How to trade using the Fibonnaci Sequence

How to trade using the Fibonnaci Sequence

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Very popular in the world of trading, the Fibonnaci sequence has been used ever since technological breakthroughs led towards the wide-spread use of trading technologies for the common man. You’re reading this article because of your interest into trading.

Whether you’re interested in starting, or you’ve already started trading, I hope to bring to you quality information regarding this method and its application in modern day trading. But first, I want to share with you the story of the person who is responsible for popularizing this sequence to the western world. I say popularized, because it is a little known fact that he was not the first one to discover it, but read on and I will share this information with you.


Who was Fibonnaci?

Nicknamed Fibonacci, an Italian mathematician whose real name is Leonardo Bonacci lived in Pisa, and he was born into a humble family of traders in 1170. His father was named Guglielmo and he worked at a trading station in Bugia (currently Béjaïa), which is a Mediterranean port in northern Algeria. Leonardo studied mathematics in Bugia, but he was also an avid traveler.fononacci

Through his travels he discovered the Hindu-Arabic numerical system and quickly figured out its advantages over the current systems in place. He is one of the most influential people that led to the adoption of the Hindu-Arabic numerical system by the western world. The way he became so influential was through his book called “Liber Abaci” or rather, The Book of Calculation, which he published in the year 1202.

In his book “Liber Abaci”, he introduces the “modus Indorum”, meaning “the method of the Indians”, which we recognize today as the Hindu-Arabic numeric system. This book explained the use of the numbers 0 to 9 and introduced the concept of placement value. It presented detailed examples of how to practically use this, to the western world innovative method. The examples included the application of Arabic numerals to bookkeeping, weight and measure conversion, interest calculations among other things. Educated Europe absolutely loved the book and it was so well-received that we can feel the effects of it’s influence even today. In the following years from 1202 to 1228 this system completely overtook the previously used Roman numerical system and improved the overall business calculation capabilities, which eventually leads to an exponential growth of accounting and banking in the heart of Europe.

Within the book, there was an interesting proposal, an observation of a problem. It involved the growth of rabbits in ideal conditions. Within the solution to this mathematical problem, was contained a sequence of numbers, which we now know as Fibonacci numbers. Interestingly enough, this is not the first time this sequence was recorded, since historians have discovered documents by Indian mathematicians at least 600 years before Leonardo himself discovered it.

Even though Fibonacci discovered this sequence, he didn’t extrapolate the relationship between the numbers and their ratio. His method was to simply collect the starting number one, add it up with every number before it, and so on.

For visual purposes the sequence is as follows:

1+1=2, 2+1=3, 2+3=5 and so forth in order to get this particular sequence….

1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377…

What he didn’t realize is that the ratio between the numbers, keeps a strong tendency towards a certain number which we know as the Golden Ratio, and it was discovered by Phidas between the years 500 BC – 432 BC.

The golden ratio can be found in nature, as well as human creations like trading systems.


Introduction to Fibonnaci ratios

Let’s first take a look at the numbers in the Fibonacci sequence again:

1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377…

What is being called the Golden Ratio is actually the relationship between each and every consecutive pair of numbers in the sequence. If you want, you can spend some time to divide each number with the previous one and see it for yourself, but I will do the calculation below for you anyways. What we are going to notice is that with every division the result keeps getting closer and closer to one specific number, which is easily rounded to 1.618.

Now this information is still useless when considering trading, but it’s important to know it for later in the article, because we will learn how to utilize the ratios gained by the following divisions into a concise and specific trading strategy.

ratio-of-fibonacci-numbersIf we continue these calculations we will reach the phi number, known today as the golden ratio, which is 1.61803398875, but for ease of communication we will round it off at 1.618. We can utilize these ratios when analyzing charts in different ways, but primarily they are used to predict the outcome of trends, either upward or downward trends.

This article can serve as both an introduction and directory towards other Fibonacci trading tool related articles. It has been suggested that humans are attracted to this pattern subconsciously, but we will leave the metaphysics for the philosophers. Truth be told, you should always try to make the most informed decisions when trading. I’m saying this because in reality the Fibonacci Ratios are not in any direct correlation with trading systems, commodities, currencies and they do not affect the market price of goods in any way. What you should consider though is that there are thousands of other trades who are using this tool to speculate the future state of the market. I’ve personally enjoyed some success when trading using this tool, but it’s never recommended to go all-in on the markets. Spread your funds, keep a professional attitude and you will turn a profit regardless of anything.

Anyways, let’s not waste any more time and let’s dive right into the specific technical details!


