Education

What is Fibonacci?

Fibonacci is a special ratio that can be implemented to describe everything from nature’s tiniest structural elements, such as electrons, to the most highly sophisticated patters in the universe including planets and other celestial bodies. This inherent proportion is considered necessary for maintaining balance in nature, and is therefore traced in the movements of market prices as the latter conform to predictable patterns. Many technical analysis tools based on Fibonacci have been developed to complement the trading process.

The Math

Scientists and mathematicians have been aware of this ratio for centuries. The ratio is derived from the Fibonacci sequence named as a tribute to 12th century Italian mathematician Leonardo Fibonacci. The sequence is maintained by adding two previous numbers in the sequence to receive the next number. For example, you receive 3 by adding 2 and 1, 5 by adding 3 and 2. And so on.

But is not the sequence that is really important; it is the ratio of the sum of the subsequent numbers in the sequence that somehow gets roughly the same proportion of 1.618 or 0.618 in the inverse. This famous proportion usually bears the name “the golden ratio”, also known as the PHI and sometimes referred to as the Divine Proportion. So why all the hype surrounding this number? In reality, almost all objects in the universe can be broken into components which would reflect the ratio of 1.618 after finding the ratio between components.

The Proof

Seems too good to be true? Take a beehive, where the ratio between male and female honeybees will be 1.618.Not convincing enough? Theories and example aside you can get the number by measuring the distance between your shoulder and fingertips and then dividing the received number by the length from your elbow to your fingertips. Are the results the same? Somewhere in the area of 1.618? The golden ratio is observed everywhere in the universe.

Fibonacci usage in technical analysis

But how is it relevant to finance, you would probably ask. The thing is there is a significant amount of math involved in the study of financial markets and the number is highly common, especially in technical analysis. Fibonacci retracements are heavily employed for spotting long-term Support and Resistance levels while Fibonacci trading strategies based on various Fibonacci tools are getting more and more popular among traders. So how exactly is Fibonacci applied in market analysis?

When used in technical analysis, the golden ratio is typically translated into three percentages: – 38.2%, 50% and 61.8%. However, more multiples can be used when needed, such as 23.6%, 161.8%, 423% and so on. Fibonacci is very useful especially for identifying potential entry and exit points in the long term perspective and when paired with other technical tools lays a groundwork for extremely efficient an accurate trading strategies that work flawlessly regardless of market conditions and levels of volatility.

The .386, .50 and .618 retracement levels comprise the primary Fibonacci structure found in charting packages, with .214 and .786 levels adding depth to market analysis. Using these numbers for Fibonacci forex trading have started to grow in popularity with the emergence of online forex brokerages when trading on the foreign exchange market became accessible for broader range of audience.

Fibonacci Retracements

For example, one of the common used Fibonacci tools, the Fibonacci Retracements levels, is used to identify long term levels of support and resistance. The key concept of the tools is that there is an extent to which the price will proceed unhindered in opposite direction after facing high or low of the trend. It is generally assumed that prices tend to find support and resistance when reaching 61.8% (0.618) 0.786(78.6%) and 0.50 (50%) retracement of the previous trend.

For example, looking at the picture above is hard not to notice that prices were hindered when meeting 38.2%, 50% and 61.8% level retracements of the analyzed trend (blue vertical line). And while the trend eventually broke these level and continued going south, the prices were significantly supported around these areas which could have been successfully exploited by traders.

An example of a trade opened using Fibonacci Retracement would be waiting for the price to reach Fibonacci Level on the long time frame (daily or weekly). Once the price reaches the retracement level a trader may consider switching to shorter time frame (like 4h or 8h) and check if the price is overbought or oversold, which can be done with the help of RSI indicator. In case of price being heavily oversold at this level (RSI reading is above 70) a reliable strategy would be waiting for the current daily candle to close above the level of support and open a buy position on the next day. The stop-loss can be placed around 30 pips below the indicated Fibonacci support while take profit can be placed around 50 pips above the entry price. If everything goes in line with your expectations, the price will surge after staying hesitant around Fibonacci level for some time. Alternatively, you can wait for a breakout of the mentioned Fibonacci Level and open sell position after the confirmation of breakout. Regardless of the outcome, never forget to place stop loss to avoid possible losses.

Conclusions

Other tools like Fibonacci Extensions, Fibonacci Arcs, Fibonacci Fans and Fibonacci Pitchforks are built around this concept. Though these studies cannot be used for timing entry and exit points when used alone, they can do so with great accuracy when used in conjunction with other technical analysis studies. For instance, combining Fibonacci with RSI can show the condition the price has around Fibonacci level while using it together with Elliot Wave can be very helpful to predict the extent of retracements after different waves.  In our Fibonacci section of the education course we will provide detailed step-by-step guide to using these tools with maximum efficiency and shed light on the most common pitfalls that traders may face when using Fibonacci.