How is Fibonacci Used in Trading?

Fibonacci Tools

Now we move into our first advanced price charting method, known as Fibonacci Analysis. Traders use basic Fibonacci retrace to find support or resistance in a trending market, and these key prices can help uncover hidden points of potential support or resistance levels not seen using basic charting methods. Most software programs or charting web sites make Fibonacci tools available to traders, and thus increased the popularity of using even simple Fibonacci techniques.
In this chapter, we will discuss how to use Fibonacci retrace to find key support or resistance levels that may form an alignment with other price levels, how to uncover hidden confluence of Fibonacci retrace levels, and how even simple Fibonacci tools can help confirm other methods of identifying price support or resistance, which leads to enhanced trade entry and exit.

What is Fibonacci in Trading?

Traders today still use insights from a number series described by Leonardo Fibonacci of Pisa, an Italian mathematician from the thirteenth century as described in his book Liber Abaci (which translates as “The Book of the Abacus”). Most modern mathematics students know the Fibonacci sequence as the classic 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, and so on, where the next number in the sequence is the result of adding the prior two numbers together. For example, 5 plus 8 equals 13, and 8 plus 13 equals 21. The Fibonacci sequence initially explained the growth and decay sequences in nature, such as the growth in generations beginning with a single pair of rabbits, and has now been expanded to include larger growth and decay cycles of much larger structures, including financial markets.

The numbers themselves are not as important to modern traders, who are more concerned with the specific ratio between the numbers that develop the idea behind the Fibonacci charting strategies used today. Dividing one number by the immediate larger number in the sequence results in the ratio of 0.618, such as the
number 55 divided by 89 equals 0.618, which forms a stable relationship when dividing any number by one Fibonacci number higher. With the exception of the beginning numbers in the sequence (5 divided by 8 is 0.625, any number in the infinite sequence above 34 results in the 0.618 relationship). The 0.618 number becomes important when using the Fibonacci retrace tool common on most software programs.

Dividing a given number by the next smaller number in the sequence results in the ratio of 1.618, as in the example 89 divided by 55 equals 1.618, or 55 divided by 34 equals 1.618. This relationship and ratio hold no matter which number in the sequence is divided by a lower number. As such, the ratio of one number to the next Fibonacci number is 1.618 times itself, or stated differently, to identify the next larger number in the series, one then multiplies a current number by 1.618, as in the example 89 times 1.618 equals 144. The ratio of 1.618 has importance for traders looking to use Fibonacci price projection or extension tools on their charting software to uncover potential range expansion price targets.

Try it for yourself with any two random starting digits, such as in the example 25 and 50. 25 + 50 = 75; 75 + 50 = 125; 125 + 75 = 200; 200 + 125 = 325; 325 + 200 = 525; 525 + 325 = 850; 850 + 525 = 1,375 to infinity. The sequential number 850 divided by 1,375 equals 0.618, and the sequential number 850 divided by the higher sequential number 1,375 equals 1.618. The application to the markets and beyond therefore comes from the mathematical ratio itself and not from the starting numbers.

Now that we have a basic understanding of the 0.618 and 1.618 ratio numbers which are important not only to mathematicians, let us now move into the realm of describing how modern traders use these ratios to create Fibonacci tools to uncover potential turning points in the market.

Fibonacci Retrace.

While many traders are familiar with Fibonacci tools, others have never heard of the concept as it relates to technical analysis or charting. The simplest way to apply the 0.618 ratios is in the common Fibonacci retrace tool on most charting software programs. Recall that in an upward trend move, price forms higher highs and higher lows, or stated differently, price forms upward impulses and downward retrace. Traders anticipate where these retrace swings to the downside will stop and then the price will resume rising in its established uptrend. Some of the easiest trades come from buying pullbacks in an uptrend to a key support level, such as a short-term moving average, rising trendline, or prior price support levels. Another trading tool is the simple Fibonacci retrace tool, which is designed to find the end of a downward retrace into support so that traders may buy shares as price begins to rise upward from a potential support level. Traders use the 0.618 ratio and derivations of this ratio such as the popular 0.382 ratios to find potential turning points in a market. Traders use percentages such as the 61.8 per cent retrace level and the 38.2 per cent retrace level. The 38.2 per cent level derives from the remainder of what is left over after measuring 61.8 per cent of a movement. In terms of ratios, think of the 0.382 as being left-over after finding the 0.618 segment, or specifically 1 minus 0.618 equals 0.382. This is why you see the 38.2 per cent retrace on standard Fibonacci retrace tools. While not officially a Fibonacci ratio, almost all traders pay attention to the 50 per cent retrace level in addition to the 61.8 and 38.2 per cent levels, which is why most default retrace tools show three lines in the chart. Thus, the 61.8 per cent, 38.2 per cent, and the 50 per cent retrace lines are what you can expect to see most frequently when doing any type of Fibonacci retrace analysis on the price chart.

Drawing Fibonacci Retrace Grids.