Fibonacci Trading Tools

From the previously derived ratios we can generate five different types of trading tools that are very useful when analyzing charts in the various marketplaces, regardless of whether we are talking about stocks, bonds, securities or cryptocurrency. The available Fibonacci tools can be used in any market, at anytime, but some tools are better for long-term analysis, while others are very effective at predicting short-term outcomes:

The available Fibonacci trading tools are:

  • Fibonacci Arcs
  • Fibonacci Fan Lines
  • Fibonacci Extensions
  • Fibonacci Time Zones
  • Fibonacci Retracements

Using these tools within your trading software or exchange platform is going to create lines which after reading this article you will be able to use to extrapolate valuable information, that will help you make the right trading decisions.

Let’s look at some information explaining how these ratios allow efficient chart analysis.


How do the Fibonacci trading tools work?

It is a very popular idea that when correctly applied the Fibonacci trading tools will present about 70% correct market prediction in individual cases, while other traders say it’s both a time and effort-intensive investment, which provides unrealistic and unreliable information.

The truth is that nobody really knows why the Golden Ratio appears in trading charts, in the size of our hands, in the way we build our cities and make our art. It’s literally everywhere and all evidence suggests that people are using it subconsciously for the most part.

Most of the traders find Fibonacci results to be way too complicated to read and use confidently, but there are those who swear by it. It takes a while to get used to reading the results and making the correct chart measurements. In general you shouldn’t get attached to the results that any trading tools will produce and you should base your predictions on more relevant price movers, such as governments passing new laws, new companies in the specific market, or similar news that bring about real change instead of the psychological notions of traders on the market.

You should consider the Fibonacci Tools as a way to look at charts in a different way and understand that they influence the decisions of other traders on the market. This argument is reasonable, because of the fact that all of the tools are available to everybody and most serious traders for whom trading is a business will use them on a constant basis.  Therefore its safe to assume that Fibonacci results present the notions of traders and what they consider the price of a commodity to be, regardless of real events.

The Fibonacci Trading Tools have been created as a way to dispel trading uncertainty, so they really, really shouldn’t be the basis for your trading decisions. But rather you should be focusing on the events that have real market driving power and shape the prices of goods.

The Fibonacci studies become a very active factor when used by a large number of traders, although it’s very unfortunate that we don’t have a way of knowing how many traders are using the tool at any particular way of knowing how many traders are basing their decisions off of these tools. Most of the time they work by driving traders to artificially create their predicted support and resistance levels.

Basically the Fibonacci studies work, because of the belief that they work. A lot of traders have experienced the so-called self-fulfilling prophecy and they’ve experienced the results that the tool has predicted. In reality there is nothing to base the decisions upon, except that the ratio is found in many surprising places in nature.

Always remember that the market is a very complex system and it’s being influenced from a variety of different factors, one of which is a large number of people looking at a charting tool and believing in its predicted outcome. I know I must be boring with this, but do not take comfort in the results you get with this tool. The markets are inconsistent, difficult to predict and it’s easy to make a mistake that can cost you a lot of money if you’re not care full.

As a conclusion to this point, you should use the following tools in combination with other charting tools and the results should be taken as a vote for or against a certain decisions, while also taking into account the results gathered from the other tools for technical chart analysis. This way you will evade the trap of over-reliance on the Fibonacci Method and make well informed and confident decisions.

Let us now delve into each and every tool and describe the main features it possesses, together with what we can hope to achieve with each tool individually.


Fibonacci Fan Lines

This particular charting technique uses three diagonally placed lines that use the Fibonacci ratios in order to help you identify future key levels of support and resistance on the markets.

fibofan5

They are created by drawing a trendline from the highest to the lowest price in any given period of time. Based on this initial trendline, the tool generates the other lines, by making a division between the vertical distance of the two selected points by the most important Fibonacci ratios, which are 38.2%, 50% and 61.8%. The fan lines are then created based on the results of the multiple computations, where every line passes through each of the three different results.


Fibonacci Arcs

Just like the Fan Lines charting technique, the Fibonacci Arcs are used for identifying nominal support and resistance levels and their ranges, by drawing three curved lines based upon the Fibonacci ratios.

Fibonnaci Arcs

They are created by drawing a trendline between the highest and the lowest price point in a given period and then drawing three intersecting arcs going through different ratio points based on the key ratios, 38.2%, 50% and 61.8%. This helps you make trading decisions when the price of your chosen commodity passes through one of these levels. The price of the asset will usually move between 38.2% and 61.8% allowing you profitable long and short positions on the particular market that you’re involved in.


