How can I use Fibonacci Levels?

[Brian Hayslip]

[Steve Walters]

Even if they are relatively new to trading most traders have heard of Fibonacci levels. What they might not know is how Fibonacci levels came about, why they are important, and how Fibonacci levels can be used in their trading. Fibonacci levels were first introduced as a concept by the 13^th century Italian mathematician Leonardo Bonacci, who was given the name Fibonacci in the 19^th century by a historian. Fibonacci introduced a series of numbers that was seen to underpin most of the natural world. The series begins like this: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89...continuing infinitely. There are several unique properties about this sequence. First, each number is the sum pf the two preceding numbers. Each number is also nearly 61.8% of the next number, and the higher the sequence goes the closer to 61.8% this becomes. Each number is also approximately 38.2% of two numbers ahead and 23.6% of the next number in the sequence. Given these facts and others, modern traders in financial markets use the following levels as Fibonacci retracements: 76.4, 61.8, 38.2, and 23.6.

Why do Traders Use Fibonacci Levels?

We won’t go into the math behind Fibonacci levels here, but it is important to know that the sequence is found in many natural structures such as your own DNA, spiral structures, galaxies, architectural constructs and many other things. The key ratio used in most natural phenomena is 61.8%, which mathematicians call the Golden Mean, although financial experts refer to it as the Golden Ratio. Besides being found in physical structures we can also see the Golden Ratio as part of human psychology. Studies have found that if people are given two value-neutral choices the responses will typically be split 62-38, not 50-50 as you might expect. And this same ratio is found within financial markets, perhaps due to the psychology of the traders. In short, studies have found that the 61.8% and 38.2% retracement levels work as support and resistance in financial markets over and over.

What Do Fibonacci Levels Mean

Financial traders will use the following Fibonacci levels when looking for support and resistance levels: 23.6%, 38.2%, 50%, 61.8%, and 100%. The most popular of these are the 61.8% and the 38.2% level. It should also be noted that 50% is not a Fibonacci level but is included by traders because of Dow Theory, which says assets often retrace moves by 50%. But what do the Fibonacci levels mean and why are they important to traders? These levels repeatedly show themselves as support and resistance levels, and they have shown themselves to be important psychological barriers within markets. And this importance has increased as more and more traders come to use them, perhaps as something of a self-fulfilling prophecy. The Golden Ratio, or 61.8% is the most important Fibonacci level. It’s at this level where markets often see buying begin as bargain hunters step in to snap up discounted assets. The Fibonacci levels have shown themselves to be great places to watch during a breakout or a pullback as they often offer resistance or support. And many traders will wait until price moves at least 5% beyond a Fibonacci level to ensure price isn’t going to react to the level. This space is needed since Fibonacci levels are not exact.

How to Use Fibonacci Levels

Nearly any charting software these days will have a Fibonacci tool built in that will draw horizontal lines at the important Fibonacci levels. You will only need to determine the low and high points in the current trading cycle for the tool to use as a baseline. Some tools will also have you decide whether to base the lows and highs on closing prices or daily extremes. Which you use isn’t critical, as long as you remain consistent from chart to chart. Once the Fibonacci levels are drawn on your chart they can be used as good potential levels to place your stop losses and price targets. Many times price struggles when it reaches these Fibonacci levels, and if it does break through it will use the old support as resistance and vice versa. Do note that Fibonacci levels are not absolutes. You should use other indicators alongside the Fibonacci levels to confirm support and resistance, and to confirm break-through from these levels. Never think that a 61.8% Fibonacci level mean price will automatically stop right at that level. The levels don’t work that way, but they do provide you with a tool that can increase your chances of success when used intelligently.