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In this article, we will get acquainted with a very familiar tool in the world of investment and financial analysis, which is Fibonacci. So, what is Fibonacci?, and how can the Fibonacci sequence be applied in real-life trading? Let’s explore this with COINSTRATEGISTS in the following article.
WHAT IS FIBONACCI?
Fibonacci is a technical analysis tool based on the Fibonacci sequence and ratios, developed by the mathematician Leonardo Fibonacci.
In reality, there are many studies related to the concept of Fibonacci. However, in the fields of forex trading, cryptocurrencies, and related areas that we will discuss, including: Fibonacci retracement and Fibonacci extension.
The Fibonacci sequence starts with the natural numbers 0 and 1, or 1 and 1. Each number in the sequence is the sum of the two preceding numbers, forming the sequence as follows: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144,…
FIBONACCI AND THE GOLDEN RATIO
Each number in the sequence, when divided by the preceding number, yields a value of approximately 1.618, a constant that appears repeatedly according to the rule. For example, 55*C = 89, and 89*C = 144. This is known as the golden ratio.
Through research and practice, traders have discovered that the Fibonacci sequence can be used to identify support and resistance levels, as well as to set up personal trading systems.
The most commonly applied ratios include: 0.236, 0.382, 0.5, 0.618, 0.786 (or 0.764), and 1.
We will proceed to explore the relationships within the Fibonacci sequence, including retracement and extension levels.
FIBONACCI RETRACEMENT
Among the Fibonacci-based trading tools, Fibonacci retracement levels are the most commonly used.
PURPOSE OF USE
Some people also refer to it as regression, and this is also accurate. Fibonacci retracement levels are used to identify potential support points when the market declines from a high to a low.
Conversely, when the market rises from a low to a high, this tool can be used to identify potential resistance levels. The Fibonacci retracement levels include: 0.236, 0.382, 0.618, 0.764.
HOW TO USE FIBONACCI RETRACEMENT
The Fibonacci indicator is most effective when the market is following a clear trend.
IDENTIFY FIBONACCI RETRACEMENT IN AN UPTREND
– Find the highest level in the trading timeframe you are observing.
– Identify the lowest levels since the initially determined high.
– Draw the Fibonacci retracement from the peak down through the successive low levels.
– Below is an example of how to generate profit with this method. You will follow these steps to determine:
– The highest level is set at 89.83, while the lowest level where the trend begins to reverse into an uptrend is 71.31.
– When drawing from the peak down to the bottom, you will identify 5 support levels: 0.236, 0.382, 0.5, 0.618, 0.764.
– At this point, you expect that as the asset’s price decreases from the peak, it will encounter support levels at these Fibonacci levels. Typically, many traders will place buy orders when the price corrects to these levels.
– Thoroughly assess the strength of the Fibonacci levels: 0.236 (weak), 0.382 (moderate), 0.5 (strong). From this, you can build a trading strategy as follows:
– The Fibo level 0.236 is weak; the price often surpasses it without much resistance.
– The level 0.382 acts as a support level, and the price returns to test the 0.236 level above. When the price fails to break through 0.236, it declines again to test the 0.382 level.
– Then, the price reverses right at the strong Fibonacci level 0.5. Finally, you can place a buy order near the 0.5 area whenever there is a corrective wave.
PROS AND CONS OF FIBONACCI RETRACEMENT
Although Fibonacci retracement is very popular, there are still drawbacks that you should be aware of.
PROS:
– All traders use the same Fibonacci ratios or other technical indicators, which can lead to price action reflecting these levels more clearly.
– You will gain deeper insights into market behavior.
– Traders achieve profits by applying Fibonacci retracement, thus validating its effectiveness.
CONS:
– Some experts argue that Fibonacci retracement levels lack mathematical and theoretical foundation, leading to their consideration as unsuitable for application in financial markets.
– Others view them as a form of self-fulfilling prophecy, as traders globally often rely on them when making decisions.
– For those who believe in the value of Fibonacci, understanding and interpreting the results accurately is not simple. You need to be truly proficient with Fibonacci to use it effectively.
NOTE:
Identify Fibonacci retracement levels on both short and long time frames to look for similarities. This will help you pinpoint significant Fibonacci levels.
When multiple Fibonacci levels clearly intersect, it may be a sign of an impending reversal. Previous Fibonacci support levels may turn into new resistance levels.
FIBONACCI EXTENSION
What is Fibonacci? If you have mastered the basic principles of Fibonacci, let’s explore how to apply them effectively.
– What is Trendline? How to recognize
PURPOSE OF USE
This type of Fibonacci helps you identify the targets that the price might be heading towards. After the price reaches the Fibonacci retracement levels, you can analyze to predict the next price target. This is a useful method for taking profit.
The Fibonacci extension levels will provide answers to this question. To apply the Fibonacci extension method, you need to identify three points: the peak, the trough, and the retracement point. The Fibonacci levels used in this method include: 0, 0.382, 0.618, 1, 1.382, and 1.618.
HOW TO USE FIBONACCI EXTENSION
– The price levels in Fibonacci extensions are determined based on previous price fluctuations, from the low to the high, using ratios of 1.272 and 1.618 to identify support levels.
– The extension levels are determined from the peak to the trough using the ratios of 1.272 and 1.618 to establish resistance levels.
– Typically, your third price target often stops at the 2.618 level if you accurately identify the two highs and lows.
To identify potential resistance levels when the price starts to rise again, knowing the positions of the 1.272 and 1.618 Fibonacci levels is crucial. This is because a sharp price drop can occur as soon as the price hits these resistance levels.
This is why identifying at least two previous lows is necessary, as illustrated above.
REVIEW
Firstly, there is no surefire way to determine which Fibonacci extension levels will act as strong resistance or support.
It is possible for the price to bounce back from a Fibonacci extension, but sometimes it can also break through this level. Another issue is that we may not accurately identify the peak, trough, and retracement zones, which depends on the experience of each trader.
MEANING OF THE FIBONACCI INDICATOR
Studying Fibonacci is valuable for estimating support and resistance levels, but it cannot provide precise points for deciding when to enter or exit a trade.
Another important point for traders to note is that Fibonacci tools should not be used in isolation; they should be combined with other technical analysis methods such as Elliott Wave Theory for more accurate predictions.
