In mathematics, a Fibonacci number is part of a series where the following number is found by adding the previous two numbers. For example, a series begins with 0, 1, 1, 2, 3; therefore, the next Fibonacci number in the series would be 2 + 3, which is 5.
The Fibonacci numbers are important because they end up describing a phenomenon that extends beyond mathematics and into art and nature. The sequence leads to the golden ratio, which appears frequently in nature. In computer science, the numbers are used for recursion and in algorithms based on the binomial heap and binary searches.
Fibonacci concept adoption in trading
In trading, the concept of Fibonacci Retracements is used as part of a trading strategy that uses a ratio of the Fibonacci numbers. The ratios are based on the observation that every number is roughly 61.8% of the next number in the sequence. For example, the number 144 and 233, when divided, results in 0.61802, corresponding to 61.8%.
An additional observation exists, and this is based on the fact that every number in a Fibonacci series is 38.2 percent of the following two numbers. For example, the in the partial series 144, 233, 327, 144 divided by 377 produces a result of 0.38196, which is 38.2%.
Because these percentages appear naturally, traders look to Fibonacci as a significant trend that can be used to predict trading patterns.
Detecting trends using Fibonacci ratios
Some traders look to make entries into positions in either an upward or downward trend using these ratios as entry or exit points. If on the downtrend, traders generally use the numbers for shorting a position. Some other traders use other technical analysis tools such as candlesticks, volume, momentum, trend lines, among others to triangulate information and obtain a higher likelihood of a reversal.
Investors use these analytical tools in a wide variety of investments including stocks, bonds, and commodities. The types of investment that use the trading strategy vary and can include the best gold stocks or any financial instrument with fluctuating prices.
Fibonacci trading strategies
Some Fibonacci trading strategies include using retracement and trend lines with any market such as option, futures, and stocks. For retracements, a strategy has certain rules including finding a trending pair. What this means is that traders observe several points to see if the trend in price is upward or downward.
The next rule involves drawing a trend line. The idea is to draw the line on the support levels if the trend is upward or on the resistance levels if the trend is downward.
The third rule uses the retracement tool to mark the points of a Fibonacci swing low and a swing high. Afterward, the trader is to wait for the price to intercept the trend line.
Traders need to demonstrate patience and observation skills during this point in the trade as this is the critical moment when money is made or lost. During this time, the price of the stock or financial instrument may hit the trend line, as expected, or it may stall or reverse.
If the price breaks from the percentages that are expected, the behavior invalidates the trade and investors should look to execute a different trade. However, if the price hits the trend line between the Fibonacci ratios of 38.2% and 61.8%, then the trade meets the first criteria. If the price of the financial instrument closes above the Fibonacci number line (38.2%), then the entry point has been set.
Although the retracement strategy can be an effective use of the Fibonacci sequence, traders also use a combination of strategies that can improve results. Such strategies include using other technical analysis techniques to triangulate information for better insight into the behavior of a trade. The more information available to a trader, the better the decisions that can be made.