In the last article we looked at how to determine whether markets were trending or ranging. In Part 13, we look at a very interesting method used to calculate support and resistance and capture the behaviour and psychology in any given market: Fibonacci. Fibonacci has become an extremely popular tool amongst technical analysts.
The Fibonacci tool on your charts, is one of the best bits of kit for predicting support and resistance levels and price targets. It works across all markets, but in my experience, it works better on the longer term charts e.g. 4hr, 1 day, 1 week. (Anything less then 4hrs and I like to use Pivots.)
What is Fibonacci?
Fibonacci was a 13th century Italian mathematician and accountant. You may be familiar with his number sequence from your maths lessons: e.g. 1,1,2,3,5,8,13,21. As you progress through the sequence, the ratio of each number to its preceding number approaches closer and closer to what is known as the golden ratio: approximately 1.618. Each number is also approximately 0.618 of its successor. This reciprocal number is known as φ (phi).
In the non-financial world, the Fibonacci sequence is employed in all manner of fields; from architecture through to physics and engineering. In nature, as well, we can see Fibonacci patterns at work. Some would argue that Fibonacci’s sequence and methods were nothing new even back in the 13th century. It is thought the Egyptians designed and built their pyramids based on similar mathematical laws.
Fibonacci’s concept, when translated to trading and investing, has to some extent become a self-fulfilling prophecy. In trading terms it works, because it is based on the behaviour of groups following patterns and lends itself perfectly to the analysis of financial markets. The concept is saying to the analyst that price retraces by a certain given amount and these amounts are governed by the Fibonacci sequence. What makes it so effective, is that the Fibonacci tool generates movements in advance that you can anticipate.
Creating Fibonacci lines.
- Fibonacci lines are placed on top of the price.
- To set these lines, you need to look for a high and low and connect them (this is a pure discretionary process, but in most cases it is obvious).
- The points you select depend on your trading time period. I like to break a chart into 3 Fibonacci sections based on the rules of technical analysis. So, on a daily chart, I will have 3 different sets of Fibonacci lines: short, medium and long term. I’m also looking if there is any overlap between the three, signifying to me stronger points of support and resistance.
- It works in all time frames (better > 4 hrs)
- It is a subjective process – but you will instantly see, when you draw the lines, if they fit the asset you’re potentially trading.
- Almost all the charting software I know has Fibonacci functionality.
Example using S&P500 Index daily chart with Fibonacci lines applied (Chart: TradingView):
Four ratios are normally plotted (although most charting packages allow you to add on or take off many more Fibonacci lines). The four most commonly used and most important are:
- 0.618 (or 61.8 per cent), the reciprocal of the golden ratio.
- 0.50 (or 50 per cent) – the second number divided by the third (1 divided by 2).
- 0.382 (or 38.2 per cent) – the reciprocal of the golden ratio squared (i.e. 89 / 233).
- 0.236 (or 23.6 per cent) – the reciprocal of the golden ratio cubed (i.e. 55 / 233).
NB: The weakest of the Fibonacci ratios is 0.50. (not really a Fibonacci number). The strongest two are 0.618 and 0.382.
Imagine the lines as price magnets – you will see the action bouncing between the upper and lower boundaries, using these lines as key support and resistance areas. This price ‘map’ is great for trading and investing as it lets you build strategies – breakouts, reversals etc and helps with your risk management – setting stops and targets. Fibonacci, like most technical tools, works better in combination with other indicators.
Example using IAG Plc (Charts: Stockopedia) Fibonacci in combination with the stochastic oscillator:
Other Fibonacci methods:
Fibonacci application is not just carried out in the manor presented above; there are other Fibonacci methodologies you can apply. Some further types of Fibonacci methods you may like to investigate are Extensions, Time and Circles. These can be found on most decent charting packages.
Further reading and learning:
If you are interested in learning more about Fibonacci, then the following reading may help:
- Fibonacci Ratios with Pattern Recognition, Larry Pesaento, Traders Press Inc, 1997.
- Fibonacci Analysis (Bloomberg Market Essentials: Technical Analysis), Constance Brown, Oct 2008
- Technical Analysis of the Financial Markets, John J Murphy, New York Institute of Finance, 1985.
- Technical Analysis, The Complete Resource for Financial Market Technicians, Charles D Kirkpatrick, FT Press, 2006.
Fibonacci is one of my favourite tools for the longer term charts. It’s very useful for laying out a map of future price support and resistance levels and possible targets. It’s also great for risk management. It may be a strange concept in financial markets and trading, but it works!
Next time: Technical Analysis (Part 14): Direct Price Analysis (DPA) – Pivots