Fibonacci retracement trading strategy

Leonardo Pisano, nicknamed Fibonacci, was an Italian mathematician who was born in Pisa in 1170. His father Guglielmo Bonaccio (Guglielmo Bonaccio) worked in a trading post in Buja, now called Béjaia, a Mediterranean port in northeastern Algeria. When he was young, Fibonacci studied mathematics in Buja. During his extensive travels, he learned about the advantages of the Indo-Arabic number system.

Key points

  • In the Fibonacci sequence, after 0 and 1, each number is the sum of the first two numbers.
  • In trading, the numbers used in Fibonacci retracements are not numbers in the Fibonacci sequence; instead, they are derived from the mathematical relationship between the numbers in the sequence.
  • Fibonacci retracement levels are drawn by taking highs and lows on the chart and marking key Fibonacci ratios horizontally to generate a grid; these horizontal lines are used to identify possible price reversal points.

Golden ratio

After returning to Italy in 1202, Fibonacci recorded hisAbacus (“Abacus Book”). inside”Abacus,” Fibonacci describes the sequence of numbers now named after him. In the Fibonacci sequence, after 0 and 1, each number is the sum of the first two numbers. Therefore, the sequence is as follows: 0, 1 , 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610 and so on, extending to infinity. Each number is approximately 1.618 times the previous number.

This value: 1.618 is called Phi Or the “golden ratio”. The golden ratio mysteriously often appears in the natural world, architecture, fine arts, and biology. For example, this ratio has been observed in the Parthenon, Leonardo da Vinci’s Mona Lisa, sunflowers, rose petals, mollusk shells, branches, human faces, ancient Greek vases, and even spiral galaxies in outer space.

0.618

The reciprocal of the golden ratio (1.618) is 0.618, which is also widely used in Fibonacci trading.

Fibonacci levels used in financial markets

In trading, the numbers used in Fibonacci retracements are not numbers in the Fibonacci sequence; instead, they are derived from the mathematical relationship between the numbers in the sequence. The 61.8% “golden” Fibonacci ratio is based on dividing one number in the Fibonacci sequence by the number after it.

For example, 89/144 = 0.6180. The 38.2% ratio is obtained by dividing the number in the Fibonacci sequence by the two digits on the right. For example: 89/233 = 0.3819. The 23.6% ratio is obtained by dividing the number in the Fibonacci sequence by the three digits on the right. For example: 89/377 = 0.2360.

Fibonacci retracement levels are drawn by taking highs and lows on the chart and marking the key Fibonacci ratios 23.6%, 38.2%, and 61.8% horizontally to generate a grid. These horizontal lines are used to identify possible price reversal points.

The 50% retracement level is usually contained in a grid of Fibonacci levels that can be drawn using charting software. Although the 50% retracement level is not based on the Fibonacci sequence, it is widely regarded as an important potential reversal level, especially recognized in the Dow Jones theory and the work of WD Gann.

Fibonacci retracement levels as a trading strategy

Fibonacci retracements are often used as part of trend trading strategies. In this case, the trader observes the retracement that occurs in the trend and tries to use Fibonacci levels to make a low-risk entry in the direction of the initial trend. Traders using this strategy expect the price to rebound from Fibonacci levels back to the direction of the initial trend.

For example, on the daily chart of EUR/USD below, we can see that a major downtrend began in May 2014 (point A). The price then bottomed in June (point B) and retreated upward to the 38.2% Fibonacci retracement level of the downtrend (point C).

In this case, the 38.2% level would be an excellent place to enter a short position in order to take advantage of the continuing downward trend that began in May. There is no doubt that many traders are also paying attention to the 50% retracement and 61.8% retracement, but in this case, the market is not bullish enough to reach these points. Instead, the euro/dollar turned lower, resumed the downward trend, and broke the previous low in a fairly smooth movement.

If there is a confluence of technical signals when the price reaches the Fibonacci level, the possibility of a reversal will increase. Other popular technical indicators used in conjunction with Fibonacci levels include candlestick patterns, trend lines, volume, momentum oscillators, and moving averages. More confirmation indicators are at work, which equates to stronger reversal signals.

Fibonacci retracements are used in various financial instruments, including stocks, commodities and foreign exchange transactions. They are also used in multiple time frames. However, like other technical indicators, the predicted value is proportional to the time range used, and a longer time range gives more weight. For example, the 38.2% retracement level on the weekly chart is much more important than the 38.2% retracement level on the five-minute chart.

Use Fibonacci extension

Although Fibonacci retracement levels can be used to predict potential support or resistance areas, and traders can enter the market to catch up with the restoration of the initial trend, Fibonacci extensions can be used to provide traders with Fibonacci-based profits Goals to complement this strategy. Fibonacci extensions include levels beyond the standard 100% level, which traders can use to predict good potential exit areas where they can trade in the direction of the trend. The main Fibonacci extension levels are 161.8%, 261.8% and 423.6%.

Let’s look at an example, using the same EUR/USD daily chart:

Looking at the Fibonacci extension level plotted on the EUR/USD chart above, we can see that the potential price target for traders holding short positions is at the 161.8% level below the 38% retracement level described earlier, or 1.3195 .

Bottom line

Fibonacci retracement levels usually indicate reversal points with amazing accuracy. However, they are harder to trade than in retrospect. These levels are best used as tools in a broader strategy. Ideally, this strategy is a strategy to find the confluence point of multiple indicators to determine the potential reversal area that provides low-risk, high-potential return trade entry.

However, Fibonacci trading tools often encounter the same problems as other general trading strategies (such as Elliott Wave Theory). That is, many traders find it successful to use Fibonacci ratios and retracements to place trades in long-term price trends.

When combined with other indicators or technical signals, Fibonacci retracements can become more powerful. InvestingClue Academy’s technical analysis courses cover these indicators and how to transform patterns into actionable trading plans.

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