projection in a potential reversal zone (PRZ) before accepting a trade.

Relative Strength Index (RSI)

As defined in Technical Analysis from A to Z by Stephen B. Achelis, "The Relative Strength Index (RSI) is a popular oscillator. It was first introduced by Welles Wilder in an article in Commodities (now known as Futures) magazine in June 1978…The name "Relative Strength Index" is slightly misleading as the RSI does not compare the relative strength of two securities, but rather the internal strength of a single security…The RSI is a price-following oscillator that ranges between 0 and 100…The RSI usually tops above 70 and bottoms below 30. It usually forms these tops and bottoms before the underlying price chart…"

For the complete explanation of RSI from Technical Analysis from A to Z, please go to http://www.esignal.com/education/resources/atoz/default.asp.

Bullish 1.618 Projection

A bullish 1.618 often occurs in an extreme sell-off. When a stock is declining, the price action can often become overextended. The 1.618 projection point can identify profitable set-ups because a stock that reverses off this area frequently provides a nice bounce.

I trade the Standard and Poor's 500 mini contracts on a daily basis and look for 1.618 extensions confirmed by extreme RSI readings for intraday opportunities. Inthis first example, the September contract of the S&P 500 Mini (ES03U) sold off sharply, forming a distinct intraday 1.618 extension.

It is important to note that I prefer to use only those 1.618 extensions that form during normal market trading hours (9:30 a.m. - 4:00 p.m. ET). In this instance, the early sell-off provided a nice reversal, and it was confirmed by an oversold RSI reading that was below 30.

Bearish 1.618 Projection

The bearish 1.618 is a very important Fibonacci number because it is an excellent area to take profits or enter a short position. As I have stated previously, the 1.618 represents an extreme price area. Often, when a stock hits this projection, it will encounter substantial resistance. If this happens, the rally will usually reverse.

Although the 1.618 area can be exceeded, it is important to understand that such action above this area can be difficult to maintain. In combination with an indicator such as the RSI, the1.618 can be an extremely effective Fibonacci measurement. Therefore, it is critical to examine a stock closely in this area and be prepared to sell.

When we examined another intraday example in the September Standard and Poor's 500 mini contract (ES03U), the Relative Strength Indicator confirmed the short-term resistance. Following a sharp morning rally, the ES stalled at a distinct 1.618 extension at 992.75 and an overbought RSI reading above 70. The ES reversed at 993.

It is interesting to note in this example that the RSI provided a double-overbought reading above 70 within 20 minutes of the first, providing further confirmation of the harmonic resistance of the 1.618 intraday extension. These situations must be respected because the measurements of the harmonic price action and RSI clearly signaled an overbought situation.

Conclusion

Combining harmonic trading techniques and standard indicators is an effective means of gauging price action and identifying potential trading opportunities. eSignal's Advanced Chart settings provide the tools necessary to use these measures.

The click and point Fibonacci retracement tool is an easy means of measuring such price movements. Furthermore, I find the highlight feature of extreme RSI readings works well as a clear means for distinguishing price action. Using these tools in combination with such other technical indicators as stochastics and the MACD can also be effective.

eSignal's charting tools enable thorough analysis of price action using the 1.618 / RSI technique and can substantially help to define profitable opportunities in the markets.

*Reprinted (and modified) with permission from HarmonicTrader.com