Fans of Fibonacci principles see them as a bedrock of price movement analysis and a way of explaining the ‘natural’ ups and downs of the market, and they are willing to put their money behind trades based on ‘Fib’ analysis. Read on to learn more about the Fibonacci trading strategy.
Developing an understanding of the influence that Fibonacci strategies have on the markets is beneficial even if you don’t directly follow them. Plenty of other investors will be using them, and there are countless examples of instances where they have been an effective trading signal, some of which are outlined below. The ‘Fib levels’ are definitely something to look out for and are often referred to in analyst research notes or news commentary.
In this guide, we’re going to look at the following:
- What is Fibonacci?
- Fibonacci retracement and extension
- Why Fibonacci works
- Developing strategies using Fibonacci levels
- Using Fibonacci with a combination of other signals
What is Fibonacci?
What is Fibonacci, or more accurately, who was Fibonacci? Born in Pisa, Italy in 1170, Leonardo Bonacci picked up the nickname Fibonacci and an interest in the Hindu-Arabic numeral system. His research included a simple calculation that at initial glance looks unlikely to help predict much at all, let alone price moves in financial markets.
Taking numbers in order and adding the previous two numbers together, he came up with this file of data:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89…
Note: the process (1+1=2, 1+2=3, 2+3=5, 3+5=8…) starts after the zero and first one.
The pattern interested Fibonacci because however far you take the number sequence, any number in the sequence is 1.618 times larger than the preceding one. This number, Phi, also refers to the Golden Ratio, the mysteriously common ratio relating to patterns found in architecture, geometry, fine art and biology, and including flower petal patterns and the formation of tree branches.
The next step involved inverting the process, dividing any number by the one following it in the sequence and observing the pattern that the resulting number was always 0.618 – for example, 21/34 = 0.618.
Any number divided by the second following number – for example, 21/55 – always equalled 0.3819 and any of the numbers in the sequence divided by the third following number equalled 0.263.
The major Fib levels that are extracted from the list of numbers in Fibonacci’s relatively simple list are 1.618, 1.3819, 1.263 and inverted 0.618, 0.3819 and 0.263. Applied to the financial markets, the theory goes that after a move in one direction, price retracements fall back to one of those Fib levels with an alarming frequency before carrying on in the direction of the initial move.
Fibonacci Retracement & Extension
Fibonacci retracement and Fibonacci extension are two terms that use the same core principles of Fibonacci to explain different types of price moves.
What is a Fibonacci Retracement?
In the below chart, the price of gold rises from $1,679 (A) to $1,915 (B), and when the momentum associated with that move subsides, price retraces to $1,769 (C), which is the 61.8% Fib level. Price holds at that level, and after consolidating, it then continues its upward movement.
Fib strategies can be used for downward as well as upward price moves. During a different time period, the underlying momentum in the EURUSD currency market was downwards.
The short-term retracement in the below chart shows the retracement from 1.154 to 1.177 being a short-term price increase to the 23.6% Fib.
The trick for investors and traders is to be able to spot which peak and trough to use and at which Fib level the retracement is expected to run out of steam. Each Fibonacci level is calculated by dividing the area between the trend high and trend low and applying the Fibonacci sequence ratios.
As a general rule of thumb, the stronger the underlying momentum, the more likely that any retracement would be shorter-lived and so to the 23.6% Fib. Weaker moves, such as that in the example from the gold market, could see price retrace further to the 61.8% Fib.
What is a Fibonacci Extension?
Fib extensions use the same primary data set 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89… but invert the ratio, so the key levels to look out for are 1.236%, 1.382% and 1.618%. The below price chart of the S&P 500 stock index shows its upward move A to B, then retrace to C, before carrying on. The Fib extension levels show price went higher than 4474 (B) before beginning to consolidate in the region of the 1.236% Fib extension. Those trading a Fib strategy, whether they went long at A or C, or anywhere else along the way, will be able to use the Fib extension levels as target points for exiting the trade.
