What are Fibonacci Numbers and Lines?
Fibonacci numbers are used to create technical indicators through a mathematical sequence developed by the Italian mathematician known as "Fibonacci" in the 13th century.
The sequence begins with zero and one, and each subsequent number is the sum of the previous two. For example, the early part of the sequence is:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987, 1597, 2584, 4181, and so on!
These numbers can be broken down into ratios, known as the golden ratio of 1.618 or its inverse 0.618, which some believe provide clues about the movement of financial markets.
Important Points To Remember:
- Fibonacci numbers and lines are created by ratios found in Fibonacci’s sequence.
- Common Fibonacci numbers in financial markets are 0.236, 0.382, 0.618, 1.618, 2.618, 4.236.
- Many traders also use 0.5, 1.0, and 2.0, although they are not officially Fibonacci numbers.
- These numbers reflect potential price movements following another price move.
- Two common Fibonacci tools are retracements and extensions, measuring how far a pullback or impulse wave could go.
How to Calculate Fibonacci Retracement Levels
Fibonacci retracements and extensions are derived from the number sequence and require specific price points on a chart, such as swing highs and lows.
Fibonacci Retracements
If a stock rises from $15 to $20, the 23.6% retracement level is calculated as $18.82, or $20 – ($5 x 0.236) = $18.82. The 50% level is $17.50, or $15 – ($5 x 0.5) = $17.50.
Fibonacci Extensions
Extensions require three price points: the start and end of a move, and a point in between (the pullback). For example, if the price rises from $30 to $40, the 161.8% extension level is $51.18 ($35 + $16.18).
Using Fibonacci Lines
Some traders believe that Fibonacci numbers play a vital role in finance, and they apply these percentages in various techniques:
- Fibonacci Retracements: Horizontal lines indicating support and resistance areas.
- Fibonacci Extensions: Horizontal lines indicating where a strong price wave may reach.
- Fibonacci Arcs: Compass-like movements from a high or low, representing support and resistance areas.
- Fibonacci Fans: Diagonal lines created from a high and low, representing support and resistance areas.
- Fibonacci Time Zones: Vertical lines predicting major price movements in the future.
- Fibonacci Levels: Used as guides for potential trade development, with price confirmation required before acting.
Arcs, fans, extensions, and time zones are similar concepts but applied differently to charts. They show potential support or resistance levels based on prior price moves, forecasting where the price may stop falling or rising in the future.
Limitations Of Fibonacci Numbers
The use of Fibonacci studies is subjective, as the trader must choose specific highs and lows, affecting the results.
Another criticism is the abundance of these levels, making the market likely to bounce or change direction near one of them. This can make the indicator appear significant in hindsight but challenging to apply in real-time or future predictions.