Technical Analysis

Leonardo Pisano, better known as Fibonacci, was an Italian mathematician who played a pivotal role in shaping the Western world's understanding of numbers. His 1202 book, Liber Abaci, not only introduced Europe to the Hindu-Arabic numeral system (the one we use today) but also unveiled a fascinating sequence of numbers – the Fibonacci sequence.

This sequence starts with 1, 1, and continues with each number being the sum of the two preceding ones: 2, 3, 5, 8, and so on, infinitely. Intriguingly, Fibonacci observed how these numbers formed ratios that mirrored natural proportions found throughout the universe.

Today, the Fibonacci sequence finds applications in various fields, including computer algorithms, biological systems, and, perhaps most surprisingly, financial markets. Technical analysts, who study past price movements to predict future trends, utilize ratios derived from the sequence, particularly the Golden Ratio, to identify potential support and resistance levels for stock prices. These levels, known as Fibonacci retracement and extension levels, are a cornerstone of technical analysis.

The Golden Ratio

The ratio we derived from the Fibonacci sequence, is known as the golden ratio. Almost everything in nature has dimensional properties that adhere to phi; the ratio of 1.618. This ratio can be seen in relationships between different components throughout nature and seems to have a fundamental function for the building blocks of nature.

Fibonacci Retracement Levels

These Fibonacci retracement levels can also be seen as a percentage instead of a ratio. Therefore, we have the most common retracements levels at 23.6 %, 38.2%, 50.0% and 61.8%.

Extension Levels

The Fibonacci extension levels would be 161.8% and 261.8%.

Fibonacci Retracements

Fibonacci retracements are a popular tool for traders, helping them navigate the market's natural tendency to zigzag rather than move in a straight line. These retracements highlight potential areas where price movements might pause or even reverse, offering clues for entry and exit points.

Here's how it works:

1. Identifying Extremes: We start by pinpointing the highest peak (All-Time High or ATH) and the lowest trough (All-Time Low or ATL) on the chart.

2. Harnessing Fibonacci Ratios: Trading platforms typically calculate key Fibonacci ratios for you, including 23.6%, 38.2%, 50%, and 61.8%. These ratios are derived from the Fibonacci sequence, a series of numbers with interesting mathematical properties.

3. Mapping the Retracement Levels: We then divide the vertical distance between the ATH and ATL by these ratios. This creates horizontal lines across the chart, representing potential support and resistance zones.

Imagine the market climbing a mountain – retracement levels act like rest stops along the way. The price might stall or even dip slightly at these levels before potentially continuing its ascent. Conversely, during a decline, these levels could indicate areas where the price might find temporary support before continuing its descent.

By using Fibonacci retracements in conjunction with other technical analysis tools, traders can gain valuable insights into potential price movements and make more informed trading decisions. Remember, these levels are suggestive, not definitive. Market behavior can be unpredictable, so it's crucial to utilize a combination of tools and strategies for successful trading.

Finding Retracement Levels in an Uptrend

Below is an example of AUDUSD in an uptrend on an hourly chart.

By using the Fibonacci tool on the chart, from the All Time Low (ATL) to the All Time High (ATH) we obtain the retracement levels. As can be seen, the main Fibonacci retracement levels are as follows:

Based on the Fibonacci retracement levels, there's a possibility that AUDUSD might retrace (pullback) from its recent peak and dip to one of these levels in the coming days. We anticipate that prices will find support at a Fibonacci retracement level, presenting an opportunity to enter a buy order.

From the example above:

• We analyze the AUDUSD chart to identify potential retracement levels.

• Based on the analysis, we expect AUDUSD to retrace from its recent peak and find support at a Fibonacci retracement level.

• We then observe the chart and see that the price indeed retraces as anticipated.

• The price dips to the 50.0% level and then finds strong support. This presents a good opportunity to enter a buy position.

Finding Retracement Levels in a Downtrend

Let us look at a chart for the AUDUSD in a hourly timeframe in a downtrend.

By using the Fibonacci tool on the chart, from the All Time High to the All Time Low (ATL) we obtain the retracement levels. As can be seen, the main Fibonacci retracement levels are as follows:

Based on these retracement levels, there is potential for AUDUSD to retrace from the recent trough (ATL) to bounce to one of these Fibonacci levels. We expect prices to find resistance at one of these levels and it will give us an opportunity to enter the market and place a sell order since we expect the downtrend to resume later. After waiting a few hours, we can observe what happened next.

