Leonardo Pisano, nicknamed Fibonacci, was an Italian mathematician born in Pisa in 1170. His father, Guglielmo Bonaccio, worked at a trading post in Bugia, now called Béjaïa, a Mediterranean port in northeastern Algeria. As a young man, Fibonacci studied mathematics in Bugia, and during his extensive travels, he learned about the advantages of the Hindu-Arabic numeral system. This knowledge has since become a foundation for modern mathematical concepts, including those useful for trading beginners.
The Golden Ratio
In 1202, after returning to Italy, Fibonacci documented his learnings in the “Liber Abaci” (“Book of Abacus”). In this book, Fibonacci described the numerical series now named after him. In the Fibonacci sequence, after 0 and 1, each number is the sum of the two prior numbers. Hence, the sequence is as follows: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, and so on, extending to infinity.
Each number is approximately 1.618 times greater than the preceding number. This value, 1.618, is called Phi or the “Golden Ratio.” The Golden Ratio appears frequently in the natural world, architecture, fine art, and biology—from the Parthenon and the Mona Lisa to sunflowers and spiral galaxies.
Fibonacci Levels Used in Financial Markets
In trading, Fibonacci retracement levels are derived from the mathematical relationships between numbers in the Fibonacci sequence. These levels include 23.6%, 38.2%, 50%, and 61.8%. The key Fibonacci ratios are calculated as follows:
- 61.8%: Derived by dividing a Fibonacci number by the number that follows it (e.g., 89/144 = 0.618).
- 38.2%: Calculated by dividing a Fibonacci number by the number two places to the right (e.g., 89/233 = 0.382).
- 23.6%: Derived from dividing a Fibonacci number by the number three places to the right (e.g., 89/377 = 0.236).
These levels are plotted on a chart by identifying high and low points and marking these key ratios horizontally. Traders use these horizontal lines to pinpoint potential price reversal zones. The 50% retracement level, while not directly linked to Fibonacci, is also widely used as a psychological and technical indicator.
Fibonacci Retracement Levels as a Trading Strategy
Fibonacci retracements are often employed as part of a trend-following strategy. Traders observe retracements within a trend to make low-risk entries in the trend’s direction using Fibonacci levels. For instance:
- In a downtrend, traders might look for the price to retrace to the 38.2% or 50% level before resuming its downward movement.
- In an uptrend, traders may expect prices to bounce from the Fibonacci levels back upward.
Example:
On the EUR/USD daily chart, a major downtrend began in May 2014 (Point A), bottomed in June (Point B), and retraced to approximately the 38.2% Fibonacci level (Point C). This retracement level provided an excellent entry point for short positions, anticipating the continuation of the downtrend.
Enhancing Accuracy with Other Indicators
The probability of a reversal increases when multiple technical signals coincide with Fibonacci levels. Examples include:
- Candlestick patterns
- Trendlines
- Volume indicators
- Momentum oscillators
- Moving averages
The combination of these indicators creates more robust reversal signals. Fibonacci retracements are versatile tools used across various financial instruments, including stocks, commodities, and forex, and they are applicable on multiple timeframes. Notably, retracements on longer timeframes (e.g., weekly charts) hold more significance than those on shorter ones (e.g., five-minute charts).
Using Fibonacci Extensions
Fibonacci extensions complement retracements by providing profit targets. These levels are drawn beyond the 100% retracement level and include 161.8%, 261.8%, and 423.6%. For example, using the EUR/USD chart, a trader entering a short position at the 38.2% retracement level might set a profit target at the 161.8% extension level (e.g., 1.3195).
The Bottom Line
Fibonacci retracement levels often indicate reversal points with remarkable accuracy. However, they are not foolproof and are best used as part of a comprehensive trading strategy that incorporates other indicators to confirm signals. For trading beginners, these tools can provide a structured way to identify potential entry and exit points.
At Axel Private Market (axelprivatemarket.com), traders can explore tools and resources to enhance their trading strategies, including the application of Fibonacci retracement levels to identify low-risk, high-reward opportunities within long-term price trends.
