Fibonacci in trading
Fibonacci was the nickname of a well-known mathematician from Italy, born in 1170 in Pisa. Leonardo’s father, Guglielmo Bonacci, was a trader in an Algerian city known as Bugia. From childhood, Leonardo studied mathematics in this city. He had to travel quite extensively for the pursuit of education. However, his journeys taught him things that others could only dream of learning. So much so, that Fibonacci even mastered the Arabic-Hindu numerical system.
Leonardo spent most of his teenage years in Algeria before returning to Italy in 1202. Upon returning, he started to document everything that he had learned up to that point. He named the book Liber Abaci, which translated as ‘The Book of Abacus’. In this detailed document, Fibonacci extensively discussed the renowned numerical series that later came to be known as the Fibonacci number sequence. Without going into the technicalities, each number in this sequence is 1.618 times higher than the figure that precedes it.
What is Fibonacci Trading?
Before we delve deeper into Fibonacci trading, its various mechanics, and how it links to Forex trading strategies, it is vital to understand the sequence itself and its distinctive mathematical properties.
The Fibonacci sequence is essentially a list of numbers where every number after zero and one is the total of its previous two numbers. These figures continue to infinity.
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89
At first glance, these numbers will appear to be quite simple; however, if you look at them from an experienced trader’s perspective, you will notice a relationship between these figures. Although covering every relationship in this article is virtually impossible, let us look at some common ones that come in handy for Fibonacci trading strategies:
- Dividing any number with its previous number will result in 1.618. The figure is famous for various extensions in Fibonacci trading
- If you divide any amount with its next highest figure, the result will be 0.618. The number creates the basis for the retracement level (61.8%) in this form of trading.
- Dividing a number by another one that’s two places higher will show 0.618 on your calculator. This creates the base for 38.2% of Fibonacci retracement levels
If you didn’t already know, Fibonacci created the Golden Ratio: 1.618. Also known as Phi or Golden Mean, the numbers in this ratio are abundantly present throughout the cosmos, biology, and other aspects of nature.
You are probably wondering how the Golden Ratio and various other Fibonacci levels come into play in trading? Well, firstly, these numbers are divided into extension levels and retracement levels. Traders can use these to determine possible turning points in the forex market.
Experts use Fibonacci retracements to identify possible reversal levels. These ratios are consistently present in the Fibonacci sequence. 38.2% and 61.8% are the most popular retracements out there. It is important to remember that 61.8 rounds up to 62% while 38.2 rounds down to 38%.
You will often see chartists applying the ratios to define retracement levels. They do this to predict pullbacks. You can also use these retracements to forecast the extent of a possible countertrend bounce after a decline. Furthermore, traders can also utilise these ratios by combining them with price patterns and indicators to form trading strategies.
Investors and traders can use retracement levels to get alerts for potential reversals in trading trends, support areas, or resistance. Chartists can quickly identify Fibonacci retracement levels as soon as a pullback starts.
Remember that these levels are not precise reversal points. On the contrary, they act as alert zones to forecast reversals. During these instances, traders should use other elements of technical analysis to identify or confirm a reversal. It could include moving averages, momentum oscillators, price patterns, and even candlesticks.
How do Fibonacci Retracement Levels help out Traders?
You can use these ratios to set price targets, determine stop-loss levels, and place entry orders. For instance, a trader may notice a stock increasing in price. After moving up, it comes back to the 62% level, then it begins to move upwards again. Because the bounce happened at a Fibonacci level in an uptrend, the trader plans to buy the stock. The trader may set a stop loss at 61.8%, as any return below this could show that the rally was not successful.
You may also notice Fibonacci levels arising within Technical Analysis in other ways. They are specifically prevalent in the Elliot Wave Theory and Gartley patterns. After a monumental price movement downwards or upwards, these types of analysis determine that reversals often happen close to a specific group of Fibonacci levels.
Unlike moving averages, Fibonacci retracement levels are mostly static and rarely change. The fixed nature of these price levels ensures easy and quick identification. It helps investors and traders to predict and react wisely to price level tests. These levels are primarily inflection points, as some form of price action takes place. It could either be a reversal or a break.
Although the retracement levels do tell you where prices might get resistance or support, there are no guarantees that the price will remain there. Therefore, you should rely on other confirmation signals as well, reducing the risk to your investments.
If there anything else to be said about Fibonacci retracements, it is that there are too many of them. It often leads to price reversals, which can turn out to be unfavourable for traders. In most cases, people are unable to determine which price level will come in handy at any specific time. When things don’t work out, fellow traders and forex experts often claim that choosing another retracement level could have avoided failure. Cases like these, however, are few and far between, and usually, these sequences prove to be productive.
Fibonacci extensions are a helpful tool for traders. They help to determine profit targets and estimate how much prices may travel after retracements or pullbacks are over. You can also use extension levels to analyse areas where prices could reverse. These levels are often present on charts and mark essential price levels based upon Fibonacci ratios.
- Some popular levels of the Fibonacci extension are 261.8%, 20%, 161.8%, 100%, and 61.8%.
- These extensions can help to determine possible price waves after a pullback.
- As discussed earlier, Fibonacci ratios are present in everyday life, which is why traders believe that they could carry significance for financial markets too.
- Although extension levels can forecast important trading areas, you must not exclusively rely on them.
Is there a formula for these Extensions?
Contrary to what many people claim, there is no formula for Fibonacci extensions. Traders often choose three points when they see an indicator on a chart. After selecting these points, they draw lines at their respective percentages. As you would expect, you must choose the first point before your move starts. The selection of the second point happens once a move ends, while the third point signifies the retracements end against that specific move.
How to use Fibonacci in Forex?
Using Fibonacci analysis can help you improve long and short-term forex positions by identifying high performing price levels. Using Fibonacci sequences in conjunction with various other types of technical analysis creates a sturdy base for trading strategies. Here are a couple of ways you can utilise Fibonacci in Forex:
You can identify key turning points by starting your preparation analysis with a single Fibonacci grid on the daily chart. Experienced traders suggest placing grids at shorter time intervals and looking for convergence, especially between critical harmonic levels.
Similar to moving averages and trend lines, the power that these levels possess can track the relative time frame along with long term trends. This helps you to make well-informed forex trading decisions that could turn you a profit.
You can divide Fibonacci grids roughly into two categories: trade preparation and historical analysis. The latter requires you to examine long-term trends in forex and you must also identify vital harmonic levels that trigger significant trend changes.
Many traders are using Fibonacci sequences to place buy and sell orders. However, as we discussed earlier, you should refer to other tools and strategies as well to achieve the best results.