The Fibonacci Indicator is an old tool that technical traders have been using for decades to predict price in financial markets such as stocks and FOREX market. It is based on the key number identified by mathematician Leonardo Fibonacci in the thirteenth century. Fibonacci is a set of sequence of numbers expressed as ratios, between the numbers in the series. In technical analysis, Fibonacci is created by taking two extreme points (usually a major peak and a trough) on a Forex or stock chart and dividing the vertical distance by the key Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8% and 100%. These levels are mainly used to predict price by using the retracement or extension approach. Once these levels are identified, horizontal lines are drawn and used to identify possible support and resistance levels. Before we can understand why these ratios were chosen, we need to have a better understanding of the Fibonacci number series.
The Fibonacci sequence of numbers is as follows: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, etc. Each term in this sequence is simply the sum of the two preceding terms and sequence continues infinitely i.e 0+1 =1, 1+1=2, 1+2=3, 2+3=5, 3+5=8 etc. One of the remarkable characteristics of this numerical sequence is that each number is approximately 1.618 times greater than the preceding number. This common relationship between every number in the series is the foundation of the common ratios used in retracement studies.
The key Fibonacci ratio of 61.8% – also referred to as “the golden ratio” or “the golden mean” – is found by dividing one number in the series by the number that follows it. For example: 8/13 = 0.6153, and 55/89 = 0.6179.
The 38.2% ratio is found by dividing one number in the series by the number that is found two places to the right. For example: 55/144 = 0.3819.
The 23.6% ratio is found by dividing one number in the series by the number that is three places to the right. For example: 8/34 = 0.2352.
For reasons that are unclear, these ratios seem to play an important role in the Forex and stock market especially the 61.8%, just as they do in nature, and can be used to determine critical points that cause an asset’s price to reverse, these points mainly acts as resistance or supports or demand and supply zones. The direction of the prior trend is likely to continue once the price of the currency or asset has retraced to one of the ratios listed above. A very easy way to pick reasonable risk to reward entries are candle stick formations or chat pattern formations on the 61.8% level
towards the general trend.
An example is shown in the diagram below.
The GBP/USD rallied after Bank of England Governor Carney Speech gave the pound strength over the greenback. In this scenario, a trend was formed and then we waited to get to its peak and then waited for a decent retracement to the 50% Fibonacci level before going long on the 3rd wave of the trend. All we need to do is to wait for a rejection pattern like pin bars, hammers, morning or evening star or any kind of price action rejection pattern on these levels.
The Fibonacci is a great tool that can be used when trading the Elliot wave system, as we all know the market moves in waves to a particular direction. However, using the Fibonacci to get good entry points is not as easy as it seems, as one has to critically search for closely watched significant turning points from investors in the market. Turning points due to fundamental releases can be profitable as well as turning points resulting from demand and supply zones in the market can be very useful. This requires constant practice as connecting wrong turning points can result into constant loss and lead to frustration.
In addition to the ratios described earlier, many traders also like using the 50% and 78.6% levels. The 50% and 78.6% retracement level is not really a Fibonacci ratio, but it is used because of the overwhelming tendency for an asset to continue in a certain direction once it completes a 50% and 78.6% retracement. In conclusion, the fibonacci tool is a wonderful tool if well mastered and can provide promising trades with minimal risk with reasonable profits.