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Mathematics plays an integral role in life and the capital markets. The ebbs and flows of market sentiment generate trends and then periods of consolidation. As consolidation occurs, the movements of price action are drawn to specific points, which can be measured using mathematics. One of the most important tools a trader can use to determine where an asset will find support or resistance is Fibonacci ratios. These ratios are common in forex trading as well as nearly all asset trading.
What are Fibonacci Ratios?
Fibonacci ratios were invented by an Italian mathematician named Leonardo Pisano Bigollo. The ratios are generated from Fibonacci numbers, which are a sequence where each number is the sum of the previous two numbers. 1,1,2,3,5,8,13,21,34 … etc. The Fibonacci ratios are calculated using the Fibonacci numbers. These include 0.382, 0.618, 0.786, 1.0. The Fibonacci ratios are calculated in several ways. A number divided by the previous number approximates 1.618 (13/8=1.625). The approximation nears 1.6180 as the numbers increase. This is referred to as the Golden Ratio. A Fibonacci number divided by the next highest number approximately 0.618.
How are Fibonacci Ratio’s Used?
Through technical analysis, there are many ways to use Fibonacci ratios. The most common are Fibonacci retracements. Most charting software provides access to some of the Fibonacci studies. Fibonacci retracements are ratios used to identify potential inflection points that be reversal points. These ratios are found in the Fibonacci sequence. The most popular Fibonacci Retracements are 61.8% and 38.2%.
What are a Fibonacci Retracements?
A Fibonacci retracement is a point that designates a level where the market is likely to find either support or resistance and possibly reverse. The 4-most common retracements are 23.6%, 38.2%, 50%, and 61.8%. A retracement would respond in a way that one of these levels would likely be a point where an asset price would find support or resistance.
For example, after an asset such as gold rises, you can apply the Fibonacci ratios to define retracement levels and the potential extent of the pullback.
As you can see from the chart of gold, prices rose from August of 2018 to March 2020 and then started to decline. Once the decline commences, you can draw a Fibonacci retracement to see a potential level of support. Fibonacci Retracements can also be applied after a decrease in prices to predict the length of a rebound. The first target of the decline in gold prices is the 38.2% retracement level which appears to be strong support and a level where gold prices rebounded. A retracement level below the 38.2% retracement on gold is 50% and then the 61.8% retracement.
Should Fibonacci Retracement Be Used Alone?
You can use Fibonacci retracements to find specific levels of support and resistance, but they should be used in conjunction with other studies. When an asset is falling, you want to consider whether the price is oversold before you purchase it. You might consider using an oscillator such as a stochastic or the RSI in conjunction with Fibonacci retracements before you pull the trigger on a trade.
Bottom Line
Fibonacci retracements are often used to identify support and resistance levels which might designate the end of a correction or a rebound that is counter to the current trend. There are several common Fibonacci retracements which include a short 23.6% retracements as well as the most common retracements which are the 38.2 and 61.8% zones. Other technical signals can be used to confirm a reversal. You might consider using an oscillator such as a stochastic or the relative strength index to confirm the Fibonacci retracement level.
