"Fibonacci trading methods belong a type of technical analysis approach that makes use of Fibonacci numbers. These numbers are based on the discovery by Leonardo de Pisa who is attributed to finding the golden ratio. The golden ratio is something that exists not just in manmade architecture but also in nature. The nautilus shell is often used as an example of the golden ratio. In the financial markets including forex, the Fibonacci ratio is also used. Traders use specific Fibonacci numbers as potential support and resistance levels. Fibonacci retracements and extensions are two commonly used terms you will come across. These are nothing but potential levels where price can retrace or levels where price can continue to trend to. While there is some mystical approach to using Fibonacci numbers, the fact that they work is because a lot of traders use and constantly monitor the Fibonacci retracement numbers. Thus it becomes a sort of a self-fulfilling prophecy. Read more about Fibonacci based trading methods in this article."
Fibonacci based trading is a type of trading approach that is based upon the Fibonacci golden numbers or the golden ratio. The general consensus of using Fibonacci based trading is that price tends to retrace toward one of the Fibonacci levels when measuring a wave or a price direction.
Traders make use of the Fibonacci tools that are available by default. Based on this, the Fibonacci levels are automatically plotted. These tools can be either retracement tools which signal the level to which price can retrace, or extension levels which signal the price levels to which price could potentially continue in its direction.
Fibonacci based trading methods also include using various other methods such as arcs and trend lines. In some cases, based on certain price measurements, you can also project the Fibonacci levels in time where price could make a reversal to its direction.
The Fibonacci numbers are based on the work of Leonardo de Pisa, who first discovered the Fibonacci numbers leading to the golden ratio or phi. This same concept is applied in technical analysis as well.
The main bottom line of using Fibonacci based methods is to find harmony in the price waves. Because price moves in a zig-zag fashion, traders use the Fibonacci numbers as a way to identify support and resistance levels.
Why do Fibonacci based methods work?
While there are many tools that based on Fibonacci levels, the retracement tools tend to work the best. There is nothing mystical about these levels. They work because a number of traders watch these levels.
Thus, the Fibonacci levels became a sort of a self-fulfilling prophecy. Due to the wide amount of interest, the Fibonacci levels tend to become support and resistance levels.
There are many combinations of Fibonacci levels. But two most commonly used Fibonacci levels are the 61.8% and the 38.2% retracement levels. The general consensus is that when price makes a correction, it usually retraces to the 61.8% or the 38.2% of the previous leg.
Besides the above Fibonacci retracement levels, other commonly used retracement levels include 23.6%, 78.2% and 50% as well. For extensions, the 161.8% is also a commonly used Fibonacci extension level.
The chart below shows an example of a Fibonacci level.
Example of Fibonacci Retracement
In the above chart, you can see that we plot the Fibonacci level by connecting the low to the high. This is the measurement of the uptrend. Following this, the Fibonacci indicator automatically plots the 61.8% and 38.2% retracement levels.
You can see how price retraces to the 38.2% Fibonacci level (marked the rectangle area) and then continues in the direction of the uptrend.
Although, the 61.8% and 38.2% Fibonacci levels are used, there is no way of telling whether the retracement will stop at 38.2% or continue lower to 61.8% of the previous way.
Therefore, typically, traders watch both these levels carefully for any signs of a reversal. The retracement off the 38.2% level is a regular or a soft retracement, while the retracement to the 61.8% is known as a deep retracement.
Uses of the Fibonacci levels in technical analysis
Then, using a combination of other technical indicators, traders then identify the areas where there is a high probability of a reversal in price.
Fibonacci based trading methods are unique.
Traders use the Fibonacci levels in various other concepts of technical analysis including the following:
- Harmonic patterns (Butterfly, Crab, Shark patterns)
- Elliott Wave counts
- Support and resistance
- Trend lines
Depending on how price retraces and extends, the various patterns are created, or measured. Therefore, Fibonacci levels are an important retracement levels that are widely used in many other concepts of technical analysis.
Traders can also build upon other concepts such as trend lines that are inclined at a Fibonacci level of 61.8 degrees or 38.2 degrees and so on.
To a layman, the concept of using Fibonacci numbers might seem a bit mystical. But there is nothing mystical about it. The sheer amount of interest in these levels is what automatically causes these Fibonacci levels to work.
Sometimes, traders make use a cluster of Fibonacci levels to automatically find support and resistance areas. These are price levels where different Fibonacci levels tend to cluster around, identifying strong support and resistance levels.
Fibonacci retracement levels can be used with any trading system and technical indicators. They work because an indicator based trading system also works on the underlying concept of support and resistance. This is the same with Fibonacci levels as well which indicate potential areas of support and resistance.