Fibonacci Trading and What It All Means

Fibonacci Trading and What It All Means

Fibonacci Trading

 

Primer: The Fibonacci Sequence

0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987, 1597, 2584 ...

What is the pattern?

The above sequence of numbers is called the Fibonacci sequence. Each number in the sequence is the sum of the two numbers that come before.

Originating in India in the sixth century, this sequence was popularized by the famous 12th-century Italian mathematician Leonardo Bigollo Pisano, known as Lionardo Fibonacci.

As we will see below, Fibonacci numbers – and their ratios – are used in technical trading. Below are the three key values to know:

  1. Any number divided by the previous number (as the sequence grows) approximates 1.618, also known as the Golden ratio.
  2. Any number divided by the next number (as the sequence grows) approximates 0.618 or 61.8%.
  3. Any number divided by a number two after it (as the sequence grows) approximates 0.382 or 38.2%.

Fibonacci ratios recur throughout mathematics, nature, architecture, and biology, such as in the shape of the Parthenon, sunflowers, snail shells, and spiral galaxies, among many other places.

Trading Fibonacci Retracements and Extensions

A core component of technical analysis is the search for recurring patterns in the price movement of a given security. Fibonacci trading uses the aforementioned commonly recurring numbers values to predict price moves.

Fibonacci retracement levels are horizontal lines indicating resistance and support, based on the Fibonacci divisions discussed above: 1.618, 61.8%, and 38.2%. Below is a total list of the Fibonacci retracement levels:

  • Retracement levels: 23.6%, 38.2%, 61.8%, and 78.6%

Calculating a particular retracement level is relatively straightforward. Assume a stock rises from $50 to $60. The 23.6% retracement level will be at $57.64, or $60 - ($10 x 0.236) = $57.64. The 38.2% retracement level will be at $57.64, or $60 - ($10 x 0.382) = $56.18.

Fibonacci extensions, on the other hand, are used to determine percentage moves in the direction of the trend. Below is a list of the common extension level:

  • Extension levels: 61.8%, 100%, 161.8%, 200%, and 261.8%

Trading Fibonacci Levels

There are two patterns to look for when trading Fibonacci retracement: a buy and a sell pattern. In the case of a buy pattern, the stock will continue upwards, fall (or retrace), and then continue the upward trend. The sell pattern is the reverse. See below for examples.

Buy PatternApple (APPL) falls to $495.79 at 15:00. It climbs to approximately $503.50 and then falls to the 61.8% retracement level of $501.14 at 15:25. Nearing the support the price rebounds and continues its climb.

Sell Pattern – Ford Motor Companies (F) begins a downward trend at $7.37 on the 11th. During the 17th the trend nears the 23.6% retracement level of $6.88. During the day it climbs to roughly $7.00 and then continues the downward trend over the following three days.

Importantly, Fibonacci levels – retracements and extensions – are used to set up particular trades. Keep an eye out for these levels, as you can set price targets, place entry orders, or determine your stop-loss levels.              Trading Fibonacci levels provide traders with a set of tools to determine when, and to what extent, a price will bounce, continuing either the uptrend or downtrend.

Where do you find the indicators? Many trading platforms have built-in Fibonacci indicators you can apply to your charts.

Fibonacci Trading Limitations

Like all technical trading strategies, Fibonacci trading has its drawbacks. One argument is that, with so many indicators, the price is bound to turn at or near one indicator. And, of course, there is no guarantee a price will retrace or extend after reaching a particular indicator. Many technical traders combine Fibonacci trading indicators with other indicators to build a case for when to buy and when to sell. As always, find what works for you.