Fibonacci retracements, the ‘golden ratio’, ‘support levels’ and ‘resistance levels’ are all very popular terms in the online trading world. You’ve probably come across these terms as you learn how to trade stocks or currencies. In this article, we will get into what Fibonacci numbers are and how traders use them to make trading decisions.
A good place to start this discussion is technical analysis – something every trader is bound to know.
Traders approach the markets using one of the two major schools of thoughts: fundamental analysis and technical analysis. Both methods are used to forecast price trends in specific stocks or currencies. The difference between the two approaches is in the inputs each method uses. Fundamental analysis uses the underlying factors that drive prices of financial instruments – from economic factors to companies’ financial and strategic conditions. Technical analysis uses the instrument’s price and volume traded as inputs. Technical analysis identifies trends and patterns that can suggest how the stock, bond, or currency will move in the future. Fibonacci is one of the tools used in technical analysis.
Fibonacci numbers and the Golden Ratio
Fibonacci was a 12th-century Italian mathematician who discovered that nature exhibited a certain pattern of numbers.
He created a simple sequence of numbers: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233…where each number is the sum of the preceding two numbers. Out of this sequence, he identified a special number, which is 0.618, dubbed the golden ratio’. This value is roughly the proportional increase of a number from the number preceding/immediately before it. All the principles of Fibonacci numbers are based on this ratio and its corollary (0.382, which is equal to 1 minus 0.618) as we’ll see.
According to Fibonacci, any nature-driven market, such as the financial market, is prone to make retracements that are either 0.618 (61.8%) or 0.382 (38.2%) of the distance a stock, currency, or index has moved.
There are four Fibonacci tools have been able to utilize the golden ratio. These are:
Fibonacci retracements: They are calculated by locating the high and low of the market chart, then drawing five horizontal lines to indicate support and resistance areas. The first line is drawn at the highest point of the chart (100%), then the second to the fifth are drawn at 61.8%, 50%, 38.2% and 0% (lowest point on the chart) in that order. When a significant price movement happens, new support and resistance levels are established near these horizontal lines.
Fibonacci arcs: As the name suggests, Fibonacci arcs involve drawing curved lines, and these lines are then used to anticipate resistance and support levels. You start by identifying the low and high of a chart, then draw compass-like curves at the 38.2%, 50% and 61.8% levels from each point.
Fibonacci fans: After locating the low and high of the chart, draw a vertical line through the rightmost point. Divide the line into 38.2%, 50%, and 61.8%, then draw other vertical lines from the leftmost point and through these points. The vertical lines are indicators of support and resistance.
Fibonacci Time Zones: These are a series of vertical lines drawn by dividing the chart into segments that are spaced according to the Fibonacci sequence. The vertical lines indicate where to expect major price movements.
Retracements are the most commonly used Fibonacci tools because of their simplicity and applicability to most trading instruments. In addition to helping traders identify and confirm levels of support and resistance, Fibonacci retracements also are used to place target prices and stop-loss orders. They can also be applied in a countertrend trading strategy.
All trading platforms used today offer a form of Fibonacci tool. Your technical setup determines the appropriate tool to use. Some traders use Fibonacci retracement only while others also consider time zones when making entries.
On an important note
Fibonacci studies are useful in estimating support and resistance levels. They cannot provide the primary indicators for entry and exit of a stock. Another crucial thing that traders should know is that Fibonacci tools should not be used in isolation but rather combined with other forms of technical analysis such as Elliott Wave analysis to get more accurate forecasts.
Research more on Fibonacci tools to better understand how you can combine its strengths with other technical analysis theories. Hopefully, you will find a suitable way to use Fibonacci numbers to extend your trading toolbox.