Most software programs incorporate Fibonacci tools into their basic or free set of indicators, such as the charting web sites tradingview.com etc. The following describes the purpose and rules for drawing a classic Fibonacci retrace grid on a chart to reveal potential support levels in an established uptrend. The purpose of drawing a Fibonacci Retrace Grid is to find potential support or turning points that will end a downward retrace swing in an established uptrend. The trader looks to buy shares if price forms a reversal candle at a major Fibonacci retrace level, or if a Fibonacci Level forms a price confluence with a moving average, trendline, or another form of support. The following steps represent the sequence to draw a Fibonacci Retrace Grid:

  1. Establish that price is in a confirmed uptrend.
  2. Observe a recent price swing high and note that price is retracing down from a recent swing high in price.
  3. Use the Fibonacci Retrace tool to start the grid by clicking on the most recent swing low in price and dragging the grid to the most recent swing high in price.
  4. Observe the 38.2, 50.0, and 61.8 per cent retrace levels the software labels on the price chart for potential downside targets and areas to identify potential price confluences with other methods, with the purpose being to buy when the price has retraced into support and maybe resuming the established uptrend.

For finding overhead resistance levels in a downtrend, repeat the procedure above but start the Fibonacci grid at the most recent swing high in price in an established downtrend and end the grid at the most recent new swing low in price to uncover the 38.2, 50.0, and 61.8 per cent overhead resistance levels. Look to sell short when price retraces into one of this overhead resistance levels, particularly if the level forms a confluence with a moving average or trend-line along with a reversal candle.

Example of Identifying Price Support Using Fibonacci Retrace Tool.

The following example of Fibonacci retrace grids designed to identify price support will be helpful in understanding this concept. Keep in mind that the technique will be opposite for finding overhead resistance levels to short-sell in a downtrend. See figure 1.1

Fibonacci Retrace Example
Figure 1.1 - Fibonacci Retrace Support Level

As refer to example above Reliance stock was consolidating since year 2009 to 2016, but when it grows in 2017 and breach its previous top marked as “1”, it stated rally northward. This was very evident signal of uptrend, hence we will apply the retrace tool from “3” to “2” to have a look at probable support are provided by the Fibonacci retrace tool, those levels are 38.2%, 50% & 61.8%. In above example it is clear that Reliance took support of 50% level. Thus once we have a clear picture of stock trend we can project the probable support region during uptrend and resistance region during down trend.

How To Identify Fibonacci Retrace Confluence Zones.

Once you master the concept of simple Fibonacci price retrace grids, you will likely begin asking yourself “Where do I begin my Fibonacci grid if I see more than one swing low to begin drawing the retrace grid?” This is an excellent question, and the quick answer is to start grids at the immediate swing low in price and draw to the immediate swing high. However, instead of ignoring prior swing lows, astute traders find value in drawing identical Fibonacci retrace grids that end at the most recent swing high to multiple beginning points based on prior swing lows in an established uptrend. Using this technique, traders are able to find hidden confluence or convergence levels of Fibonacci grids that can provide valuable information available to those who use this method.
A traditional Fibonacci retrace grid starts at a key swing low and ends at a key swing high in an uptrend to find a lower support level, or alternately, starts at a key swing high and ends at the most recent swing low in a downtrend to find an overhead resistance level. When price undergoes a lengthy uptrend or downtrend, multiple swing levels form which create multiple departure points to create Fibonacci grids. Instead of finding the three primary retrace levels to expect a price reversal, Fibonacci retrace confluence grids drawn off multiple swing lows to a common swing high help find the more important potential turning points in a market. The goal is to observe any exact price retrace level confluence and then observe any resulting retrace levels that overlap relatively close to additional retrace levels. In taking the extra time to find convergence zones, you can gain a quick edge over traders who use single retrace grids exclusively.

Drawing Fibonacci Confluence Retrace Grids.

Similar to the rules of classic Fibonacci retrace grids, a trader who draws multiple grids off-key swing lows attempts to find confluence zones of major Fibonacci retrace levels. Instead of drawing a single retracement grid as drawn above, a trader would draw a retrace grid that ends with the most recent swing high in an uptrend but begins at two, three or more key swing lows in an established uptrend. To find overhead confluence resistance levels in a downtrend, a trader would end with the most recent swing low and then begin a classic Fibonacci retrace grid at two, three, or more swing highs in an established downtrend.

The purpose of drawing a Fibonacci retrace confluence grid is to find hidden, important levels of convergence starting with more than one standard Fibonacci Retrace grid. Instead of finding the three main retrace levels, a trader is interested in finding price levels where two or more main Fibonacci grids align closely or exactly.

The following steps represent the order a trader should take to draw multiple Fibonacci Retrace Grids:

  1. Establish that price is in a confirmed uptrend.
  2. Observe a recent price swing high and note that price is retracing down from this high in price.
  3. Use the Fibonacci Retrace tool to start the grid by clicking on the most recent swing low in price and dragging the grid to the most recent swing high in price.
  4. Continue drawing similar Fibonacci Retrace grids in the same manner from prior key swing retrace lows in price.
  5. Observe the levels that align closely and watch for price to move toward these levels.
  6. Consider establishing a buy position in the event that other forms of analysis such as reversal candles, momentum divergences, or other forms of support align at or near the confluence price level.

For finding confluence retracement grids in a downtrend, repeat the same procedure but begin each new grid at prior swing highs in a downtrend and end each grid at the most recent swing low in price in order to uncover confluence overhead resistance levels to establish short-sale positions on any momentum divergence, reversal candle, or other methods of charting that uncovers resistance levels or sell signals.

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