A technique from 1202 - Really?
Who was Fibonacci?
Fibonacci (1170 – c. 1240–50), also known as Leonardo Bonacci, Leonardo of Pisa, or Leonardo Bigollo Pisano was an Italian mathematician from the Republic of Pisa, considered to be "the most talented Western mathematician of the Middle Ages".
Fibonacci popularized the Hindu–Arabic numeral system in the Western world primarily through his composition in 1202 of Liber Abaci (Book of Calculation). He also introduced Europe to the sequence of Fibonacci numbers, which he used as an example in Liber Abaci.
You may have seen this?
This is what’s called the Golden ratio. I am not looking to go into depth on Fibonacci use cases, spirals, fans, arcs, circles, wedges and channels. However, it was important to mention so you can go away and do your own research on Fibonacci beyond this “welcome to” post.
Why is this useful for trading?
The Fibonacci sequence is quite possibly the most used tool in trading stocks, Forex, Commodities and even crypto.
In mathematics, the Fibonacci numbers, commonly denoted Fnuch that each number is the sum of the two preceding ones, starting from 0 and 1.
However, you are probably more familiar with Fibonacci extension and retracement levels.
It’s all based on the same logic.
Fibonacci numbers appear unexpectedly often in mathematics, so much so that there is an entire journal dedicated to their study, the Fibonacci Quarterly. Applications of Fibonacci numbers include computer algorithms such as the Fibonacci search technique and the Fibonacci heap data structure, and graphs called Fibonacci cubes used for interconnecting parallel and distributed systems.
They also appear in biological settings, such as branching in trees, the arrangement of leaves on a stem, the fruit sprouts of a pineapple, the flowering of an artichoke, an uncurling fern, and the arrangement of a pine cone's bracts.
Just look at this image once more!
So what?
The fact that these numbers appear in nature, it has clearly been adopted in art and architecture – this is due to the human desire for pattern recognition. It’s built into our DNA, the fact that we as a collective want to identify such patterns, will in fact drive charts.
I have written articles on Elliott Waves - which again is quite possibly one of the biggest use cases for Fibonacci, definitely an easy way to see the powers at work.
Here’s a link to one such article;
How to use Them?
If you have been trading for some time you are most likely familiar with Fibonacci techniques, if you are new, here is some basic logic to get you started.
As mentioned above there are several tools for Fibonacci, as a new trader I would suggest only looking at extensions and retracements to start you off.
Retracement
These levels often work well as support and resistance, you will find opportunities to enter on pullbacks (retracements) against the overall trend. Common levels here are 23.6%, 38.2%, 50% (although it’s not technically a real fib level, another topic for another time) then of course the 61.8% and the 78.6%.
How to draw these on the chart – you are looking for 3 points let’s assume A,B & C. You are looking for A to be at the start of your trend. Often this will be a swing low or high.
Let’s assume we are looking at an uptrend and we want to see the pullback. A would be placed here as above.
The next step is to use the extension tool and click A and drag to point B as below;
and the pullback level;
Now we have a move A to B we can start to look for areas of interest, in this example we can see the pullback was to the 38.2% level.
Some people are critical on the levels, for me I like it to tag the level and if it goes a little deeper then I still like it, if it doesn’t tag the level I would round it down to the lower level. Meaning if it fails at say 37.9% I would like to still think of it as only the 23,6% fib level. But there is no hard and fast rule on this.
Now this gives me A and B with a 38% pullback for C.
One way to trade using this could be a simple Buy at the break of B with a stop “Below” C
Not telling you this is what you should do, it’s just one method some do use. Obviously, you could increase the stop and put it under A instead.
Difference between Retracement and Extensions?
The data you gather by assessing the pullback becomes valuable when looking for potential targets, so whilst we used 2 touch points (A & B) for getting the retracement level, the most accurate extension forecasting tool would be to use all 3 (A, B and C). Although it can also be done by using only A and B as well, It’s another one of those not so clear rules.
Whilst the retracement tool gives us the pullback, the extension will give us some target areas.
Let’s start with the simple (not my preferred) method;
This is known as the extensions – 2 points (A, B) drag the curser from A to B and click and then back to A and click off.
With this method you will notice in your back-testing those areas of interest will often be at the 61.8% of the A to B move. This means if A + B = 100, then the target would be around 161-2.
Also, the 100% of the A-B move giving a target example of 200 and lastly the 1.618 level. Giving a target of 261-2 level. Again, no hard fast rule. This is just something seen over and over again.
Expansion levels
To start with go from A to B with the extension tool and pullback to C and click off. Assume you are using TradingView
Much like the Extension you will notice similar characteristics of the moves up (in this example of the uptrend)
Something interesting
I mentioned above this is a great tool to use alongside Elliott Waves, here’s an example of how this works and can fit into the charts.
In this image above we use the same A point as a starting point, B becomes the 1 and 2 becomes the C. We can then work the Fibonacci extension & expansion levels to determine where 3 is likely to go. And then we can use the retracement for the pullback for (4) as well as new extensions for the projection of the 5th wave.
A few months back, I wrote an article here on tradingview on the psychology on the charts, it’s worth highlighting that here.
Click the link/image to view the article;
Nothing is 100% certain, but using these methods will help give you a better understanding of waves and swings, logic for pullbacks and reason for extension levels.
I hope this helps someone out here!
Disclaimer
This idea does not constitute as financial advice. It is for educational purposes only, our principle trader has over 20 years’ experience in stocks, ETF’s, and Forex. Hence each trade setup might have different hold times, entry or exit conditions, and will vary from the post/idea shared here. You can use the information from this post to make your own trading plan for the instrument discussed. Trading carries a risk; a high percentage of retail traders lose money. Please keep this in mind when entering any trade. Stay safe.
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