Mind The Math Behind Markets

"The four most dangerous words in investing are: 'this time it's different.'"

– Sir John Templeton

Fibonacci levels are widely employed technical analysis tools that help locate important resistance and support zones within an asset’s price chart. Such levels are based on the idea that after prices have experienced a strong move upward or downward, prices retrace a predictable portion of the movement before resuming in the original directional momentum.

What Is the Fibonacci Sequence?

The Fibonacci sequence was discovered in the 13th century by Italian number theorist Leonardo “Fibonacci” Pisano Bigollo. Fibonacci introduced Hindu-Arabic numerals to European mathematicians, and in his book Liber Abaci, developed a series of numbers (0, 1, 1, 2, 3, 5, 8, 13, 21, and 34) that stretches to infinity. Each number in this sequence is equal to the sum of its two previous numbers (0+1=1, 1+1=2, 1+2=3, 2+3=5, etc).

Another remarkable feature of this sequence is that each number is approximately 1.618 times greater than its predecessor. This common ratio between every number in the sequence is the foundation of the Fibonacci series, the applications of which can be found in areas as diverse as computer algorithms, biological studies, as well as in trading and investing.

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How Is the Fibonacci Sequence Applied to Trading?

Asset prices don’t move in straight lines. They typically trend directionally, whether upward or downward, or even sideways. Within these broader directional moves, prices often retrace a portion of the move, often referred to as a pullback, before resuming the previous directional movement. The Fibonacci common ratio, 1.618, is the foundation of the retracement levels commonly applied by traders and investors.

Fibonacci retracement levels are created by choosing two extreme price points on a price chart. The distance between these two vertical price points is then divided into the following Fibonacci levels – 0.00%, 23.6%, 38.2%, 50.0%, 61.8% and 100.0%.

0.00% marks the starting point of the price correction, while 100.00% represents a complete reversal back to the starting point of the original price move, measured by connecting the two extreme price points. The most important Fibonacci levels are 23.6%, 38.2%, 50.0% and 61.8%, which are horizontally plotted on an asset’s price chart to potentially locate high probability price reversal zones.

Considering the depth of the various Fibonacci levels, a 23.6% retracement is deemed to be relatively shallow. Shallow retracements happen often, but pullbacks from 38.2% and 50.0% are considered moderate and could potentially provide more reliable trade entry triggers.

The most important Fibonacci level for traders to monitor is 61.8%. This retracement level typically reflects the maximum distance up to which a pullback or “countertrend” price reversal can extend. If the countertrend fails to cross above or below the level, the result is the renewal of the original trend.

While Fibonacci levels may sound complicated, it is a really simple visual tool for identifying areas where an asset’s price will likely encounter congestion in the form of support or resistance. When you trade with FXTM, including on a Standard Account, you can add Fibonacci levels to the charts available on the MT4 and MT5 trading platforms.* Each platform comes loaded with several different Fibonacci studies, each of which can be applied to varying trading styles and strategies.

Another standout feature of Fibonacci levels is that, unlike other technical indicators, these levels are fixed horizontal price levels. The fixed nature of Fibonacci levels makes it easier for traders and investors to quickly identify potential price reversal areas.

How Do Fibonacci Retracement Levels Work?

When applied correctly, Fibonacci retracement levels are especially useful when other catalysts or momentum drivers are absent. The primary reason certain Fibonacci levels tend to work is because so many traders track them, and regularly use them as part of their trading strategy.

If a major Fibonacci level is identified on a daily or an hourly price chart, you can rest assured that a significant number of traders will be monitoring that level, eagerly waiting to initiate trades. In essence, Fibonacci retracement levels work because a number of investors place orders near these levels, producing the corresponding support and resistance zones.

Fibonacci Drawbacks

1. Academics often consider Fibonacci retracement levels to be an illusion, only functioning as a prediction that either directly or indirectly becomes true because of itself.
2. Fibonacci levels are not usually standalone trading entry signals and may require other confirmation from technical indicators like overbought/oversold oscillators or candlestick reversal patterns.

A Few Final Thoughts on Fibonacci Levels

Fibonacci retracement levels are used to locate areas where a pullback or trend retracement price move is likely to end. Fibonacci levels are ultimately useful for setting risk and reward parameters before entering a trade because of their significance. However, it is crucial to confirm reversal areas with additional signals like candlestick patterns, classical chart patterns, volume analysis, or oscillator action.

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*The MT5 trading platform is not yet available to UK traders.