How Fibonacci Trading Works

Fibonacci trading is a concept in the technical analysis of a security. Fibonacci trading is nothing but identifying support and resistance levels that will most likely trigger a price reversal.

The golden mean or phi is a result of the Fibonacci numbers. This proportion divides a measured wave such as price and gives potential levels of support and resistance. These levels signal a high probability of a reversal.

It is not always easy to understand the ins and outs of the financial market. This is especially true when the understanding and application of complex analytical methods becomes involved.

In this article, we will look at the history and background of Fibonacci numbers and The Golden Ratio.

We will then outline three specific money management tips that can help increase your profit potential. Support and resistance levels (?) are an important consideration for most traders. Support and resistance levels help to identify entry and exit points when trading.

The Fibonacci percentage retracement level is a result of the Fibonacci number sequence. The golden ratio is one such sequence which is very popular with many traders. But what are they exactly?

Brief history of Fibonacci numbers

A man named Leonardo of Pisa, who was better known as Fibonacci, first introduced the sequence to Western Europe in a book named Liber Abaci.

It is a pattern of numbers that usually start with zero and one. The next number in the sequence is always the sum of the previous two numbers.

Thus, if the previous digits were three and five, the next digit will be eight.

Thereafter, five plus eight (previous two digits) equals thirteen – meaning the next digit is thirteen. Eight plus thirteen (previous numbers) equals twenty-one meaning the next number is twenty-one.

The sequence starts like this: zero, one, one, two, three, five, eight, thirteen, twenty-one and continues. It was only in the 19th century that the theory of Fibonacci came to be known as the Fibonacci sequence.

Fibonacci trading and the Elliott Wave Principle

Ralph Elliott, widely known as the father of the Elliot Wave Theory put Fibonacci retracement and extension levels to use in work.

He developed a model called the Elliot Wave principle that suggests combined investor psychology moves in natural rhythms. In other words, collective buying and selling takes place according to natural patterns.

These patterns alternate between optimistic (upwards) and pessimistic (downwards) waves.

Elliot said that five waves (three optimistic and two pessimistic) are followed by three (two pessimistic and one optimistic). The pattern, slightly more complex, then repeats itself.

Only after Elliott developed his theory, did he realize that it is based upon Leonardo of Pisa’s theorem.

In essence, Elliott provides a framework (based on Leonardo’s pattern) that shows whether selling or buying will result in a gain or loss.

Elliott Wave Theory, Charles Dow and the Critics

This framework looks at previous waves (prices) and predicts whether the next wave (and how many of them) will be upwards or downwards. After the death of Ralph Elliott, the theory was introduced to Wall Street with the support of many researchers.

Certain economists even likened the contribution to that of Charles Dow’s. However, not everyone agrees with the theorem and some financial professors are against it.

Critics of the Fibonacci based trading methods however dismiss the theory on lack of scientific evidence and claim it to be a self-fulfilling prophecy, more than anything else. Those for it, however, continue to maintain that it occurs so many times in financial markets for it to be random.

How does Fibonacci Trading work?

The ratios arise from the following number series: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144 and so on.

This series of numbers is derived by starting with 1 followed by 2 and then adding 1 + 2 to get 3, the third number. Then, adding 2 + 3 to get 5, the fourth number, and so on. After the first few numbers in the sequence, if you measure the ratio of any number to the succeeding higher number, you get .618.

For example, 34 divided by 55 equals .618. If you measure the ratio between alternate numbers you get .382. For example, 34 divided by 89 = 0.382 and that’s as far as into the explanation as we’ll go.

These ratios are called the “golden mean“. These are the ratios you HAVE to know:

Fibonacci Retracement Levels 0.236, 0.382, 0.500, 0.618, 0.764

Fibonacci Extension Levels 0, 0.382, 0.618, 1.000, 1.382, 1.618

You won’t really need to know how to calculate all of this. Your charting software will do all the work for you. Besides, we’ve got a nice Fibonacci calculator that can magically calculate those levels for you.

How to use Fibonacci levels in trading?

However, it’s always good to be familiar with the basic theory behind the indicator so you’ll have the knowledge to impress your date.

Traders use the Fibonacci retracement levels as potential support and resistance areas. Since so many traders watch these same levels and place buy and sell orders on them to enter trades or place stops, the support and resistance levels tend to become a self-fulfilling prophecy.

One trader who incorporated Fibonacci numbers and The Golden Ratio into his trading was the legendary trader W D Gann.

We feel that the use of Fibonacci numbers with the Gann trading method provides traders with the best possible combination to seek long term trading profits.

Fibonacci Trading Example
Fibonacci Trading Example

An example of how to use Fibonacci levels is shown above. You can see how the 61.8% Fibonacci level acts as support and when it is breached, the 61.8% support turns to resistance.

Fibonacci Defines Stop Loss Levels

A trader can use Fibonacci numbers to set stop loss orders. For example, if there are three Fibonacci price levels within a certain price level, then traders can set a stop loss order above or below the level.

A Fibonacci number helps define stops in the following way, if a trader trades against a support zone, if the support zone is violated and the price trades below that zone, the reason for the trade is negated and the position should be closed.

Setting stops using Fibonacci retracements takes the emotion out of trading and gives a pre-defined exit point.

Fibonacci Defines Position Size

Depending on the risk you are prepared to take per trade, Fibonacci numbers can also define position size. For instance, if prices are right on a specific level, you may wish to have more positions than if the price is further away.

Fibonacci Defines Objectives

With Fibonacci trading, once a pattern completes against a Fibonacci price zone you can use them to set profit objectives to bank partial profits or tighten stop loss levels.

This clear objective for traders helps them to lock in profits. The great advantage of Fibonacci numbers and the golden ratio is the fact that they take the emotion out of trading and can define not only stop losses to exit a market, but also set profit objectives as well.

How Fibonacci trading works – Conclusion

There are many professionals who use a lot of different techniques in using the Fibonacci defined trading methods.  The space given us, however, is just not enough to discuss all of them.

Nonetheless, the methods discussed should be enough to give you a hint on how Fibonacci analysis works.  Should you want to further your knowledge about Fibonacci analysis and its components, there are a lot of web sites that offers online courses on the subject.

Again, some traders consider Fibonacci trading as advantageous while others do not.  There is, however, a key into making Fibonacci trading work for your advantage, and that key is proper knowledge of Fibonacci analysis.

Traders who become successful with Fibonacci trading have a deep knowledge on how to analyze market trends using Fibonacci analysis.