The Fibonacci retracement instruments are based on a theory invented centuries ago, while these rules and principles are still effective for making trading predictions. How to use the instruments correctly?
The Fibonacci retracement method among the grounds of technical analysis
Successful traders base their predictions upon diverse instruments of the technical analysis. Some of the instruments go as far back as the XIII century. This refers to the Fibonacci retracement invented by the Italian mathematician Leonardo Pisano nicknamed ‘Fibonacci’.
What is Fibonacci retracement primordially?
The Italian mathematician built up an endless sequence of numbers where every next number is equal to the sum of two previous members. For instance, the part of this consequence has the following form: 0, 1, 1, 2, 3, 5, 8, 13 …
The invented consequence is applied to illustrate diverse mathematical phenomena (e.g. the interdependence of two neighboring numbers is striving to the Golden Ratio).
That is an amazing fact, the consequence invented more than 800 years ago, laid the ground for the Fibonacci retracement strategy, one of the most widespread and effective trading instruments, no matter what kind of asset is purchased or sold.
The Golden Ratio and market quotations
According to numerous researches, the Golden Ratio is the most harmonious whole-part relationship. The ratio is equal to the number 1.618, which is the most widespread in natural forms. The American entrepreneur and engineer Ralf Elliott was the first to start looking for the Golden ratio inside market quotations.
Mr. Elliott came to the conclusion that rate movements are dependent on specific rhythms and waves, which are based on the above-mentioned 1.618 etalon number. The conclusion is grounded on profound research of charts (daily, weekly, monthly, etc.).
The Fibonacci retracement instruments used in trading
There are four instruments based on the Fibonacci consequence: levels, arcs, fans, and time zones. A trader needs to understand these instruments profoundly.
The Fibonacci retracement levels are directly calculated from the consequence. These levels are counted in percent; hence, a trader receives the following levels: 0.0%, 23.6%, 38.2%, 50.0%, 61.8%, 78.6%, 100%, 161.8%, 261.8%, and so on. The trading strategy based on these levels helps traders predict the price movement within a short period.
The Fibonacci arcs are considered potential levels of support and resistance. A trader needs firstly to build the trend line, while the second extremum point becomes a center for three arcs, which cross the trend line on different Fibonacci levels: 38.2%, 50%, and 61.8%.
The Fibonacci fans serve for the determination of support and resistance levels as well. A trader finds the extremum points of the trend (minimum and maximum). An imaginary vertical line should be placed in the maximum extremum point. A trader draws a line from the minimum extremum point to cross the imaginary line on three Fibonacci levels: 38.2%, 50%, and 61.8%.
Fibonacci time zones
These instruments are vertical lines that correspond to the Fibonacci consequence numbers: 1, 2, 3, 5, etc. According to the trading strategy, significant rate changes are expected nearby the lines.
Applying of the Fibonacci retracement to a chart
Newcomer traders are interested in how to draw Fibonacci retracement. The following steps are required:
1. Determine the minimum and maximum extremum points of a trend line. Traders should specify a trend correctly, as the strategy is based upon this item.
2. Follow the correction and wait until it ends (the new extremum point is higher than the trend line maximum or lower than the trend line minimum).
3. Place the 0.0% level on the new extremum point and stretch the Fibonacci lines downward or upwards, depending on the trend movement.
4. Build the Fibonacci arcs and fans to determine precisely the levels of support and resistance.
5. Enter the market when the price is reversed to the levels 21.6%, 38.2%, 61.8%, or 78.6%. Some experts recommend traders setting stop-loss on the 100% level.
6. Build new Fibonacci levels to predict expected profits. Place the 0.0% to the end of correction and stretch the lines in the reversed direction.
7. Place the take-profit on the 161.8% level. The longer trend is, the higher growth is expected.
The above-mentioned algorithm displays the most common market situation, but traders need to decide on their own which levels are the best time for entering and leaving the market, based on the levels of support and resistance.
Pros and cons of the strategy
Traders interested in how to use Fibonacci retracement should understand the strategy has both pros and cons.
Among the key advantages of the strategy the following are listed:
• There is a high probability that a price movement corresponds to the Fibonacci retracement rules.
• A trader understands the market behavior better.
• The instruments are compliant with all markets (stocks, foreign exchange, cryptocurrencies).
• Traders are able to check the efficiency of the instrument within a short period.
• The Fibonacci retirement is simpler for understanding compared to other instruments of technical instruments.
As for the cons, the following disadvantages are distinguished:
• Some experts are convinced the Fibonacci retracement lacks mathematical and theoretical grounds.
• That is harder to build up algorithmic strategies using Fibonacci retracement.
• The instrument is less effective within small time-frames.
Combination of instruments
The professional traders focus on the higher efficiency of Fibonacci retracement, while combined with other technical analysis instruments.
For instance, the combination of Fibonacci instruments and Elliott waves helps traders predict the price movements better. As the instruments are oriented on a trend, traders combine the instruments with the MACD indicator.
! Note that the Fibonacci retracement mastering doesn’t lead to making a trader the lord of markets and quotations. This method is among the ways to help you comprehend the market better, while all kinds of assets are still risky.