The Role of Fibonacci Numbers in Technical Analysis and Trading
Each number in the Italian mathematician Fibonacci’s sequence results from the sum of the previous two numbers. The starting point of the sequence is 0 and 1. Their sum is 1 (0+1), a new number in the sequence. The following number, the sum of the previous two, is 2 (1+1).
Fibonacci Sequence Calculation:
- 0 + 1 = 1
- 1 + 1 = 2
- 1 + 2 = 3
- 2 + 3 = 5
- 3 + 5 = 8
- 5 + 8 = 13
Fibonacci sequence of numbers: 1, 2, 3, 5, 8, 13, 21, 34…
Fibonacci found that each successive number is approximately 1.618 times the previous one. This pattern of increase finds many manifestations in nature and science. It is known as the “golden ratio.”
In technical analysis, 61.8% (e.g., 21/34=0.618), 38.2% (e.g., 13/34=0.382), and 50% retracements are important support and resistance. The 50% level is not a direct result of the sequence of numbers but has proven highly significant given its median value.
Fibonacci Retracement Levels
The 38.2%, 50% and 61.8% retracement levels are considered support or resistance, depending on the direction of the trend. If a hypothetical asset rises from 0 to 1, a possible future decline will find support at levels of 0.618, 0.5, and 0.382 (38.2%, 50%, and 61.8% retracement of the 0 to 1 movement, respectively). These are critical support points around which prices are expected to experience fluctuations, possibly resulting in an upward trend continuation.
In the opposite direction, in a hypothetical 1 to 0 decline, we can define resistance levels at 0.382, 0.5, and 0.618 (38.2%, 50%, and 61.8% retracement of the 1 to 0 decline, respectively).
When a support or resistance level is broken, prices are expected to move toward the next Fibonacci level.
Chart 1: Fibonacci 38.2% Retracement. Source: Investing.com
Chart 2: 50% and 61.8% Fibonacci Retracements. Source: Investing.com
Chart 3: 50% Fibonacci Retracement. Source: Investing.com
Chart 4: Entire Trend from Charts 1-3. Source: Investing.com
Most often, traders look for opportunities to open a position in the direction of the primary trend. Charts 1 – 3 show how individual retracements can be used to open a position in the main direction. Chart 4 shows the entire downtrend and its end, which occurred with the break of the trend line.
Trading Strategy
Like any support and resistance, Fibonacci levels are used as an entry point to open a position, place stops, and take profits. Setting price targets is based on the “golden ratio” concept. Once prices have realized a retracement, the primary trend is expected to resume. Price targets may be set using Fibonacci extension levels at 138.2%, 150%, and 161.8% of the movement. In Charts 5 and Chart 6, the price target of 161.8% has been reached.
Chart 5: Fibonacci extension. Source: Investing.com
Chart 6: Fibonacci extension. Source: Investing.com
Some trading strategies are built on the idea of retracements and extensions. For example, a set of rules for:
- Opening a position at a 50% retracement
- A price target of 150% extension
- A stop-loss where the trend started
Such tactics would fix a risk/reward ratio of 1:2. While extremely simple, the strategy defines an entry, stop, and target. Of course, other analytical tools could provide further precision.
Conclusion
The Fibonacci sequence is an objective method for identifying critical support and resistance levels. Technical analysts often construct their trading strategies around these key retracement values. Trading Fibonacci levels is most effective when complemented by other analytical tools.
Next: Indicators and Oscillators
