TOPIC TWELVE
Technical: Fibonacci Retracements
Fibonacci numbers or sequences are considered by many mathematicians as figures which can explain even common developments in nature and biology. They are strongly related to the 'golden ratio' and play a significant role in trading technical analysis.
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TECHNICAL: FIBONACCI RETRACEMENTS
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​You may have already been introduced to the term Fibonacci or Golden Ratio in school, novels or popular movies such as The Da Vinci Code. Fibonacci numbers are a sequence of whole numbers starting from zero and one (0 & 1). The idea is that the sequence continues to infinity by adding the previous two numbers (i.e. 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, etc.).
As the sequence gets further from the start, any number divided by the previous number will be approximately 1.618 which becomes more accurate the larger the numbers get. Similarly, any number divided by the next highest number will be approximately 0.618 (61.8%). Other important ratios are using a number and dividing it by two numbers ahead (e.g. 55 / 144) which approximates 0.382 (38.2%) or taking a number and dividing it by three numbers ahead (e.g. 55 / 233) which approximates 0.236 (23.6%). Again the further and larger the numbers used, the more accurate the ratio is to these percentages.
Note: The '50%' level is also added into Fibonacci retracement indicators on platforms due to its psychological value.
This series was created by an Italian mathematician called Leonardo Bonacci in the thirteenth century and has since been used to model modern architecture and play a big part in several mathematical models. The ratios can evidently be found in many cases of human biology as well as the nature that surrounds us. Based on these ratios, traders are able to utilise these sequences to come up with ideal entry and exit points.
Popular levels and applying Fibonacci in trading
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When it comes to popular ratios, 38.2% and 61.8% are considered the most popular and strongest. The other two common levels of 23.6% and 50% are also considered good points by many traders. A trader may look for the market retracing from a high and low range to reach one of the key percentage points and turn around. Once price hits 23.6% and passes that level, consider the 38.2%, then the 50% and lastly 61.8%.
When applying the Fibonacci retracement, whether it starts from top to bottom, or bottom to top, start from the left and drag the marker along to the right (see charts below). Look for a clear market peak or lowest trough for top or bottom starting points.
For a market trending upwards and has started to drop, start by selecting the clear lowest low and drag the Fibonacci indicator to the top of the trend to the highest high. The technical terms applied to these points are the swing high (two lower highs on either side) and the swing low (two higher lows on either side).
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Naturally the market doesn't always reverse at these points every time. When a clear opportunity does arise, mixed with another strong indicator or a support/resistance, the theory is a probability of a reversal increases.
The 23.6% level is the closest and therefore most likely to be hit or passed through. Traders may use this level with tighter range trading strategies or patterns.
The 38.2% and 50% are considered the medium levels and would be more likely traded on by those using slightly longer term charts such as the daily.
Lastly the 61.8%, the deepest level and also considered the golden level based on the ‘Golden Ratio’ of Fibonacci, is often viewed as the most effective entry point. Waiting for this level could miss out on earlier bounces on the 38.2% or 50% points.
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Fibonacci in price retracements
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The most common way of trading Fibonacci retracements is by using them to identify where the market may hit a support or resistance level and pull a reversal. When a market price moves quite heavily, traders use these ratios to pick and predict where a pullback or bounce in price could happen based on previous advances.
The ratios can be used as confidence or assurance points when analysed alongside other indicators and patterns in the market (e.g. an RSI also showing overbought/sold at the same time or trending support or resistance lines).
The chart below is another textbook example of how the Fibonacci retracement mixed with an 'existing support line' plays a part for the market to turn around. It can be seen that the line used by the 61.8% ratio happens to also be a 'resistance' level for price prior to breaking it. Resistance levels once broken often can turn into support levels when the market comes back. Having this support happen to be the 61.8% Fibonacci level has increased a traders confidence to enter a buy position here.
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An example of a market which has declined significantly to the 61.8% retracement level before bouncing back to a complete recovery can be seen below.
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