When it comes to technical analysis, one of the most well-known techniques is the Fibonacci ratio trading.
This ratio, which is sometimes termed the “Golden” ratio is a well-known mathematical relationship based on the sequence called the Fibonacci sequence.
Traders use these ratios in order to plot particular chart levels from price extremes. These levels are seen as particular resistance and support levels for the trade.
They can be plotted as horizontal or vertical lines, fans or arcs. We will take a look at some of the most effective Fibonacci trading strategies that one can employ.
What is the Fibonacci Ratio?
The Fibonacci Ratio is a ratio that has presented itself in a number of natural biological settings in nature. This is why it is termed the “golden ratio”.
It is calculated with the help of the Fibonacci sequence. This was developed by an Italian Mathematician where each number is the sum of the two numbers immediately preceding it. For example, the Fibonacci sequence is 1, 1, 2, 3, 5, 8 etc.
What is really important from the numbers though is the ratio of a number and the number immediately prior to it. This is 1.618 or 0.618 as the inverse.
This is particularly interesting as it applies to a number of elements in nature. For example, the ratio of the leave arrangement in plants or the dimensions on a starfish. It is also present in humans with the bones in our fingers with lengths at a ratio of 1.618 to each other.
Given that the financial markets are made up of human participants, many people are of the view that the Fibonacci numbers can be applied to charts.
The golden ratio is used to calculate various percentage levels which are used to plot the a number of lines in the Fibonacci chart. It is these levels that are of particular importance for the trader.
These percentage levels are the 38.2% level, the 50% level and the 61.8% level. As you can probably tell, the 61.8% level is the inverse of the Golden ratio and 38.2% is the the ratio of the numbers 2 away from each other. Some traders also include the 23.6% level and the 161.8% level as it gives them more granularity.
These Fibonacci percentages are then used in order to plot lines that are a specific percentage away from a particular pricing extreme. These lines are then used by the traders as resistance or support levels.
One of the most well-known Fibonacci trading techniques involves the use of the Fibonacci retracement. This is essentially a range of horizontal lines that are plotted at a certain percentage from the start to the end of a pricing advance. These are called the “retracement levels”.
In the below chart we have the USDZAR currency pair which has been plotted with 30 minute candlesticks. As we can see, the price hit a daily low at 8am Thursday 13.128. There was a subsequent advance to 13.3129 at 12am on the Friday morning.
The Fibonacci retracement is then calculated from the advance of the uptrend (100% level) and plotted till the end of the uptrend (0%). The numerous levels between these two extremes are the Fibonacci retracement levels. These include the critical golden ratio level at 61.8%.
As you can see, the prices did tend to reverse themselves when they hit some of these retracement levels. This acted as a resistance level for the price trends.
There are a number of different retracements based on these levels. All retracements that are less than 23.6% are considered “shallow” retracements. Retracements that are between 38.2% and 50% are considered moderate retracements. Lastly, you have the golden retracement which is at the golden ratio level (61.8%).
Fibonacci Fan Lines
Fibonacci Fan lines are slight adaption of traditional Fibonacci levels. These basically make use of the Fibonacci retracement levels to draw trend lines. These are then also used as support and resistance levels for a trending asset.
Below we have the example of S&P 500 with the retracement levels drawn. As you can see, we have also drawn trend lines from the start through each of the retracement levels. These are “falling” fan lines.
These trend lines will now act as support and resistance levels for the S&P 500 as we go forward. You could see the points at which the trend lines acted as resistance as the index attempted to reverse course.
Fibonacci Time Zones
Another interesting use of the Fibonacci levels is when plotted across different times. These are vertical lines that represent different times in the trading day based on the Fibonacci levels.
These Fibonacci “zones” are a number of days forward and are potential reversal points. These are not as indicative of potential reversals as the Fibonacci retracement but they are nevertheless monitored by some traders.
As the first few numbers in the Fibonacci sequence are quite close together, it is hard to make any reasonable adjustment at that point as it looks a lot like noise. However, it is when we get to the 6th retracement zone that the trader will start to take note.
