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The Fibonacci sequence is found everywhere in nature, from spirals of galaxies to branches of a tree and from DNA molecules to hurricanes. Financial analysts, who believed that market movements demonstrate phenomena similar to nature, pioneered using Fibonacci ratios to identify and predict asset price trends. Read on to learn all about using Fibonacci levels for trading.
The Fibonacci sequence is a number sequence with every number being the sum of the previous two, starting from 0 and 1 as the first two numbers. So, the sequence is:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55…
Also known as the Golden Ratio, 0.618 is the ratio of any two consecutive numbers on the Fibonacci sequence. This means that each number is approximately 1.618 times larger than the previous one:
1/1=1
2/1=2
3/2=1.5
5/3=1.666…
8/5=16
13/8=1.625
21/13=1.61538
34/21=1.619
55/34=1.6176
… And so on
On skipping a number in the sequence and calculating ratios, you get two more constants: 0.382 and 2.618.
3/1=3
5/2=2.5
8/3 = 2.66…
13/5=2.6
21/8=2.625
34/13 =2.615
55/21 =2.619
Continuing the process generates more such constants.
Traders use these ratio constants as Fibonacci levels. The most popularly used retracement levels in trading are 23.6%, 38.2%, 50% and 61.8%. Although 50% is not strictly a Fibonacci ratio, it is a commonly used level. The most popularly used key extension levels are 61.8%, 100%, 161.8%.
Traders use Fibonacci ratios to mark the level to which an asset’s price might retrace after a pullback or the price point to which it may rally after a breakout. A useful feature of the Fibonacci indicator is that it can be used for any timeframe. Therefore, it can be used by scalpers, intra-day traders, swing traders and those using long-term strategies.
Traders start by selecting two price points around the current price point. The lower level is 0 (0%) and the higher is 1 (100%). These two levels are called the anchor points. Then, using a Fibonacci charting tool, horizontal lines representing the Fibonacci percentages are drawn. Commonly, traders pair Bollinger Bands, Moving Averages or any other indicator to identify whether they should be using retracement or extension levels. This means they speculate whether the market is going to reverse or continue on its trajectory to decide whether they should use these levels as entry or exit points.
A common challenge that traders face is identifying the anchor points. Traders use other indicators to identify the 0% and 100% of the Fibonacci indicator. Then, they apply the Fibonacci indicator to generate the retracement and extension levels.
Retracement levels are used when the price begins a new trend in any direction. The price may either retrace or return to the previous trend or a previous level, at any of these levels. Retracement levels are plotted within the anchor price points.
Traders open long positions when the price is trending upwards, and the Fibonacci retracement becomes the support level.
Traders open short positions when the market is bearish, and the Fibonacci retracement level serves as the resistance level.
The Fibonacci indicator does not predict whether the price will bounce back or not. It only signals the possible levels. Whether it will bounce or not can be predicted using other indicators and market updates.
Experts in the industry believe that knowing when to get out is as critical as knowing when to get in. The extension levels are marked beyond the anchor points. Fibonacci extension levels are the ones where a trader takes profits and exits the position. Whether one should exit or not can be determined by using other indicators that help identify the strength and volume during a trend.
During an uptrend, traders set take profit levels to exit long positions at the extension levels. These levels become levels of resistance.
Since the market finds support at Fibonacci extension levels during a downtrend, traders usually choose to exit short positions at these levels.
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