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Using Fibonacci Ratios to manage your trades efficiently
Sphinxes, Pyramids and Pharaohs…
What do these have in common with the financial markets?
In the early 1200’s, an Italian mathematician Leonardo Pisano Fibonacci uncovered a secret about this ancient civilization that would revolutionize the entire mathematical world... including the financial markets!
While studying the Great Pyramid in Egypt, Fibonacci made a startling discovery and uncovered a unique mathematical sequence of numbers that changed several theories of trigonometry, algebra and geometry.
He developed the famous Fibonacci sequence of numbers, which simply says that the third number is effectively the sum of previous two numbers: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, and so on.
But the real value lies in the fact that the ratio of any number to the next higher number is approximately 0.618, and the lower number is 1.618.
• The key Fibonacci ratio of 61.8% - also referred to as “the Golden Ratio” or “the Golden Mean” - is found by dividing one number in the series by the number that follows it. For example: 8/13 = 0.6153, and 55/89 = 0.6179.
• Similarly the 38.2% ratio is found by dividing one number in the series by the number that is found two places to the right. For example: 55/144 = 0.3819.
• The 23.6% ratio is found by dividing one number in the series by the number that is three places to the right. For example: 8/34 = 0.2352.
These ratios developed by Fibonacci actually go back thousands of years to the time of the Egyptians and the Greeks. In addition to mathematics, they also used the ‘Golden Mean’ in architecture and music.
Subsequently, these ratios have become the foundation of many effective trading systems, but the truth is they are seldom used properly. And ironically, though it is one of the most effective tools of technical analysis, it is also the most misunderstood.
These Fibonacci ratios can accurately anticipate when the market makes a major turn and identify key turning points for tops and bottoms... only if you know how to read them correctly. If you can learn to use them correctly, you can increase the probability of profitable trades and minimize potential losses.
These numbers are more effective in the forex markets, since forex is a highly trending market. Prices are constantly changing in an oscillatory pattern, thus following the Fibonacci ratios quite precisely.
These Fibonacci levels act as strong indicators of resistance and support levels, which helps to improve the accuracy of the entry and exit point for every trade. One of the biggest advantages of trading with Fibonacci numbers is the fact that you can set profit objectives and define stop losses to exit a market as well.
The different Fibonacci ratios are the cornerstone of price structure and go hand-in-glove with effective chart patterns like
Elliot waves, Harmonic patterns, Divergence etc.
Fibonacci ratios can be divided into four main groups:
• Time zones
In this first article on Fibonacci ratios, we will concentrate on the Retracements, Fans and Expansions and understand the basic concepts behind them. The next article will cover the different situations/patterns, where we should ideally use these ratios.
Using the Fibonacci ratios
For some reason, these ratios seem to play an important role in the financial markets, just as they do in nature, and can be used to determine critical points that cause price to reverse. Price has an uncanny way of respecting Fibonacci ratios, often quite precisely. Hence one can use these to ascertain the correct technical levels.
Price action is never random, and every wave leaves behind clues for the next move. We can thus use previous price action to anticipate subsequent price movement.
Most traders tend to use the standard Fibonacci retracement tool for all kinds of situations, with the standard values of 38.2; 50.0; and 61.8.
But every trading situation demands an appropriate Fibonacci ratio with different values.
Using these ratios in a proper way gives us a tremendous advantage over the crowd and we will attempt to identify the correct situations to apply the appropriate ratio.
The basic rules for plotting Fibonacci ratios
Let us start by laying down the basic rules of plotting Fibonacci ratios. As mentioned, even though these ratios are used extensively, the basic rules are not followed, which tend to give an incorrect picture.
The following rules apply to all the Fibonacci ratios:
• The Fibonacci ratios should always be plotted from the left side to the right of the chart.
• They should always be plotted on pivot points (swing highs/lows). Visually identify the levels from where price changes trend. In short, identify the waves of the price movement.
• They cannot be plotted on swing points in the middle of a wave.
• They should always be plotted on the wicks of the candles and not on the real body.
