Fibonacci studies are one of the keys to a good trading plan, so it’s important that you learn as much as you can about this concept.
Leonardo Fibonacci was an Italian mathematician who discovered naturally occurring ratios that tended to describe the proportion of things in the universe.
These ratios arise from a series of numbers:
1, 1, 2, 3, 5, 8, 13, 21, 34, 55…and so on
This series takes the previous two numbers, adds them together to make the next number, so for example 1+1=2 and 5+8=13 … and so on.
The way the ratios are derived comes from the fact that if you divide 2 of the numbers you get the ratio 0.618…. for example 5/8 = 0.618.
And if you divide alternate numbers you get the ratio 0.382… for example 13/34 = 0.382.
These ratios are called the “Golden mean” and have been applied to trading and are found on the Fibonacci retracement tool.
Here are the key retracement levels that you need to know about:
0.236, 0.382, 0.500, 0.618, 0.786
And here are the key extension levels that you need to know:
0, 0.382, 0.618, 1.000, 1.270, 1.382, 1.618
Ultimately you won’t need to know about how to calculate these levels etc because your charting package will do all this for you, but it is good to have an idea of where the numbers came from.
The concept is simple, traders look at retracement levels as potential areas of support and resistance whilst they look to extension levels as possible areas to take their profits.
Here is a chart example:
As you can see above we have applied the Fibonacci tool to the chart after the price has made its initial move up.
Then you can see that there are 4 red levels shown, these are the Fibonacci retracement levels from which we expect price to come down to and then bounce off back up.
Because most traders use Fibonacci it is a very powerful tool, and if you know how to apply it correctly in the market you can get yourself a distinct edge in your trade plan.
Next: Support and Resistance