If you have heard the word Fibonacci, you know that it has something to do with the trading world. Since it often appears in trading, you most likely have heard or seen it somewhere. Some traders will die by these magic ratios we will go through in this article. Why you may ask?
So, let us look at what Fibonacci is, and what is the history behind it?
History of the Fibonacci sequence
The Fibonacci sequence was created by the Italian mathematician Leonardo Pisano Bigollo, known by several names in history, including Leonardo of Pisa; Pisano means from Pisa, and Fibonacci, which means son of Bonacci.
Some of the Western world’s most renowned traders and merchants during the Middle Ages were Italians, and they needed this arithmetic to keep track of their commercial transactions.
The calculations were figured out using the Roman numeral system (I, II, III, IV, V, VI), but that system made it hard to add, multiply and divide what the merchants needed to keep track of their transactions.
In 1202, Bigollo published his famous book called the Liber Abaci, meaning the “book of the abacus”, to put his knowledge on paper. This book showed how superior the Hindu-Arabic arithmetic system was to the Roman numeral system. Moreover, it showed how that system of arithmetic could be applied to benefit the Italians.
The Fibonacci sequence resulted from a mathematical problem about rabbit breeding in the same book by Bigollo. The problem stated that:
Starting with a single pair of rabbits (one male and one female), how many pairs of rabbits will be born in a year if each male and female rabbit gives birth to a new pair of rabbits every month. The new pair of rabbits begin giving birth to additional pairs of rabbits after the first month of their birth?
This is where the Fibonacci ratio comes into play.
The Fibonacci ratio is considered to be the most important part of Fibonacci’s entire career. Any number divided by the last number gives us 1.618 as we further down the string. This phenomenon of numbers is known as the ‘Fibonacci golden ratio’. As you go on in this article, we will tell you more.
For the people who follow Fibonacci, there are many examples in nature that follow this ratio. For example, hypothetically, if you divide the number of female bees by male bees in a hive, you will get 1.618 as the answer.
And not just animals; the Fibonacci number system also applies to humans. There are many examples of this golden ratio relating to the human bodies as well, and one such example is the ratio of the length of your forearm to your hand, which is 1.618.
The Fibonacci sequence explained
The Fibonacci sequence comprises of 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144 and so on. Every number in this pattern is simply the sum of the two preceding terms, and the pattern goes on.
A remarkable feature of this numerical pattern is that each number is approximately 1.618 times greater than before. This common relationship between every number is the building block of the ratios. It is so commonly used in the trading world and why technical traders determine retracement levels.
The key Fibonacci ratio is 61.8 percent, and it is calculated by dividing one number in the series by the next number in the sequence. For example, 21 divided by 34 = 0.6176, and 55 divided by 89 equals approximately 0.61798.
The 38.2 percent ratio is found by dividing one of the numbers in the series by the number two spots to the right. Similarly, 55 divided by 144 is approximately 0.38194.
You can divide one number in the series by the number three places to the right to get the 23.6 percent ratio.
For example, eight divided by 34 equals about 0.23529.
Fibonacci in forex
It is also still unknown why these Fibonacci ratios seem to play a role in the forex market, and at the same time, they also apply to nature.
Traders attempt to put these ratios to use to determine the critical points where an asset’s price momentum is likely to reverse, which is an integral part of the trading world.
Fibonacci retracements are the most commonly used of all the Fibonacci trading tools. It is partly because of their relative simplicity and their applicability to almost any trading instrument.
You can draw support lines, identify resistance levels, place stop-loss orders, and set target prices. Fibonacci ratios are also a key element in a countertrend trading technique.
Fibonacci retracement levels are horizontal lines that show potential support and resistance levels. Each level, like the numerical patterns, is associated with one of the above ratios or percentages.
It shows how much of the last price move has retraced. The direction of the previous trend is likely to continue. But, the asset’s cost usually retraces to one of the ratios listed above before that happens.
Fibonacci trading strategies
Fibonacci retracement lines are mostly a part of trend-trading strategies. For example, if a trend retracement occurs, you can utilise Fibonacci levels to trade in the direction of the underlying movement. The price of a currency pair is more likely to bounce from the Fibonacci level back in the direction of the initial trend.
If you want to buy a specific pair but have missed out on a recent upswing, Fibonacci levels can be useful. Of course, you could wait for a downturn in this circumstance.
Traders can discover likely retracement levels and open potential trading positions by charting Fibonacci ratios such as 61.8 percent, 38.2 percent, and 23.6 percent on a chart.
A frequent forex trading strategy is to combine Fibonacci retracement lines with the MACD indicator. When a pair’s price reaches a large Fibonacci level, this approach searches for a crossing over the MACD indicator. When this occurs, a position will be opened in the trend’s direction.
Another key forex method is to use Fibonacci levels in conjunction with the stochastic indicator. This two-line indicator can assist in identifying overbought and oversold conditions when the price reaches a significant Fib level, the algorithm checks for key signals from the stochastic indicator. The combination of the two signals indicates a chance to open a position.
Fibonacci in Summary
Many traders are successful when applying Fibonacci ratios and retracements to place trades within long-term market patterns.
When combined with other indicators, Fibonacci retracement can become even more powerful.
