While some people may be under the impression that mathematics rarely tangles with real-life applications, it’s very safe to say that mathematics is the building core of any technology we develop. The Fibonacci sequence is one of the most famous mathematical formulas that has found its way in a world of pure numbers- trading. Whether you are trading cryptocurrency, stocks, or fiat currency, you’ve probably heard about Fibonacci retracement and the predictions that can be produced by using it. The Fibonacci sequence has a simple idea behind it; a sequence composed of the sum of the last two numbers. It’s been dubbed “nature’s secret code” and “universal rule”. Believed to apply to the dimensions of the 3 Great Pyramids, flowers, seashells, and many iconic structures, both synthetic and organic. But how does it apply to trading and investment? Keep on reading to get to the bottom of this.
What are Fibonacci Retracements?
Technical traders are very familiar with Fibonacci retracements, and it’s important to understand that retracements don’t have a lot to do with the sequence of numbers but rather the mathematical ratios between them. In trading technical analysis, a Fibonacci retracement starts by taking two points, often the highest and lowest ones. The vertical distance between the two points taken is divided into 5 ratios; 23.6%, 38.2%, 50%, 61.8%, and 100%. If these levels are accurately identified, a trader can draw horizontal lines that show potential resistance and support levels.
The Identified Indicators
The retracement is important for traders who are trying to get an early start on their competition. It is set to determine stop-loss and target prices. If a stock or a currency starts to move higher, a trader would want to know when to place their order. As mentioned by NetPicks.com, the 30% retracement is a pretty good area to look for trades in as they allow you to catch trends at their earliest. The little dip in the currency after it plateaus a higher high can be anticipated with the 61.8% Fibonacci ratio. This is a pretty good entry point to the asset. On the other hand, traders who would like to place a stop-loss on a positively moving asset can place it right at a 61.8% level, as dipping below it could mean that it will reach a lower low.
In technical analysis, Fibonacci levels are the basis of different trading styles and theories, such as Gartley patterns and the Elliott Wave theory. Its best use in such scenarios is locating the reversal point where the asset can start moving in the opposite direction. Keep in mind that Fibonacci retracements are dependent on static ratios and not real-time calculated averages, making it much easier for a trader to identify their entry and exit points, in addition to inflections and break-out points.
How Do Ratios work?
The Fibonacci sequence is infinite as it takes the sum of the last 2 preceding numbers. What makes the sequence interesting is that the ratio between any two numbers on the sequence, except the first 4, is around 1.618. This is the foundation where technical traders define their retracements with. The 61% ratio is derived by dividing a number in the series by the number that comes after it. The 38.2% ratio is the result of dividing one number by the 2nd number that follows it. 23.6% can be obtained by dividing it with the 3rd following number.
Setting Retracement Grids
The key to using the Fibonacci retracement properly is to perfect setting the retracement grids. Using the wrong levels can mess up the entire plan you have by giving you useless points that you can’t rely on. It’s better to use multi-trend grids that allow you to combine both long-term and short-term frames to predict an accurate range in the future. Focus on using the 0.382, 0.50, 0.618, and 0.718 levels when you’re placing the grid in both uptrends and downtrends. The first 3 ratios are known as compression zones, where the price range will become tighter the more frequently it bounces, with the last zone being a signal to a trend shift. As you finish retracing both long-term and short-term zones, you will see a series of grids with lines showing support and resistance when aligned and whipsaws when not.
The claim that Fibonacci retracement is 100% accurate is wrong while claiming it not to work is also wrong. The main principle that the Fibonacci retracement is built upon is a mathematical anomaly, which doesn’t derive itself from logical proof, but rather a mathematical phenomenon. It is very useful in confirming a lot of indicators, especially when aligned with other technical analysis techniques.