The Fibonacci sequence is a series of numbers where every number is calculated by adding together the two preceding numbers. This pattern can be found throughout the natural world, including in seashell spirals and sunflower patterns, and is also relevant within the financial market.
Leonardo Fibonacci, an Italian mathematician, introduced the Fibonacci sequence in 1202 in his book Liber Abaci. Fibonacci posed a thought experiment involving rabbit breeding, leading to a sequence where each number is the sum of the two preceding ones.
The Fibonacci sequence is expressed as: 0, 1, 1, 2, 3, 5, 8, 13, 21, and so on. As the Fibonacci sequence advances, the ratio between consecutive numbers (the first number divided by the second number) approaches approximately 1.618, a number known as the Golden Ratio.
The pattern is commonly used to calculate ratios that traders and analysts apply to identify turning points in price charts.
Fibonacci in Trading
In technical analysis, traders add Fibonacci ratios as horizontal lines on a chart to identify potential support and resistance levels to predict targets and potential trend reversals, known as Fibonacci retracement levels.
What are Fibonacci Retracement Levels?
Key Fibonacci levels used in trading include 23.6%, 38.2%, 50%, 61.8%, 78.6%, and typically come from calculating the relationships between the numbers in the Fibonacci sequence.
The Fibonacci sequence number string derives all the Fibonacci retracement levels. For example, dividing a number by its following number results in 0.618 (61.8%), which is a key Fibonacci level. Dividing it by the second number following it results in 0.382 (38.2%), another key level. Every level outside of 50% (which is not a Fibonacci number) is based on some calculation within this number string.
Fibonacci retracements are used to identify potential pullbacks within an existing trend. Suppose the price of Bitcoin rises by $1000 and then drops by $236. In that case, it has retraced 23.6%, which is a Fibonacci number. If the price dips further, traders might look at the next retracement levels of 38.2% or 61.8%.
Of note, Fibonacci extensions are also calculated using the string of numbers and are used to project potential price targets beyond the current trend, like during price discovery. Common extension levels include 61.8%, 100%, 161.8%, 200%, and 261.8%.
How to Use Fibonacci Levels
Traders tend to use Fibonacci retracement levels to know when to enter and exit a trade.
For example, during an uptrend, a trader notices that the price of an asset has decreased by 38.2%. This could provide the perfect entry to purchase that asset with the hopes that the asset will recover that retracement.
Longer-term traders can use the Fibonacci retracement levels as key reference points for setting stop-loss orders. If you’re unfamiliar, a stop-loss order acts as a safety net to automatically sell a trader’s position if the market price drops below that level. Traders might place their stop-loss just below a key Fibonacci retracement level to protect their capital if the price continues the downtrend rather than bounce from that level.
Fibonacci Sequence Essentials
- The Fibonacci sequence, found in nature and art, also has applications in trading through retracement levels, which indicate potential support and resistance areas.
- Key Fibonacci retracement levels, derived from mathematical relationships within the sequence, include 23.6%, 38.2%, 50%, 61.8%, and 78.6%.
- Traders use Fibonacci retracement levels to identify potential entry and exit points, and as reference points for setting stop-loss orders to manage risk.