The keen-eyed will note that 50% and 1.50% tend to also be included as levels in Fib charts. The number is not actually a Fib number generated by dividing or multiplying sections of the series 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89… The reason 50% is included in most charting software is that it is such a psychologically important level.
Why Fibonacci Works
As with all trading strategies, there are those who are opponents and proponents of how useful Fib strategies can be. While there are some grey areas around the topic, the below reasons help explain why it is so popular.
- Simple but powerful – The core principles of Fib strategies are relatively easy to grasp. Some technical analysis indicators use much more complicated formulae to develop trading signals and Fib is not one of them. Ideas that are easier to understand have a better chance of being adopted more widely.
- Natural order – The references found in nature, the patterns of seashells and formations of stars offer an intuitive feel that there is something ‘just right’ about Fibs.
- A self-fulfilling prophecy – If certain ideas become adopted by a large enough proportion of the market, then that alone can be enough to make them work. Even those who don’t regard Fib theory as being worth basing investment decisions on can still make a profit from following the actions of others. Fibs are one of the best-known technical indicators, and most people in the market will be at least monitoring them and possibly trading them.
- Easy to use – Open any trading dashboard and you’ll be able to find a market with a price chart where the real-time price is sitting at a Fib level of some sort. The software tools used to overlay the Fib levels involve clicking on a peak and a trough of a price chart and then all the Fib levels are laid out in front of you. The ease with which Fibs can be found just adds to their appeal.
It’s worth considering opening a Demo account to establish how easy it is to spot Fibs and practice putting on positions based on them using virtual funds. That way, the learning process is risk-free. You’ll struggle to find a broker that doesn’t have tools that allow you to apply Fib levels to charts, and as mentioned, it only requires two clicks to set up that familiar ladder-style graphic. Depending on which broker you choose, it can take as little as 10 seconds to register for a Demo account, and within a matter of moments, you can be set up trading Fib-based strategies using real-time prices but virtual cash.
Developing Strategies Using Fibonacci Levels
As with the examples in the Gold, USDEUR and S&P 500 price charts, Fibs can be used in any trending market. Retracements and extensions can be identified and used as signals of trade entry and exit points, and it’s only in sideways trending markets where Fib analysis breaks down.
Using Fibs to Set Trade Entry Points
There isn’t any advanced mathematics required to spot trade entry points. The simplicity of the strategy is that it’s just a case of identifying the initial move and following pull-back, and these are everywhere in the market. Some of the skill is learning how to identify which peaks and troughs to use as A and B and which of the choice of Fib levels to use. It takes some time and quite a lot of trial and error to get used to identifying the Fib to match different market conditions, which again points to the benefit of starting off using a Demo account.
Using Fibs to Work Into a Position
Take an example where a whole pile of analytical research is pointing towards putting on a position. Using Fibonacci strategies can help with the process of working into the position to allow for a more elegant entry into the trade. Some capital is allocated at the 0.263, some at the 0.381, and some at 0.618. You, of course, might not get filled at all levels, but if you’re looking to benefit from averaging into a position, then Fibs are a convenient indicator for when to do so.
Using Fibs to Set Stop Losses
Not only do Fibs help traders to spot entry and exit points, but they also help with risk management. One common strategy is to place stop losses behind a Fib level. This fits in with standard technical analysis, so if the support breaks, then losses are capped.
All Asset Groups
No asset market experiences price moves that go in a straight line. The jagged pattern of peaks and troughs can be found in any sector ranging from crypto to bonds. Bull markets in the equity sector are typified by extended periods of upward price movement with periodic retracements. These opportunities to ‘buy the dips’ are a happy hunting ground for investors looking for the optimal time to join the rally.
Trade Short as Well as Long
The Fibonacci patterns apply in markets where momentum is leading towards decreases as well as increases in asset prices. While stock markets tend to have a natural bias towards gradual upward movement, the forex markets in particular have no particular bias to upward or downward movement. Fibs can be used to spot trade short position entry points, such as the one seen in the USDEUR example.
