It is characteristic of the stock prices to fluctuate daily. The prices move from one direction to another and bounce back. Fibonacci levels play a critical role in highlighting movements.
Fibonacci is a popular term among technical traders thanks to the role it plays in helping them identify trend-trading entry points. The Fibonacci retracements are founded on numbers and their mathematical relationship.
Traders take two extremes on a stock chart and divide them by the key Fibonacci ratios to develop the Fibonacci retracements. Once identified, horizontal lines are drawn on the chart to determine possible resistance and support levels.
What is Fibonacci?
Leonardo Fibonacci, a mathematician, made the Fibonacci sequence of numbers. The series of numbers are such that they are the sum of the two preceding numbers, as in the example below.
1, 1, 2, 3, 5, 8, 13, 21 and so on. Note that the sequence is indefinite.
Understanding Fibonacci Retracement Levels
The argument is that the markets comprise Fibonacci ratios. Market movements don’t take place in a straight line. Traders employ the Fibonacci ratios to establish the different movement points, such as the points where the market resumes previous positions and where the prices stop.
The interesting thing about the Fibonacci retracement levels is that they often mark the reversal points with incredible accuracy. You can use the Fibonacci retracement levels for long-term investments and even day trading.
They also play an essential role in technical analysis tools to identify market cycles. Traders can also use the tool in the foreign exchange, commodities market, indices, and shares.
Essentially, they are sleeping lines showing where the resistance and support will possibly occur. The different Fibonacci levels are presented with percentages such as 23.6%, 61.8%, and 78.6%.
When a line is drawn between a high and a low, the Fibonacci indicator will create levels between the high and low.
How are Fibonacci Retracement Levels Used in Trading
The Fibonacci levels are created by dividing the vertical distance between the low and how points with the Fibonacci ratios. Then traders draw horizontal lines where ratios like 0.0%, 38.2%, and 61.8% are. While 50.0% is not one of the ratios, traders still use it, mainly because this is where most securities retrace.
Investors can draw the Fibonacci lines using a Fibonacci line tool on the charts on most trading platforms. For instance, if the trader analyzes an upward trend, they have to select the tool and drag it from the low to the high price. The indicator on the chart will then mark the ratios.
If you are observing a downward trend, the steps are similar. Select the Fibonacci tool and move your cursor from the highest to the lowest price; the key ratios will be marked on the chart.
Traders use Fibonacci levels to identify stop-loss levels, place entry orders, and set price targets.
Traders need to note that Fibonacci does not only apply to rising markets. Traders can use it during bouncebacks.
There are two common ways traders use Fibonacci. You can enter to make an aggressive entry at each level. Most traders will enter each level and place stop-loss orders on both sides. Alternatively, investors can lie in wait for the prices to reach resistance or support, then make an entry. Traders stand by for the prices to move back in the original direction at support and resistance.
The best levels to pay attention to are 38.2%, 50%, and 61.8% retracement levels; this is both for down trending and up trending markets as they represent the possible turning points.
Fibonacci Levels Pros and Cons
Fibonacci retracement levels have several benefits that traders should be aware of. The Fibonacci levels are subjective and can be used in several ways.
Some traders make profits using the indicator. Others may lose. Therefore, the different traders’ views on the indicator’s effectiveness will vary; others may view it as effective and unreliable.
It can be confusing for traders trying to understand the rationale behind the indicator’s trading strategies. Fibonacci doesn’t give traders easily identifiable weak or strong signals; instead, it helps them identify possible reversals, corrections, and countertrend bounces.
Traders apply Fibonacci levels for trend trading. The indicator is handy when an investor misses an uptrend; they can use it to identify a pullback. Plotting the ratios helps traders identify retracement levels and potential trading positions.
You can use the indicator alongside various other trading strategies and tools like the stochastic indicator and the MACD indicator. Fibonacci can be used during different time frames but is considered more effective with longer timeframes and a broader strategy.
While not every trader is comfortable with the indicator, Fibonacci levels can give them valuable insights into market turning points that are not so evident. However, the bottom line is you can use Fibonacci to cut losses on your trades and make profits.