In the below image, we have the Fibonacci time zones plotted on the USD/CAD pair with daily candles. As you can see there is quite a lot of noise with the first few candles. However, from 6th zone onwards the trader could have used these levels as indicators of potential reversals.
It is also important to note that because these are merely zones and are hence not hard reversal points. The trader should use them only as a guide. He should use other technical analysis tools to confirm his / her view about the potential reversal.
Now that you have an idea of some of the basic Fibonacci studies, it will help to take a look at some practical trades that could be implemented with these levels.
Due to the fact that Fibonacci sequences are Fractal, these strategies can technically be used for any time frame on the trade, even down to shortest frame.
Example 1: Shallow Retracement
We will take a look at an example of a shallow retracement which is a Fibonacci retracement that is below the 50% line. These usually happen quite quickly and require the trader to have a quick finger.
In the below chart we have the price of Spot Silver plotted with 15 minute candles. You can also see that we have plotted the key Fibonacci retracement levels given by the advance in the price.
As you can see, the trader would have noticed the shallow retracement at the 1576 level. Indeed this acted as a support level for the price of silver. The trader could have entered a long position on the price of silver and generated some profit from the increase in the price.
You can also notice that the original 0% level or initial high reached by the asset acted as a resistance level for the price of silver.
Example 2: Golden Retracement
The Golden retracement is one of the most well know Fibonacci retracements as it uses the key level of 61.8%. Traders treat the golden retracement as a stronger support level. It is also easier to act on the golden retracement as there is some distance between from the peak of the previous trend.
In the chart below, we have the price of Bitcoin with 30 minute candles as its timeframe. As you can see, the price was advancing from 4,065 to 4,478 over the course of the Wednesday and Thursday.
The Fibonacci retracement levels were plotted below that. As you can see, the golden retracement level is at 4,218 and these acted as a support level for the price of the asset for the whole of the Friday.
The trader could have used this retracement level as an opportunity to enter Bitcoin in a long position when it hit this support level. Indeed, this seemed to happen twice.
The retracement on Bitcoin seemed to continue downwards on its third attempt below the support given by the golden retracement level.
Example 3: Rising Fibonacci Fans
When there is an asset that is trending up in price, one can plot the Fibonacci fan lines given by the key levels and use these to determine key support levels for the asset. This allows the trader to monitor these support levels even with an asset trending up.
In the below image, we have the AUD/JPY cross plotted with 3 hour candles. As you can see, the price was advancing for a number of days. We have also plotted the Fibonacci retracement levels.
Along with the Fibonacci levels, we have drawn the rising fan lines that cross through these levels. The trader will observe that the 50% Fibonacci fan line level was acting as a support for the asset.
The trader could have used this as an opportunity to go long the AUD/JPY as it hit these levels at least four times over three days.
Eventually, the retracement broke through the support level given by the 50% level and began an advancement downward continuing the long retracement slide.
Example 4: Falling Fibonacci Fans
On the other side from the rising Fibonacci fan, one has the falling Fibonacci fan. This is used when an asset is advancing downwards and trend lines are drawn through the key retracement levels.
The trader will look to the Fibonacci fan levels to act as key resistance levels to the asset breaking through and trending upwards.
In the below image, we have the EUR/SGD that is plotted with 1 hour candlesticks. The price was trending lower from Friday the 11th to Monday the 14th. The Fibonacci retracement levels are drawn with the fan lines through the key levels.
As we can see, the falling fans are acting resistance levels to the price recovering from the adjustment downward. This happened on at least three occasions as the price was moving downwards. You can clearly see it on the 50% Fibonacci fan level as well as on the 61.8% (golden retracement) fan level.
Although the Fibonacci studies are seen as important levels when it comes to identifying corrections or a counter trend bounce, these do sometimes retrace themselves on occasion.
Fibonacci levels are also helpful to identify potential reversals of trends. However, these are termed reversal “zones” as they are slightly more complicated to identify with certainty.
This is the reason that the trader needs to confirm potential trend reversals with other tools such as momentum indicators, chart patterns and complex candlestick patterns.
Indeed, this is something that is not entirely restricted to Fibonacci retracement and trend levels. The more technical indicators that confirm a trading signal the more concrete and strong it is.