In the second article of our continuing Technical Analysis series, we learned how to leverage some of the more common advanced indicators: exponential moving averages (EMA) and moving average convergence divergence (MACD). In this article, we are going to introduce other common but even more advanced trading tools based on the Fibonacci sequence, namely:
- Fibonacci Retracement
- Fibonacci Extension
What is the Fibonacci Sequence?
The Fibonacci sequence describes the number series 0,1,1,2,3,5,8,13,21,34,55 etc. so that each number is the sum of the two preceding ones, starting from 0. This seemingly simple numerical sequence and the ratios derived from it are of mathematical importance that transcends industry - but of course in this article we’ll look at how it’s applied in finance and trading.
Fibonacci In Trading
The Fibonacci tool is meant to help find further price support or resistance levels by displaying regions of pullback, or retracement, of a price trend. These regions are associated with Fibonacci % levels of 23.6, 38.2, 61.8, 78.6, and although not officially a Fibonacci ratio, 50 is commonly used as well.
Specifically, the Fibonacci Retracement tool is primarily used when you assume that a current price trend has reached its top, while the Fibonacci Extension is used when a low is assumed.
Traders usually use the Fibonacci retracement tool after a price surged continuously and then stopped or declined sharply in order to help gage how far the retracement will go.
It is applied by connecting two significant price points to one another, typically a recent high and a recent low. After selecting the tool from the left chart menu, your first point would be the bottom of the price hike you’re assessing, while the second would be the top of the climb.
As shown in the example below, this application would correctly associate the 1 level with the bottom and the 0 level with the top, to create static regions between the fib levels for your analysis.
In short, the levels indicate the % the asset has lost in value from that from the charted gain. For example, if the price touches the 38.2 level, it has lost, or retraced, 38.2 percent of its gain. In this example, we connected a low of 3,158 to a high of 4,213 - a gain of 1,055. When the price eventually fell back to 3,810, it lost 403 points, or 38.2% of that 1,055 gain.
You will also see the price found support and bounced heavily in the ‘golden pocket zone,’ which refers to the levels between 0.618 - 0.65. The zone is usually seen as a key range in which a price reversal is likely. Pro tip: the .65 level is not included by default, so you have to doubleclick on the charted tool to add it!
While the fib retracement tool helps find support levels, the fib extension levels assist in looking for additional resistances in the direction of the trend.
After a price continuously dropped and then stopped or reversed sharply, we can assume that the price found a short-term bottom. Thus, we can apply the Fibonacci extension tool to connect the latest high with the assumed short-term bottom, to help gage how much the price could rise before facing rejection at a resistance level to continue the downtrend.
The fib extension is set up the same way as the retracement tool, with the key difference being a reversal of the levels, now associating 1 with the high and 0 with the low. Pro tip: To make it easier, simply click reverse on your retracement tool and it automatically switches the levels and you’ll have the ‘golden pocket’ zone included again.
Again, the golden pocket zone between 0.65 and 0.68 is the area where a short term price reversal can be expected, with the 0.382 fib level also seen as a strong trend reversal level. Of course this holds only true if we assume a price reversal at all. Consequently, both tools can be utilized to both identify supports or resistances, ensuring we spot good entry and exit points.
The Fibonacci tool is used not only to find supports and resistances, but also to identify trend reversals. While the retracement tool is commonly used to spot support, the extension tool is used to find additional resistances with the 0.382 and ‘golden pocket’ levels generally viewed as most important.
Remember, it’s important not to view any indicators in isolation, and most traders do in fact look for confluence between different indicators before making trading decisions. Quadency's first-class TradingView integration allows you to apply a number of indicators to create and save your advanced charts.