By Ed Ponsi, a globally recognized lecturer and teacher and the former chief trading instructor for Forex Capital Markets*

In a study released by researchers at the prestigious Cass Business School in London, Roy Batchelor, Professor of Banking and Finance, and researcher, Richard Ramyar, take great pleasure in debunking the "myth" of Fibonacci. In their work, titled "Magic Numbers in the Dow", they analyze the movements in the Dow Jones Industrial Average from the years 1914 through 2002.

Their rigorous studies concluded that Fibonacci retracements have no effect whatsoever on price movement in the DJIA. Are they right? Well, let's just say that they're barking up the wrong tree. Maybe the best way to explain their conclusion is with a story from my own experience.

I used to trade on several equity desks on Wall Street, and I can tell you that even the mere mention of Fibonacci often evoked laughter and ridicule. "You might as well try to find trades using a Ouija board," laughed one trader. And, I laughed right along with them because, at the time, I didn't know any better.

When I switched from stock trading to Forex, I brought those anti-Fibonacci prejudices with me. After a short while, I was surprised to observe that, in the Forex market, Fibonacci worked frequently, and it worked well. Despite my preconceived notions to the contrary, I found Fibonacci to be an extremely effective tool for trading Forex.

The fact is this: Fibonacci doesn't work well on the Dow because it is not a part of the "culture" of stock or index trading. Stock traders don't generally use Fibonacci, and, therefore, it doesn't work in the stock market. This is because Fibonacci works like a self-fulfilling prophecy, much the way pivot points do in the futures market.

When you think about it, pivot points are a random calculation: The reason they work is because so many futures traders use the same calculation, and, therefore, they come up with similar support and resistance levels. If enough traders place their orders at the same pivot point level, that pool of orders can cause the price to stop falling (or rising) when it reaches that level. This is the essence of a self-fulfilling prophecy.

Fibonacci operates in much the same way; currency traders commonly use it, and it is a big part of the Forex trading "culture". So, when a major trend begins to falter, Forex traders all around the world locate the major retracement levels (38.2%, 50% and 61.8%), and, frequently, many orders will accumulate at those levels.

Not just individual traders, but also the major banks, institutions and hedge funds -- the "big boys" of the Forex trading world -- place these orders. If enough orders congregate at the same Fibonacci retracement level, they form a barrier, causing the exchange rate to bounce when it reaches that level.

For example, in mid-November of 2006, the Australian Dollar / Japanese Yen (AUD/JPY) currency pair, after rallying for approximately 400 PIPs, began to retrace from its peak. After falling for five consecutive sessions, support kicked in at the 38.2% Fibonacci retracement level.

Why did AUD/JPY choose to reverse at this particular point? It could have been a coincidence, but I've observed this type of price behavior in the Forex market too many times to ignore this phenomenon.

It's likely that traders, seeking an entry point in anticipation of a resumption of the uptrend, chose to locate their entry orders at the 38.2% Fibonacci retracement level. The combined buying power of these orders is what makes it a viable area of support. This is just one of many examples of a currency pair bouncing sharply from a key Fib level.

In another example, the Great Britain Pound / U.S. Dollar (GBP/USD) currency pair raced higher by more than 650 PIPs from October 11 through November 10, 2006. In this case, instead of finding support at the 38.2% Fibonacci retracement, the currency pair fell clear through to the 50% retracement, where it bounced for three consecutive days.

The idea that Fibonacci "doesn't work" on the Dow Jones Industrial Average should come as a surprise to no one who has traded both the equity and Forex markets. This technique is primarily used to trade reversals in the Forex market, where it is an ingrained part of the trading culture and, thus, an effective candidate for creating support or resistance levels through a self-fulfilling prophecy.

Perhaps our friends in the academic world need to make one key distinction before studying the effectiveness of Fibonacci, and that would be this: The next time you plan to do a similar study, be sure that you are analyzing Fibonacci in the correct trading market. Put that in your pipe and smoke it, professor!