Fibonacci Sequences and the Golden Ratio in Forex Trading
The Fibonacci Sequences
The Fibonacci sequence is a series of numbers that begins with 0, 1, 1, 2, 3, 5, 8, 13, etc. Each of the proceeding numbers in the sequence is derived by adding the preceding two numbers. For example, the number 13 in the series is obtained by adding 5 and 8. The next number in the series would be “21” (the sum of 8 and 13).
The Golden Ratio
What is intriguing about the Fibonacci sequence is not the numbers in the series but their ratios. The Golden Ratio, roughly 1.618, appears to be prevalent among us in nature. It is said that even the behaviour of the financial markets conforms to this ratio.
Fibonacci and Finance
Technical analysts generally rely on three to five percentages of the Golden Ratio. The most frequently used percentages are 23.6%, 38.2%, 50%, 61.8% and 76.4%.
Analysts apply these percentages to their analysis of the markets through four (4) main methods:
Fibonacci Retracements
Fibonacci Arcs
Fibonacci Fans
Fibonacci Time Zones
Fibonacci Retracements
As the most frequently used among the four (4) main types of Fibonacci-based tools, Fibonacci Retracement is used to identify probable reversal levels. The levels are obtained with the various percentages of the Golden Ratio. In addition to alerting traders to probable reversal areas, these retracement levels also alert them to areas of support and resistance. The most commonly used percentages for tracing retracement levels are 38.2% and 61.8%.
Normally, after a rally, analysts will use the various percentages of the Golden Ratio to try and identify the retracement levels as well as to predict the scale of pullback. It is also possible to use Fibonacci Retracements after a decline in prices in order to predict the extent of the counter trend correction.
It should be noted that the levels identified with Fibonacci Retracements do not represent hard reversal regions. Instead, they alert traders to regions that could reverse the trend. Traders should always use other technical analysis tools like candlesticks and moving averages to confirm their findings.
Fibonacci Arcs
Fibonacci Arcs are arcs which expand outward from a baseline. The first arc is based on the 38.2% ratio, the second arc on the 50% ratio and the third arc on the 61.8% ratio.
From the diagram above, we can see that the base line extends from the trough to the peak of the price movements. These arcs represent probable support and reversal areas that traders should pay special attention to as prices rebound after a rally.
Fibonacci Fans
Fibonacci Fans are trend lines based on retracement levels. They help traders identify possible support areas, resistance areas and reversal areas.
When prices drop below a Fan line, traders often predict that future prices will fall even further to the next corresponding fan line. As such, Fibonacci Fan lines act as a support level for an upward trending market.
Conversely, if prices rally above a Fan line, then that Fan line is seen to act as a resistance level. If, however, prices manage to cut across the Fan line, then the next higher trending Fan line is regarded as the resistance level.
Fibonacci Time Zones
Fibonacci Time Zones comprise vertical lines that are divided into a series of different time zones. The chart is divided into sections spaced according to the ratio of the Fibonacci sequence.
The areas indicated by these lines are areas in which a significant price shift is expected. In other words, Fibonacci Time Zones are used to identify potential areas of trend reversal.
Conclusion
Technical tools based on the Fibonacci sequence and Golden Ratio are very popular among traders. However, we should never form our analysis solely through the application of Fibonacci-based tools.
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