By Richard Cox
There is nothing used by technical traders that is more metaphysical or “astrological” than the Fibonacci sequence. The rationale for why many of these calculations become relevant is truly mind-boggling to many, myself included. Personally, I would argue that this information should have nothing to do with any of the traded markets. But the fact is that these strategies are prevalent enough that they become a self-fulfilling prophecy and all technical traders need to understand these basic calculations. Without this knowledge, many clusters of stop-losses will go unnoticed. And, since large stop-loss areas drive momentum more than almost anything else, an understanding of significant Fibonacci levels is critical.
The Fibonacci sequence is based on a ratio that is used to describe the proportions of many things found in nature. This is the often-referenced “Golden Ratio” and is based on a sequence of numbers, in which each term is the sum of the two preceding numbers: 1, 1, 2, 3, 5, 8, 13, 21, 34 and so on. Or, in other words, each term is approximately 61.8% of the following term. This percentage is what is most closely watched by traders. Other percentages that are commonly watched are 38.2%, 50%, and 23.6%. These percentages are then plotted on charts as retracements, fans, arcs or time zones. Below, we will look at some real-time chart examples of the more common Fibonacci applications.
By far, the most common use of Fibonacci in technical trading is done with “retracements,” which enable the identification of support and resistance levels even in areas where no significant historical price movement can be seen. First, a trader must locate an impulsive price wave movement with a clear beginning and end. Then, Fibonacci tools will calculate the area where prices have “retraced” in the amount each standard Fibonacci percentage. This is easily seen on a plotted chart:
The price wave is measured from roughly 1.4200 to 1.6000. This is about 1800 points of movement, so if the price falls 900 points, to about 1.5100, we will have a 50% Fibonacci retracement. As a general rule, we would expect support to come in at these typical percentage levels. (Conversely, if the price swing was a downward movement, we would expect resistance at these levels.)
On this chart, we have some interesting formations: The 38.2% Fibonacci retracement coincides with the 100-period exponential moving average. Do you see how this could result in a potential trade setup?
This occurrence adds validity to the original argument that prices will have a difficult time falling through this significant Fibonacci area, which means this is a potential buy zone. Moreover, the Relative Strength Index indicator is beginning to approach oversold territory. If the indicator is at or below the 30 region when price falls to the buy zone, we would then have 3 complimentary arguments for entering into a long position. A possible stop-loss for this trade could be placed below the 61.8% retracement, as this level would be seen as strong support and prices dropping below this level would be thought of as unlikely.
Fibonacci arcs follow a similar logic. Prices are measures from a significant high and low and curved lines are plotted at the 38.2%, 50% and 61.8% regions. Traders use these levels to anticipate support and resistance areas as prices should remain contained within these areas.
Fibonacci fans are plotted differently and are shown using diagonal lines. After significant highs and lows are identified, a vertical line is drawn on the right side of the chart and section-off into the significant percentage levels, 38.2%, 50% and 61.8%. These levels give traders levels of support and resistance. Below is an example:
The last example is the Fibonacci “time zone,” which is plotted with vertical lines. The chart is divided into segments based on the Fibonacci sequence. (Remember, this is 1, 1, 3, 5, 8, 13, 21 and so on.) These plotted lines are shown in percentages and enable traders to anticipate areas where significant price movements will occur. Below is an example:
Many traders use the Fibonacci levels created by some of these methods as the primary rationale for trading ideas. But it is important to remember that a successful trader will almost never use a single method as an argument for entering a trade. A trader needs to put probability in his favor as much as possible, which means that a confluence of events is needed before a decision can be made. Oftentimes, beginning traders become over anxious and feel as though they need to be in a trade at all times. If this is your logic, you will not last long in this business. The patient trader will have more than enough opportunities to enter the market over the course of a trading career. It may seem overly zen-like to say it but patience will reap rewards, over-zealousness will only drain your trading account.