What we can see is that after touching the all time low, prices began to rally all the way up to near the 50.0 % Fibonacci retracement level where they stalled just below that level before resuming the downtrend. We had a good opportunity to enter the market with a sell order.

Summary

The previous examples showcased how Fibonacci retracement levels can be a helpful tool for identifying potential entry points in the market. We saw prices retracing to specific Fibonacci levels, creating temporary support or resistance zones where we could place buy or sell orders.

However, it's crucial to approach Fibonacci retracements with a healthy dose of realism and here is why:

• Market Unpredictability: While retracement levels offer potential support/resistance, the market doesn't strictly adhere to them. Prices can sometimes pierce through these levels, making them unreliable at times.

• False Signals: What appears to be a retracement based on Fibonacci levels could very well be the start of a trend reversal. This can lead to missed opportunities or even losing trades.

Fibonacci Extensions

Fibonacci extensions are used by many traders to determine target levels where they wish to take profit. These extensions consist of all levels drawn beyond the standard Fibonacci levels (below the100% level), with the most common extension levels being 161.8%, 261.8% and 423.6%. Fibonacci extensions are a good way of finding out what price move is expected after a swing high or swing low is crossed.

Using Fibonacci Extensions in an Uptrend

Fibonacci retracements are a valuable tool, but they're not the only trick in the Fibonacci toolbox. When the market's in an uptrend, Fibonacci extensions can help us identify potential resistance levels.

Here's how it works:

1. Identifying the Uptrend: First, confirm that the market is indeed in an uptrend. Look for a series of higher highs and higher lows.

2. Swing High and Retracement: Locate a recent swing high followed by a retracement (pullback) in price.

3. Fibonacci Extension: Unlike retracements, Fibonacci extensions are drawn opposite to the trend. Use the Fibonacci tool on your chart, extending from the swing low of the retracement up to the swing high.

4. Key Levels: We're particularly interested in the 161.8% and 261.8% Fibonacci extension levels. These levels represent potential areas where the uptrend might encounter resistance and the price might stall or even reverse.

Imagine a Staircase:

Think of the uptrend like climbing a staircase. Fibonacci retracements might represent rest stops along the way, while Fibonacci extensions highlight potential points where the stairs might level off or even have a small step down before continuing upwards.

In the chart below we can see that AUDUSD is in an uptrend. Prices retraced and dipped to the 50.0% Fibonacci retracement level.

We can see that this 50.0% Fibonacci level was upheld and prices found strong support at this level before bouncing back up to resume the uptrend. Prices eventually rose above the previous swing high (the ATH we used when plotting the Fibonacci retracement levels).

Here the uptrend held intact and there was a good opportunity to take profit. We would have bought on the dip (just above the 50.0% Fibonacci level). Then we used the Fibonacci extension in order to calculate the target (profit) levels.

In the chart below we can see that the 161.8% Fibonacci extension level was reached which was our intended profit target. This would have been a good place to take some profit.

Some Drawbacks

Fibonacci extensions can be a compelling tool for spotting potential resistance in uptrends, but it's crucial to approach them with a realistic perspective. Here's why:

• Uncertainty Reigns: There's no crystal ball in trading. While extensions highlight potential resistance zones (161.8% and 261.8% being particularly interesting), prices may or may not actually hit these levels.

• The Power of Perception: The allure of Fibonacci extensions often stems from a phenomenon known as a "self-fulfilling prophecy." Many traders utilize these levels, so a cluster of orders might appear around them, influencing price action. This creates the illusion that the Fibonacci levels themselves are dictating price movement.

Trading with Clear Eyes:

So, how can you leverage Fibonacci extensions effectively?

• Guide, Not Gospel: View these levels as guidelines, not guarantees. Combine them with other technical indicators and price action analysis for a more comprehensive view.

• Price Action is King: Focus on how price interacts with these levels. Does it stall, bounce, or break through? This observed behavior can offer more concrete trading signals than the Fibonacci levels themselves.

Remember:

The market is a complex ecosystem driven by various factors. Fibonacci extensions offer a helpful perspective, but they shouldn't be the sole pillar of your trading strategy. By understanding their limitations and using them in conjunction with other tools, you can make more informed decisions and navigate the market with a healthy dose of realism.