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Understanding the Role of The Fibonacci Sequence in Trading

Updated: Jun 19, 2024 | Published: Jun 19, 2024
Verified Investing
By Verified Investing
Understanding the Role of The Fibonacci Sequence in Trading

Trading Fibonacci Retracements

The Fibonacci Sequence forms the basis for one of the most-used investment tools: the Fibonacci retracement. Even if you know how the Fibonacci Sequence works, you may find the percentages used in Fibonacci retracements a mystery. This article will explain that mystery and more as we discuss what Fibonacci retracements are and how they work.

The Origin of the Fibonacci Sequence

The Fibonacci sequence is a linear difference equation that was introduced to the West in 1202 by Leonardo Pisano Bigollo, also known as Fibonacci. It appears in many places in nature, from the arrangement of seeds in a sunflower to the shell structure of a nautilus, giving it almost mystical qualities. It has often been used in art and architecture as well.

Fibonacci Sequence

What Is The Fibonacci Sequence?

The Fibonacci sequence describes a list of numbers where each one equals the sum of the two preceding numbers, carrying on to infinity. Starting at 0, the Fibonacci numbers are:

0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, etc.

What Is The Golden Ratio?

The Golden Ratio is closely related to the Fibonacci sequence. It is denoted by the Greek letter phi (𝜑). The golden ratio is when the ratio between two numbers equals the ratio of the larger number to the sum of the numbers. Given two numbers a and b, with a larger than b, they are in the golden ratio if the ratio between a and b is the same as the ratio between the sum of a + b and a:

If a/b = (a+b)/a then a/b = 𝜑

Algebraically, 𝜑 is defined as (1 + √5 ) / 2, which gives us approximately 1.6180. If you’ve seen a Fibonacci retracement chart, you should immediately recognize this number from the 61.8% retracement level.

What Are Fibonacci Retracements?

Fibonacci retracements are not Fibonacci numbers. They are a form of technical analysis using Fibonacci ratios to mark out possible resistance and support levels for trades on price trend charts using recent highs and lows as boundaries. Fibonacci retracements are nothing more than mapping certain percentages between a high and a low.

Fibonacci retracement levels are represented on a chart by horizontal lines marking 61.8%, 38.2%, and 23.6% retracement levels. The 50% retracement level is considered a retracement level all its own. It is not derived from the Fibonacci sequence but is often included in Fibonacci retracement charts as an additional data point.

Fibonacci retracements can also be used for risk management, helping a trader establish stop-loss levels and favorable points to exit a trade and take profits.

How To Use Fibonacci Retracement Levels

Modern trading tools will automatically draw Fibonacci retracement levels once you set the swing highs and lows. To map out Fibonacci retracements by hand, you take the difference between the high and low, then multiply it by .618, .382, and .236 to find the Fibonacci retracement levels.

EXAMPLE:

A stock falls from $100 to $50 and begins to rebound. To map the Fibonacci retracement levels of a possible rally, you would take the difference between the high and the low ($100 -$50 = $50), multiply it by .236, and then add that number to the low to get the first retracement level:

50 x .238 = 11.80;

50 + 11.80 = 61.80.

You would then mark a horizontal line at $61.80 on your price trend chart. You would do the same for the 38.2% ($69.10) and 61.8% ($80.90) retracement levels.

Advantages of Using Fibonacci Retracements

Fibonacci retracements are static prices and easy to understand. They represent possible inflection points in an asset’s price movement. They help traders identify logical positions for stop-loss orders, which helps with risk management. They also provide easy-to-understand visual cues for potential support and resistance levels.

Fibonacci retracements are flexible. They can be used to analyse prices in practically any timeframe.

Disadvantages of Using Fibonacci Retracements

Some disadvantages of using Fibonacci retracements include their reliance on past data, the possibility of false signals, and the effects a volatile market can have on invalidating plotted levels. Another factor to consider is that everyone either uses or watches Fibonacci retracements, which can lead to crowded trades and invalidation of a retracement level.

“It’s Dangerous To Go Alone!”

A trader or investor should never rely on a single market metric. It’s important to have corroboration from different sources before committing to a trade. Trading volumes, moving averages, momentum oscillators, and candlestick patterns are all popular methods of financial analysis that can work with Fibonacci retracements to provide a more accurate trading picture.