Incorporating Fibonacci Levels Into Other Strategies
Fib levels are very real-time in nature. They provide an instant update on where price is in terms of support and resistance levels. However, Fibs can be used as part of other strategies such as those using Elliott Wave Theory. These use a sequence of Fib indicators as part of a longer-term strategy.
The Impact of Time Intervals on Fibonacci Strategies
Each trading situation needs to be considered in its own right, but the general consensus among analysts is that Fibonacci retracement patterns are more reliable if taken over a longer time frame – a 38.2% retracement on a weekly chart being more important than at 38.2% retracement on a 10-minute one.
Which Fibonacci Level is Best?
While the likelihood of one or other Fib level coming into play depends on the specific market conditions of the time, analysts do tend to prioritise some levels more than others. The 23.6% and 38.2% levels are not as widely referred to as the 61.8% and 50% levels. As with other aspects of Fibonacci levels, it’s a case of getting a feel for what the broader market is watching. The fact that those two numbers are the most keenly discussed makes them the ones to watch.
Over-trading and impatient trading are two of the fastest ways to lose money. Using Fibonacci retracements to identify trade entry and exit points might not be 100% accurate, but it might stop you putting on bad trades at the wrong time.
Using Fibonacci with a Combination of Other Signals
Fibonacci strategies are one of a long list of technical indicators available to traders. They are very popular and very user-friendly, but one important factor to consider is the benefits of using a range of different signals at the same time. A buy signal using Fib levels that corresponds to one using indicators, such as moving averages or relative strength index, is a stronger signal than one that is not.
Fib Analysis Case Study – Buying Bitcoin Using Fibs and Moving Averages
Cryptocurrencies are one market associated with wild price moves and potential dip-buying opportunities. The extreme volatility means that risk-reward is scaled up, but the fundamental principle of trying to find a collection of signals rather than just one still applies.
After its eye-watering price surge in 2020, Bitcoin experienced a series of price pull-backs through the first half of 2021. For many who missed the initial upward move in the price of BTC, this was a chance to get over their FOMO. At the point in the below chart, 25th March 2021, there was some uncertainty about which way price would go next.
The daily price chart was showing relatively clear peaks and troughs, which meant that it was easy to overlay the Fibonacci price levels that confirmed that the price of $51,418 was sat at the 61.8% Fib level. Price had fallen back 61.8% from its initial move.
The confirmatory signal was provided by the simple moving average (SMA) with the 50-day moving average being at the $50,963.
With the benefit of hindsight, we can see that a long position in BTC placed on the basis of those two indicators signalling ‘buy’ would indeed have been profitable, at least if it was closed out prior to 22nd April. The risk on the trade could have been managed by placing a stop loss below one of the following support levels:
- $50,963 50-day SMA
- $50,000 psychologically important price level
- $48,989 – 76.4% Fib level
Assuming entry price at $51,418, target price at the previous high of $61,172, and the stop loss set at the lowest of the three levels, $48,989, then the win-loss cost ratio = (61,172 – 51,418) / 51,418 – 48,989) = 4.01. If faced with the same scenario on four different occasions, only one of the trades would have to go as planned to break even, which would be a ratio that’s acceptable to many trading profiles.
The Bottom Line
- One of the major benefits of Fib strategies is that they are so simple to use.
- Overlaying Fib graphics onto a particular price chart is easy to do, and there is good reason to believe that a lot of traders and analysts across the rest of the market are also doing the same.
- Another benefit of understanding and using Fibs is that they occur with an uncanny frequency. In the financial markets, it often counts to follow the herd, or at least be aware of what indicators the herd is using.
- Read here about the ways Resistance and Support levels can help identify trading opportunities.
- This article helps readers take Fibonacci to the next level with the use of Harmonic Levels.
- Head here to find out how Fib levels play a part in determining Pivot Points.