Many of the tools available for traders are based on the present or past. Candlesticks show current trends, moving averages show trends based on X amount of days or hours in the past. Fibonacci retracements are a bit different, as this is a tool to predict potential support and resistance levels.
The Fibonacci sequence
In the 11th century Leonardo of Pisa introduced the world to an unique sequence of numbers. This was called the Fibonacci sequence.
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233 etc.
Each number is based on the two numbers that come before it, and the pattern can go on forever obviously. Each number is approximately 1.618 times bigger than the number before it. This number is also called ‘the golden ratio’ and is referred to as ‘phi’ a.k.a Φ.
This number is also seen in nature a lot, but that’s something for another story. Alongside 1.618 other ratios are important as well, which include 0.382 (number from the sequence divided by the one two places to its right) and 0.236 (number divided by the one three places to its right).
These numbers are key to find patterns. Prices react to these levels quite regularly. This can give a trader optimal entry or exit points.
Applying the ratios
Before you start using the Fibonacci retracements in your analysis, you will first need to identify a ‘swing high’ and a ‘swing low’. These are the highest and lowest points in a chart. There’s however one requirement, these peaks need to have two lower peaks next to them. This gives your tool more strength, but it’s not crucial. Using the Fibonacci tools, you need to connect the swing low with the swing high. This means you start at the bottom and move to the top.
Each of the Fibonacci lines was used as a support line, with the strong downfall as an exception. This can give you an idea of where the price will land – and stabilize a bit – next.
When you want to use Fibonacci to indicate resistance levels, it’s key that you turn around the process and connect the swing high to the swing bottom. You will move from the top to the bottom.
Please keep in mind that Fibonacci lines can be useful to identify future support, but it’s in no way a guarantee. If you want to increase your probability, combine this tool with other indicators like RSI and Moving Averages. None of these can be considered false proof indicators, but when many indicators predict the same thing and outside influences are stable, they are very likely to turn out just the way it was predicted.