The use of Fibonacci retracement levels is one of my personal favorite technical tools. In combination with support and resistance levels, the Fibonacci reversal levels can give great probability setups, especially for the trend traders among us. It yet surprises me that a lot of traders hardly use these powerful tools to help them in their search for reversal and target levels in trading. It is therefore about time that traders who are not familiar with Fibonacci will learn its power.
Once again Fibonacci ratios are used to identify potential reversal levels. These Fibonacci ratios are a sequences of numbers identified in the thirteenth century by an Italian mathematician Leonardo Pisano, nicknamed Fibonacci. Fibonacci was born in Pisa in the year 1170 and in his work he was influenced by Indian and Arabian merchants that visited. The number sequence Fibonacci documented is on its own not that interesting, but the ratio’s between the numbers are! We can find these ratio’s can be found throughout nature, biology, architecture, and basically anything that has a mathematical foundation. For unknown reasons these ratios are constantly returning in financial markets. They can be used to determine critical price levels that cause the price to reverse. The Fibonacci number sequence is as follows (sum of two preceding numbers):
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, etc.
Each number is approximately 1.618 times greater than the preceding number. More common we refer to this ratio with its inverse, which is 61.8%. This 61.8% ratio is called Phi or often referred to as the “golden ratio”. We get this golden ratio by dividing a number in the Fibonacci series by the number that follows it, for example: 55/89 = 0.618.
This ratio has been observed in the Parthenon, Leonardo da Vinci’s masterpiece the Mona Lisa, ancient Greek vases, sunflowers, rose petals, three branches, human faces, and even the spiral galaxies of out space.
Besides the “golden ratio” other important ratios in the Fibonacci series are: 38.2%, 23.6% and although not really a Fibonacci number, 50%. To get the 38.2% ratio you divide a number in the series by the number two places to the right (i.e. 21/55 = 0.382). In a similar way we get the 23.6% Fibonacci level, only you take the number three places to the right. The 50% retracement level is not based on a Fibonacci number but it is widely viewed as an important potential reversal level.
In financial markets the most important Fibonacci levels are: 38.2%, 50% and the 61.8%. These percentages are used by traders as ratios at which the market is likely to retrace against. Most charting software packages have Fibonacci retracement levels as a standard function. To determine these levels you start with a significant high, and then drag the tool to a significant low (or vice versa). The tool will plot the Fibonacci ratios on your graph. These retracement levels help to estimate how deep a pullback will be in a trending market.
There is no strictly rational explanation why so often price action bounces off from these Fibonacci levels. But it would be a mistake to dismiss Fibonacci methods as a useless superstition, since so many active traders make use of Fibonacci retracements and extensions in their strategies.
The likelihood of a reversal increases if there is confluence of technical signals at certain Fibonacci levels. Popular technical indicators that are commonly used in conjunction with Fibonacci levels are structure support/resistance, candlestick patterns, trend lines, momentum oscillators and moving averages.
Where above we discussed how Fibonacci retracement levels can be used to forecast potential areas of support or resistance which offer great entry possibilities, Fibonacci extensions are used for profit targets. Like the name suggests, extensions are levels drawn beyond the standard 100% level and are commonly used to project areas that make good potential exit levels for your trades. Key Fibonacci extension levels are 127.2%, 161.8%, 261.8% and 423.6%
Fibonacci retracement levels often mark reversal points with decent accuracy. These levels are best used in confluence with a broader strategy of several indicators that identify potential reversal areas. Once used in confluence Fibonacci retracement and extensions levels provide great entry and exit opportunities that can boost your profits a lot.