Who is Fibonacci? What does he have to do with trading?
What are the Fibonacci trading tools and why are they so popular among technical traders?
If you don’t know the answers to these questions, this blog post is for you.
The sections below will reveal to you the power behind the Fibonacci secret and demonstrate the use of the Fib tools using real chart examples.
Also in this blog post – 3 trading tips that will drastically improve your Fibonacci Trading performance!
So make sure you do not miss those at the bottom of this post.
Who is Fibonacci?
The Italian mathematician, Leonardo Bonacci, also known as Fibonacci, is responsible for two major changes in the western mathematics world:
- Popularizing the Hindu-Arabic numeral system
- Introducing the Fibonacci Sequence (or…The Fibonacci Numbers)
Fibonacci was born around the year 1175 in the city Pisa, Italy.
He used to travel extensively around the Mediterranean coast, meeting with many merchants and learning about arithmetic systems. That is how he was introduced to the Hindu-Arabic numeral system, was fascinated by it and used his power and influence to introduce it to the western world.
Unlike the Hindu-Arabic numeral system, the Fibonacci sequence was Fibonacci’s own revelation.
The Fibonacci Sequence started as a mathematical solution to the growth of the population of rabbits, but with time it became a major part of modern age mathematics and geometry.
One of the most modern uses of the Fibonacci sequence, is the use of Fibonacci’s Ratios in the world of trading.
The Fibonacci Ratios are created by dividing between numbers from the Fibonacci Sequence.
One of the remarkable characteristics of the Fibonacci Sequence is that each number is approximately 1.618 times greater than the preceding number.
The key Fibonacci Ratio is 61.8% (also referred to as “the golden ratio” or “the golden mean“).
It is found by dividing a number from the Fibonacci Sequence by the number that follows it.
For example: 8/13 = 0.6153, and 55/89 = 0.6179.
So what does all this math has to do with trading?
The Fibonacci Retracement levels
We all know that prices move in waves. It doesn’t matter whether you trade stocks, currencies, futures or commodities, it is rare to see a price that move in a straight line.
The market’s waves (direction and power) reflect the balance between buyers and sellers at any given time. If you wish, the balance between Supply and Demand.
As a trader, we trade those waves. Our goal\desire is to recognize the shift of power between Sellers and Buyers and to capitalize on it by placing a trade.
This is where Fibonacci comes in to play.
Years of studies have shown that prices tend to react to Fibonacci Ratio lines. Some will call it a Self Fulfilling prophecy, some will rationalize it in a different way but the result remains the same – Price often shifts its direction when it meets a Fibonacci Ration level.
At the chart above we can see that the first pullback (B to C) ended at the 50% Fibonacci level.
The second pullback, the bigger one of A to D, ended at point E – The 61.8% Fib level.
The Fibonacci Retracement levels are levels that reflect potential Target Zones of pullback moves.
Basically it means that at these Retracement levels the price is expected to shift back to the direction of the original trend.
The common Fibonacci Retracement levels are 38.2%, 50%, 61.8%, 78.6% and 88.6%
Let’s see an example:
As mentioned above, Fibonacci Retracement levels are potential target zones for pullback moves.
The example above ($HP 240 minutes chart) shows how each bullish pullback ended at a Fibonacci Retracement level. After meeting the Fib levels the price turned back to the direction of the bearish trend.
Trends and Fibonacci Levels
So now that we know that the price reacts to Fibonacci Levels, the question is which level should we trade?
While $HP chart proves that the price reacts to Fibonacci levels, it doesn’t provide an answer to this question:
- The first retracement ends at the 38.2% Fibonacci level
- The second retracement ends at the 50% Fibonacci level
- The third retracement ends at the 61.8% Fibonacci level
Should we simply try and trade each and every Fibonacci Level??
There must be a rule that we can use that will help us to focus on the “right” level! right?
Well… the quick answer is NO.
Like everything else in technical analysis there is no “Right” or “Wrong” – There are only probabilities and odds.
But there is something that we can use – The strength of the Trend.
Studies have shown that there is a correlation between Fibonacci Retracement Levels and the strength of the trend:
- Strong trends – Price usually reacts to the 38.2% or the 50%.
- Normal trends – Price usually reacts to the 50% or 61.8% (highly common reversal level)
- Weak trends (or shifts in trends) – Price usually retraces to the 61.8%, 78.6% or 88.6% before a shift in short term trend.
If you think about it, it actually makes a lot of sense:
When the we have a very strong trend (like the bearish example above), sellers are eager to sell while buyers are afraid and they quickly take profits.
When the trend is weaker, Sellers start to hesitate on when to add more positions, while Buyers dare to exploit the seller’s weakness more.
Let’s look at more examples:
In this example ($AUDCAD, daily chart) we can see a “Normal Trend” in which the price reacts twice to the 61.8 Fibonacci Level.
If we will zoom into the 240 minutes chart we can see how in the first bullish wave, which was very strong, the Buyers used the 38.2% levels to load up and pushed the price higher and higher.
Fibonacci Extensions – Projecting Targets
While Fibonacci’s Retracement levels are used to find potential Target Zones for pullback moves, Fibonacci Extensions are used to find potential Target Zones for trend continuation waves.
Just like with Fibonacci Retracement levels, also here we see more commonly used Fib Extension levels:
- The 127% and 161.8 (the golden ratio – Important level) are very popular extension levels that often being used in Harmonic Trading (read more)
- The 200% and 261.8% are also highly common among harmonic traders and often lead to powerful reversals.
Traders often cover their positions when prices reach the Fib Extension levels and therefore we see the reaction of price to these levels (self fulfilling prophecy)
Here’s an example:
In this example ($GLD 240 minutes), point 3 is the 61.8 Fib Retracement of the 1->2 leg.
As expected, the price reacted to the Fibonacci Level, turned continued moving in the direction of the bearish trend.
The classic potential Target Zones for the bearish reversal (based on structure analysis) were 164, and 163 (previous low, point 2).
But if you assume that the trend will continue (as actually happened) the Fib Extensions levels come into play and you can used them to project the future price move.
In this example we can see that the price reached the 127% of the 1->2 leg.
Later, in the same example, you can see how point 5 was the 50% Retracement level of the 3->4 leg, and that from there the price continued all the way down to the 161.8% Fib Extension level before turning back up again.
Just like I mentioned for Fibonacci Retracement levels, also with Extensions we see correlation between the strength of the trend and the levels that the price reacts to.
In strong trends the price usually tends to reach the 161.8, 200, 261.8 levels and in weaker trends, 127, 138.2 and 141.4 will probably be more relevant.
3 Tips for Fibonacci Traders
Here are 3 powerful tips that will drastically improve the performance of your Fibonacci Trading:
- Combine the use of the Fibonacci Tools with other technical elements (trend lines, MA lines, structure, patterns etc…):
- Use Fibonacci confluence zones for better accuracy:
In the example above ($T daily chart), point 4 is the 61.8 Fib level of 1->2 leg and also the 161.8 Fib extension of 2->3 leg. Sharp reversal from this Fib confluence Zone
- Use harmonics – Harmonic trading patterns use Fibonacci Retracements and Extensions levels to create powerful patterns (learn more about Harmonic Trading)
The purpose of this blog post was to explain and demonstrate the basic concept behind Fibonacci Trading.
The examples above, along with the trading tips I wrote above should allow you to practice your Fibonacci analysis and identify interesting potential Buy/Sell Zones.
I encourage you to try out the simple Fibonacci tools that you can find in each charting/trading software (you don’t need to spend money on special indicators), test them and see how they work.