Fibonacci trading tools are used for determining support/resistance levels or to identify price targets. It is the presence of Fibonacci series in nature which attracted technical analysts’ attention to use Fibonacci for trading. Fibonacci numbers work like magic in finding key levels in any widely traded security. In this article, I will explain one of the famous Fibonacci trading strategy: retracement to identify support level.
Fibonacci sequence is a series of numbers, starting with zero and one, in which each number is the sum of the previous two numbers.
1 + 1 = 2
1 + 2 = 3
2 + 3 = 5
3 + 5 = 8…..
The Fibonacci sequence is 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610……
It extends to infinity and can be summarized using below formula:
Xn = Xn-1 + Xn-2
What are some interesting facts about the Fibonacci sequence?
There are some interesting properties of the Fibonacci sequence. Divide any number in the sequence by the previous number; the ratio is always approximately 1.618.
Xn/Xn-1 = 1.618 55/34 = 1.618 89/55 = 1.618 144/89 = 1.618
1.618 is known as the golden ratio. I would suggest searching for the golden ratio examples on the Google images and you will be pleasantly astonished by the relevance of the ratio in nature.
Similarly, divide any number in the sequence by the next number; the ratio is always approximately 0.618.
Xn/Xn+1 = 0.618 34/55 = 0.618 55/89 = 0.618 89/144 = 0.618
0.618 expressed in percentage is 61.8%.
The square root of 0.618 is 0.786 (78.6%).
Similar consistency is found when any number in the sequence is divided by a number two places right to it.
Xn/Xn+2 = 0.382 13/34 = 0.382 21/55 = 0.382 34/89 = 0.382
0.382 expressed in percentage is 38.2%
Also, there is consistency when any number in the sequence is divided by a number three places right to it.
Xn/Xn+3 = 0.236 21/89 = 0.236 34/144 = 0.236 55/233 = 0.236
0.236 expressed in percentage terms is 23.6%.
The ratios 23.6%, 38.2%, 61.8%, and 78.6% are known as the Fibonacci ratios.
Fibonacci retracement trading strategy
The Fibonacci ratios, 23.6%, 38.2%, and 61.8%, can be applied for time series analysis to find support level. Whenever the price moves substantially upwards or downwards, it usually tends to retrace back before it continues to move in the original direction. For example, if the stock price has moved from $200 to $250, then it is likely to retrace back to $230 before it continues to move upward. The retracement level of $230 is forecasted using the Fibonacci ratios.