What Is Fibonacci Trading?
Updated: Aug 24, 2021
Fibonacci Trading Defined
Fibonacci trading refers to investors who apply ratios from the Fibonacci number sequence onto various markets and securities to find investment opportunities. The Fibonacci sequence helps identify recurring patterns that may inform individuals of what may happen in the future.
On a price chart, Fibonacci trading is also referred to as a Fibonacci retracement (technical indicator), where investors divide the distance between two prices (usually a high and a low) with the following ratios:
23.6%
38.2%
50%
61.8%
And 100%.
Once calculated, investors use these levels to estimate future support or resistance price levels. Learn the history of Fibonacci trading, how it works, and whether it’s useful for investors to include in their strategy (e.g. forex trading strategy).
Table of Contents
Fibonacci Trading Explained with Examples
Fibonacci Trading History
Leonardo Fibonacci, the founding father of Fibonacci trading, was an Italian mathematician born in "Pisa". He lived from 1170 - 1240. While alive, he introduced Indian and Arabian mathematics to Europe and authored the “book of Abacus” - where he originally shared concepts of the Fibonacci sequence.
In the book of the Abacus, Leonardo asked the following question.
“A certain man put a pair of rabbits in a place surrounded on all sides by a wall. How many pairs of rabbits can be produced from that pair in a year if it is supposed that every month each pair begets a new pair which from the second month on becomes productive?”[1]
The answer would produce the number sequence that we know now as the Fibonacci sequence: 1, 1, 2, 5, 8, 13, 21, 34, 55.....each number is the sum of the two preceding numbers. This sequence is the foundation of many common occurrences globally and is utilised by investors to analyse their portfolios.
The Golden Ratio is quite significant in the world of mathematics, and finding it in the Fibonacci sequence is no surprise as a result.
In the 19th century, French mathematician Edouard Lucas and other scientists discovered these sequences in nature. Check out this short video below to see various instances of this phenomenon.
Fibonacci Trading Charts Explained
On price charts, Investors will not see the Fibonacci sequence but rather a set of ratios that correlate to that sequence:
Ratio 1: The Golden Ratio = any number on the Fibonacci sequence divided by the number immediately preceding it. The answer will always be approximately 0.618.
Ratio 2: Any number on the Fibonacci sequence divided by the number 2 spots to the right. The answer will always be approximately 0.382.
Ratio 3: Any number on the Fibonacci sequence divided by the number 3 spots to the right will always be approximately 0.235.
These are the numbers you will see as percentages on any Fibonacci tool you may be familiar with;
23.6%
38.2%
50%
61.8%
And 100%.
Because these ratios have occurred so often in nature, traders long ago decided to look for them in the financial markets. They represent price being "on-sale" as they are retracements in the current trend.
"The golden ratio is everywhere; how about we see if we can find it on our trading charts!" "Let's measure 61.8% of a move in one direction and see if the price does anything interesting after pulling back to that percent of the initial move." - A Random Investor
Naturally, the abundance of the golden ratio's appearance applied this line of thinking to all the other Fibonacci ratio numbers.
Fibonacci Trading Example
Usually, Fibonacci trading is deployed on a trending market and between two extremes of price; a high and a low. For example, investors may use Fibonacci to estimate how far a retracement is likely to go in a bull market trend.
For example, as a market trends upwards and peaks, it may fall by 61.8% before continuing its original uptrend. Commonly referred to as a market correction or retracement.
Taking Bitcoin USD’s (BTC-USD) price behaviour between August 9, 2021, and August 13, 2021, the following chart demonstrates how prices tend to react at certain Fibonacci ratios.[2]
At most Fibonacci trading levels, price tends to congest or reverse, providing support or resistance to BTC-USD price.
Fibonacci Trading Tools
Fibonacci Extension Indicator
In a trend, the directional moves are longer than the pullbacks or the retracements. Therefore, it is logical to assume that the next move in the trend after a pullback should cover roughly the same distance as the previous move.
Key point: There is a difference between the levels on a Fibonacci extension and the Fibonacci numbers beyond 100 on the regular Fibonacci retracement tool.
On the retracement tool, the extended numbers are simply a duplicate of the same ratios of the previous trend but extended one more time beyond the movement's peak.
On the extension tool, the Fibonacci ratio starts on the retracement. This is why it's best to use these tools together to find the retracement level and set targets.
When investors apply the Fibonacci extension tool, we will get three points. The first point starts at the beginning of the impulse or trend move, the second point is at the end of the said move, and the third point is at the retracement.
The projection will appear, but it will be quite narrow. Feel free to drag the third point horizontally to suit your purposes as long as the zero line remains lined up with the retracement.
This tool is used to set Take Profit levels more accurately. The idea is that price should reach one hundred percent of the previous impulse once momentum continues in the trending direction. Therefore, the 100% level makes an excellent first target.