• On the other hand, if we are looking for support/resistance levels of any Fibonacci ratio, we should consider the close of the real body of a candle. (Example: if we plot the Fibonacci retracement ratio and we see that price finds support at the 61.8% Fib level; A candle wick can go below the Fibonacci 61.8 level, but we cannot have a close of the real body below this level, or the support is invalidated).
Having established the basic rules, let us have a detailed look at the different Fibonacci ratios.
Price always moves in waves and we can use the Fibonacci retracement levels to identify possible levels of support/resistance. Retracements occur when a given market is rapidly heading in a certain direction. The market retracts as traders tend to take some profits. This retraction represents a good time to re-enter the market, since the levels will be very appealing before the market starts growing again.
The Fibonacci retracement is calculated by taking two extreme points (the swing high and swing low) on the price movement and dividing the vertical distance by the key Fibonacci ratios. Once these levels are identified, horizontal lines are drawn and used to identify possible support and resistance levels. The direction of the prior trend is likely to continue once the price has retraced to any of the ratios.
The basic use of Fibonacci retracements is to find potential levels of support or resistance “behind” the market. If the market is moving up and making new highs, Fib retraces will draw levels BELOW the current price. The standard ratios used in the Fibonacci retracements are: 38.2; 50.0; 61.8 and 78.6.
Ideal situation: Price in an existing trend, and we are looking to rejoin the trend after a pullback.
In case of an uptrend, we plot the Fib retracement on the existing uptrend, from swing low to swing high (left to right). We are thus looking for support at the Fibonacci levels and if the pullback is held within the Fib retracements, it is an indication that price should resume the uptrend again.
The Fibonacci projections are used to determine the expected price targets, once price has found support/resistance at the Fibonacci retracement levels.
Taking the previous example, if we are anticipating price to resume the uptrend, we use the pullback to determine the expected targets.
The calculation of the Fibonacci projection, projects the price action forward using the last prominent moves.
The Fibonacci projection is calculated by taking two extreme points of the price pullback (in this case the swing high and swing low of the price) and adding the key Fibonacci ratios of 127.2%, 161.8%, 200.0% and 261.8%.
Ideal situation: Estimating the price targets after the pullback is completed.
We project the price action forward, estimating that it will reach the fib levels.
The Fibonacci fans are a charting technique consisting of diagonal lines that use Fibonacci ratios to help identify key levels of support and resistance. Fibonacci fans are created by first drawing a trend line through two points (usually the high and low), and then by dividing the vertical distance between the two points by the key Fibonacci ratios. Each result of these divisions represents a point within the vertical distance. The ‘fan’ lines are then created by drawing a line from the leftmost point to each of the three representing a Fibonacci ratio.
Fibonacci Fans give strong indications of direction and act as effective filters for a trend. It is considered that these lines will serve as future levels of support/resistance for a developing pullback or a new trend.
Ideal situation: To validate a 1-2-3 pattern.
The next article will cover the 1-2-3 pattern and how we can use the Fibonacci fans to determine if the pattern is valid. But in brief, if the pullback of the 1-2-3 pattern is within the required fan levels, then we can consider it to be a valid pattern.
The Fibonacci expansion is a great tool for establishing profit targets. It offers a distinct advantage over the other usual Fibonacci ratios since it does not plot levels “behind” the market, but in “front” of the market. In other words, if the market is moving up and making new highs, the standard fib retracements will draw levels BELOW the current price, but the fib expansions will draw levels ABOVE the current price.
To draw Fibonacci Expansion targets, we require three swing points.
We measure the distance from Point A to Point B. However, we can’t project price targets until Point C has been established.
Only when Point C has been formed, we have the necessary three swing points and we can plot the Fibonacci Expansion Tool on Point A, Point B, and Point C.
Ideal situation: Estimating the price objectives of a 1-2-3 pattern.
Once again, the next article will cover this in further detail.
I hope this article has cleared the common misconception of the Fibonacci ratios and has established the basics. The next article will take the Fibonacci ratios to the next level by precisely defining the ideal situations to use them.