3.09 Applying the Fibonacci sequence in technical analysis

 

Contents  

• What is the Fibonacci sequence?
• The Golden Ratio and Fibonacci coefficients 
• What are Fibonacci retracement levels?

What is the Fibonacci sequence?

The Fibonacci sequence is a tool commonly used in technical analysis that helps traders to forecast support and resistance levels, and identify potential market turning points. The string is derived from a mathematical formula in which each successive word is the sum of the previous two. For example, the string starts with the numbers 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, and so on.

Fibonacci levels

In technical analysis specific Fibonacci levels, which are derived from the proportions within the sequence, are often used. The most commonly used levels are 23.6%, 38.2%, 50%, 61.8%, 100%, and 161.8%. These percentages represent the various degrees of correction or expansion that can occur after significant price movements.

• 23.6%: Often the first level of support or resistance that indicates a shallow correction.

• 38.2%: A popular correction level used to identify more significant stops in a price movement.

• 50%: Although not an official Fibonacci level, it is commonly used in technical analysis as the midpoint of a move.

• 61.8%: A key level, also known as the "golden ratio," often observed as a turning point.

• 100%: Indicates a full correction or expansion from the initial movement.

• 161.8%: Indicates a possible extension of the price movement beyond previous peaks or lows.

Application in Technical Analysis

Fibonacci Retracements

Fibonacci retracements are used to identify support and resistance levels where the price may stop during a correction in a trend. To draw Fibonacci retracements on a chart, select the starting point (lowest low) and the ending point (highest high) of the price movement. The trading platform will then automatically draw the elimination levels, which can serve as potential support and resistance areas.

Fibonacci Extensions

Fibonacci Extensions are used to forecast future price levels after a correction. They are particularly useful in trading strategies based on trend continuation. To draw Fibonacci extension, choose three points on the chart: the beginning of the movement (the bottom), the peak of the movement, and the end of the correction (the next bottom).

Difference between Fibonacci retracements and Fibonacci extensions

Fibonacci retracements are used to identify potential support and resistance levels within the current trend, usually in the context of corrections. Fibonacci extensions, on the other hand, are used to forecast future price movements after a correction has ended, thus identifying future target levels.

Using extensions to forecast prices

Fibonacci extensions allow traders to identify potential target points for price movements, which is particularly useful in trading strategies based on trend continuation.

 

Interpretation and Practical Application

Key level identification 

Fibonacci levels help traders to identify key support and resistance levels that can act as turning points. For example, if the price is approaching the 61.8% level, traders can expect a trend reversal to occur at this point.

Trading strategies

Traders use Fibonacci levels in various trading strategies:

• Support and resistance levels: Determine entry and exit points for positions based on elimination levels.

• Risk management: Determining stop-loss levels near key Fibonacci levels.

• Price targets: Determine profit target levels based on Fibonacci extensions.

 

How to draw Fibonacci projections

Selection of points: bottom, peak, next bottom

To draw Fibonacci projections, choose three key points on the price chart:

1. Bottom (Point A): The beginning of an upward movement.

2. Peak (Point B): End of upward movement.

3. Another bottom (Point C): End of the correction.

 

Practical steps on the price chart

1. Pick the Fibonacci extensions drawing tool in your trading platform.

2. Select point A (the bottom), point B (the peak) and point C (the next bottom).

3. The Fibonacci extensions will be automatically displayed on the chart, showing potential target levels.

 

Interpretation of Fibonacci projections

Identification of key resistance and support levels

Fibonacci extensions help to identify key resistance and support levels that can act as potential price targets. These levels often represent barriers that the price may encounter as it continues to move in the direction of the trend.

Application in trading strategies

Traders can use Fibonacci projections to:

• Set profit targets.

• Determine entry and exit points for positions.

• Determine stop-loss levels to manage risk.

 

Application examples

Historical Data Analysis 

Historical market data analysis can help you understand how Fibonacci projections have worked in the past. Analyzing past price movements and their relationship to Fibonacci projections can provide valuable insights into the effectiveness of this tool.

An example of the use of Fibonacci extensions

On a bitcoin (BTC) price chart, pick a low as point A, a peak as point B and another low as point C. After drawing the Fibonacci projection, you'll notice levels such as 161.8% and 261.8%, which can serve as potential price targets for future uptrend moves.

 

Application in Trading Strategies

Examples of the use of Fibonacci extensions can be found in both traditional financial markets and cryptocurrency markets. The analysis of real cases allows you to see how Fibonacci extensions can help you forecast price movements and make informed trading decisions.

The Fibonacci sequence, thanks to its mathematical properties, is widely used in trading strategies. It helps traders both in identifying support and resistance levels and in predicting potential market turning points. Below are various trading strategies using Fibonacci projections, as well as examples of their application in real-life trading.

 

Trading Strategies with Fibonacci Extensions

-> Trend Following 

The strategy of following a trend is to identify and trade according to the direction of the main trend. Fibonacci projections can help establish target levels for price movements within this trend.

• Steps:

  1. Identify the main trend (upward or downward).

  2. Use Fibonacci projections to identify potential target levels.

  3. Determine entry levels based on corrections (Fibonacci retracements) within the main trend.

-> Reversal Trading

A trend reversal trading strategy involves identifying moments when the market may change direction. Fibonacci extensions help to identify potential turning points.

• Steps:

  1. Look for candlestick patterns or other indications that signal a possible trend reversal.

  2. Use Fibonacci extensions to determine target levels after a reversal.

  3. Confirm the reversal signal with other technical tools.

 

Combining Fibonacci extensions with other tools

-> Connection to support/resistance levels

Fibonacci extensions can be combined with traditional support and resistance levels to increase the accuracy of forecasting turning points and price targets.

• Steps:

  1. Draw support and resistance levels on the chart.

  2. Apply Fibonacci extensions to the chart to see where these levels overlap.

  3. Treat these overlapping levels as stronger support/resistance.

-> Integration with other technical indicators (RSI, MACD)

Reinforce trading signals by combining Fibonacci projections with other technical indicators, such as the Relative Strength Index (RSI) or Moving Average Convergence Divergence (MACD).

• Steps:

  1. Use Fibonacci projections to identify potential target levels.

  2. Confirm these levels with signals from RSI (e.g., overbought/oversold levels) or MACD (e.g., signal line crosses).

  3. Trade accordingly to the confirmed signals.

 

Examples of trading scenarios

Case Study 1: bitcoin (BTC)

1. Trend Following:

   • Bitcoin rises from $30,000 to $40,000.

   • Correction to $35,000.

   • Fibonacci projections indicate a potential target level at $45,000 (161.8%).

2. Reversal Trading:

   • Bitcoin drops from $40,000 to $30,000.

   • Reversal formation (e.g. hammer) at the $30,000 level.

   • Fibonacci projections suggest a target level at $35,000 (61.8%).

Case Study 2: Ether (ETH)

1. Trend Following:

   • Ethereum rises from $2,000 to $3,000.

   • Correction to $2,500.

   • Fibonacci projections indicate a target level at $3,500 (161.8%).

2. Reversal Trading:

   • Ethereum drops from $3,000 to $2,000.

   • Reversal formation (e.g., bullish engulfing) at the $2,000 level.

   • Fibonacci projections suggest a target level at $2,500 (61.8%).

 

Summary

Fibonacci extensions are a powerful tool in trading strategies, allowing traders to predict future price movements with greater accuracy. Combining them with support and resistance levels and other technical indicators can significantly increase the efficiency of technical analysis and trading decisions. Through practical application and analysis of real transactions, traders can better understand and use these tools in their strategies.