This may make sense if the market is making new all-time highs and there is no resistance point overhead to use as conservative stop levels.
Above, we have the example of the S&P500. A hard right edge example. If you were trading the S&P500 right now and applying the Fibonacci extension tool to set targets, these are what your targets would be.
Fibonacci Time Indicator
This indicator is meant to apply the Fibonacci sequence forward in time rather than in pips. Where other Fibonacci tools look vertical in value along the y axis, this tool looks horizontal through time, along the x-axis.
The idea here is that investors can expect prices to react in certain ways at the Fibonacci levels, usually in combination with the existing trend.
It is drawn the same way. From one swing point to another and the time levels along the Fibonacci sequence are drawn in. Naturally, there was some reaction near to one of these levels.
Bear in mind; there are so many levels that it is simply probable that one of them would get hit, very much like every other Fibonacci tool. Hence, the level that lined up with support and resistance proved significant.
What if we had a little fun with these?
Disclaimer, having fun does not necessarily equate to better trading
What if we combined the Fibonacci retracement tool and the Fibonacci time tool to pinpoint at what level and at what time price would react?
According to the chart, the price will react again at that same price level, but not yet. It will again react in a few more bars. Until then, we can expect some consolidation if these tools are to be believed. Now....of only, there was one tool that could just combi...
There it is. Time-based and price-based Fibonacci levels are combined into one indicator. This tool is drawn the same way as the previous Fibonacci tools but provides more data. This tool has trend lines meant to project Fibonacci-based Take Profit levels into the future neatly.
Using the same chart, I will apply other Fibonacci tools for illustration purposes. Many of these tools appear first on Tradingview and subsequently take a long time to make it to other trading platforms.
Fibonacci Trading Pros and Cons
Due to simplicity, investors may fall victim to the ease of use of Fibonacci trading levels as a replacement for a complete investment strategy. Fibonacci trading, although an intriguing phenomenon, comes with its drawbacks.
Pros explained
Versatile: The Fibonacci tool can be used in many ways, including simply being a piece of a larger trading plan meant to help set various levels for taking profits, stop losses, and entries or adding to existing trending positions.
Static: Because the Fibonacci ratios are fixed, no one will spend time tweaking the indicators to see "secret levels". Everyone sees the same levels, and the consensus is what moves price. If everyone is reacting to the same price levels, the retail trader needs to ensure he is in the trade.
Standardised: The Fibonacci tool has been accepted and used by many traders for a long time. This applies across asset classes as well. As stated before. It is a consensus that moves price.
Cons explained
Subjective: There are many lines on the Fibonacci tool. Conclusion this confuses any line could be the level at which price reacts and down the investor’s opinion and experience.
Hindsight bias: It is easy to tell which line works and which don't work in hindsight. However, when trading in real-time, this becomes challenging. Hene many traders combine Fibonacci levels with other indicators.
Rabbit hole: Many Fibonacci tools display Fibonacci levels in various ways, including; rays, circles, fans, "time", and many more. Studying all Fibonacci tools can be pretty helpful but incredibly time-consuming, and the information gleaned from using these variations of the Fibonacci tool may not be as worthwhile.
What It means for Retail Investors
Fibonacci trading, by itself, falls short of a complete investment strategy. Sensibly, forms of Fibonacci analysis should sit as part of a broader investment strategy. For example, Investors should use Fibonacci in conjunction with fundamental intrinsic value indicators like macro currency strength meters.
The Fibonacci tool would be great as a technical indicator as an additional entry criterion for pullback trading and trend trading. However, relying on it alone would not be enough to form a complete strategy. Below is an example of how retail investors can include Fibonacci in their trading.
Fibonacci Trading Strategy Example
In Summary
It's not about magic numbers, really. The underlying concepts are simple.
Price moves in waves. The depth of counter-trend moves gives us valuable information about what the market participants are doing. With deep retracements, look for a trend change or expect the formation of a Fibonacci pattern. With shallow retracements like flag patterns, look for trend continuations.
Fibonacci indicators have no settings. Therefore, whatever levels you see are seen by all other traders. Therefore these are clear levels. Trader volume at that level becomes support because everyone expects everyone else to get in at those levels. If we all start buying simultaneously at the same level, demand goes up, as does the price.
There are many levels on the Fibonacci tool. However, the level most closely aligned with existing support and resistance areas or supply and demand tend to work best.
There are many Fibonacci tools. The retracement measures how deep to expect a pullback to go, and the extension measures how far the impulse can go. These tools can also be displayed in several ways, through fans, circles, rays etc. All these tools do is use this same information to help us gauge momentum.
Article Sources
Leonardo Fibonacci. “Liber Abaci," Pages 283-284. Springer-Verlag, 2002.
Trading View. "BTC-USD, https://uk.tradingview.com/chart/kXT5aI4n/?symbol=BITSTAMP%3ABTCUSD". Accessed Aug. 12, 2021.