Fibonacci Time Zones

Considered to be an indicator, usually used by technical traders to identify period in which the price of the selected asset will experience high amounts of increasing price action and upward trends.

fibotime1

This particular charting technique utilizes the sequence known as Fibonacci Numbers, which we mentioned before. Based upon these numbers the tool generates vertical lines that begin at the chosen starting position. It is usually used for long-term planning and it’s highly suggested that the chosen starting point is a moment in time when a large market movement has already happened. From this starting point onwards, the tool generates the vertical lines on a per-day basis corresponding to the particular value of each subsequent number in the Fibonacci number sequence.


Fibonacci Extensions

This tool is used within Fibonacci Retracement, which we will save for the end of the article. It provides valuable information regarding the places of support and resistance on the markets. Extensions are composed of all the different levels, based on important Fibonacci ratios and are often used to determine which areas will provide the traders with profit, so that these traders can expect and place orders ahead of time.

fiboexp1

What do we mean by retracement? The term explains a situation where the price of an asset moves in either upward or downward motion and then bounces back slightly, often to the 38.2% level, but frequently enough to the 61.8% level as well. It is recommended that you use this tool when the market moves more than a 100% of the previous movement. When used in combination with other indicators and patterns it allows traders to place realistic price targets for their assets.

It is not uncommon for the market to follow these extensions and many traders take the information gathered by using this tool as reliable, although the real reasons for the markets to follow the results of this study are completely unknown and irrational.

Practical Use

The best practical way to use Fibonacci extensions is when the prices of assets are at new highs or lows and there is absolutely no clear date as to what the support or resistance levels are on the charts. When in this particular situations, you can use this tool to get a basic idea of approximately where the asset is going to start falling in price, so you can get out of the market at the right time. Using these tools increases your chances at making profits regardless of the fact if you’re trading long or short. Fibonacci extensions can be used to calculate both upward and downward movements on the market.

With this being said, the only way to be really practical is to make decisions based on other factors as well, not only on the Fibonacci extensions. Wise traders will wait for candlestick patters, like price action, to become convinced that a stock is going to reverse at the target.

Bottom Line

These extensions are easily applied to any trading style, regardless of whether you’re trading on a montly or a five minute chart, these tools can help you set relatively realistic price targets and also expect the future movements of the market. However consistent the results of these tools are, it is very important for you to know that you should absolutely never allow Fibonacci to be the one and only deciding factor in your trading decisions, because as I have said more than a couple of times in this article, the results gathered from these tools are simply projections based on the specific ratios which for some reason correlate with the movements of the market. They are no specific reasons for these changes in price, except for people’s willingness to sell and buy at any time.


Fibonacci Retracements

This term is used in technical analysis and it refers to areas on charts signifying support and resistance. Fibonacci retracement uses horisontal lines to highlight areas of expected support and resistance at key Fibonacci ratios, before the particular trend continues in the original direction it was headed towards. To create these levels, you need to draw a trendline between the highest and lowest price of a period and the tool then divides the vertical distance by the most important of Fibonacci’s ratios, 23.6%, 38.2%, 50%, 61.8%.

700px-fibo5

It is a very popular tool used by technical traders, because it helps them identify places where they can strategically place transacions, price targets and stop losses. The notion of Fibonacci retracement is used in many different indicators, including but not limited to… Gartley patterns, Elliot Wave Theory and Tirone levels. For some unknown reason, after the market moves significantly the new support and resistance levels are usually near the results of the Fibonacci ratios. These levels are static and they do not move together with the chart like moving averages do. Their static nature allows for an easy and quick identification of price levels and subsequent order creation. This allows both long and short-term traders to expect and hastily react to the market when these price levels are starting to get tested. The ratio levels signify places where it’s usual for the market to struggle and either break to a new height or fall back again.


Trading Fibonacci Retracement Levels

These retracement levels can be used as triggers for buy orders or drawbacks in an uptrend. It’s highly encouraged that you utilize other tools and indicators such as the 200-day moving average, because when they overlap with the results for the Fibonacci retracements it generally suggests a fortified support or resistance is to be expected.

The one to keep an eye at is the 0.618 or rather 61.8%. This is the usual bounceback that the market makes when due to fear, most of the asset holders will release, but there is always someone there to pick up a bargain and it often drives the price up to the 61.8% level, where it usually peaks out before plummeting back into a down trend. Some of the more conservative traders hold out for a few waves before setting trades in order to ensure themselves that the support and resistance factors are there.


Did you like this article? I really hope that you’ve picked up on some new and useful information that you can utilize in your technical analysis of market charts.

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