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Fibonacci in Technical Analysis

Fibonacci tools utilize special ratios that naturally occur in nature to help predict points of support or resistance. Fibonacci numbers are 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, etc. The sequence occurs by adding the previous two numbers (i.e. 1+1=2, 2+3=5) The main ratio used is .618, this is found by dividing one Fibonacci number into the next in sequence Fibonacci number (55/89=0.618). The logic most often used by Fibonacci based traders is that since Fibonacci numbers occur in nature and the stock, futures, and currency markets are creations of nature - humans. Therefore, the Fibonacci sequence should apply to the financial markets. There are many Fibonacci tools used by traders, they include:

  • Fibonacci Retracements
Arguably the most heavily used Fibonacci tool is the Fibonacci Retracement. To calculate the Fibonacci Retracement levels, a significant low to a significant high should be found. From there, prices should retrace the initial difference (low to high or high to low) by a ratio of the Fibonacci sequence, generally the 23.6%, 38.2%, 50%, 61.8%, or the 76.4% retracement.

Note that a trendline was drawn from a significant low (beginning of trend) to a significant high (end of trend). The chart below shows that Fibonacci Retracements can be used to retrace downtrend moves as well: fibonacci retracements act as support and resistance.  Notice after the bottom that price rallied to the 23.6% retracement level and then was promptly rejected downwards. After breaking resistance a few months later, the 23.6% retracement became support. Price rallied up to the 50% retracement level, where it ran up against resistance. Price continued to fluctuate between the 38.2% retracement level (acting as support) and the 50% retracement level (acting as resistance).

  • Fibonacci Arcs
Fibonacci Arcs are percentage arcs based on the distance between major price highs and price lows. Therefore, with a major high, major low distance of 100 units, the 31.8% Fibonacci Arc would be a 31.8 unit semi-circle.

After the significant bear market, the rally was stopped by the 50% arc; the 50% arc retracement acted as resistance, 38.2% arc than gave support, bouncing between the 50% arc and the 38.2% arc for many months. After price broke through the resistance arc at 50%, price moved up to the next significant Fibonacci ratio, 61.8%, where it found a new resistance level. The prior resistance level at 50%, after being broken, became a new support level. The next Fibonacci arc was at 100%, where price met resistance.

  • Fibonacci Fans
Fibonacci Fans use Fibonacci ratios based on time and price to construct support and resistance trendlines; also, Fibonacci Fans are used to measure the speed of a trend's movement, higher or lower. If prices move below a Fibonacci Fan trendline, then price is usually expected to fall further until the next Fibonacci Fan trendline level; therefore, Fibonacci Fan trendlines are expected to serve as support for uptrending markets. Likewise, in a downtrend, if price rises to a Fibonacci Fan trendline, then that trendline is expected to act as resistance; if that price is pierced, then the next Fibonacci Fan trendline higher is expected to act as resistance. The Fibonacci ratio is also used to predict areas of time in which price could change course.

  • Fibonacci Time Extensions
Fibonacci Time Extensions are used to predict periods of price change (i.e. lows or highs). For example, after a downtrend, a reversal would be expected at a significant Fibonacci Time Extension line. Similarly, after an uptrend, a reversal warning could occur if a Fibonacci Time Extension was soon approaching. The Fibonacci Time Extension tool is created by locating a significant high (low) and finding a significant retracement or extension low (high).

Fibonacci Tools are very popular, possibly the very reason that they appear to work. Whether or not a trader believes Fibonacci ratios work beyond nature and into the financial markets, traders should be aware of Fibonacci Retracements (most often used) and the other Fibonacci Tools. Because there are many traders out there who do believe that the Fibonacci ratios apply to the financial markets, that means there are real supply and demand forces working on the markets at these important Fibonacci junctures. This is important because, after all, supply and demand is the concept that moves the markets.