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Here's How To Use Golden Ratio And Fibonacci Sequence In Trading

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  • 18 Apr 2023

The Golden ratio--1.618--is derived from the Fibonacci sequence, named after its Italian founder, Leonardo Fibonacci. In the sequence, each number is simply the sum of the two preceding numbers (1, 1, 2, 3, 5, 8, 13, and so on). When further translated into percentages, this ratio can be used in the stock analysis and mainly uses four techniques: Fibonacci retracement, arcs, fans, and time zones.

In technical analysis, the golden ratio is typically translated into three percentages: 38.2 per cent, 50 per cent, and 61.8 per cent, which are considered key retracement levels for a stock or an index. However, more multiples can be used when needed, such as 23.6 per cent, 161.8 per cent, 423 per cent, and so on.

The retracement levels of 38.20 per cent, 50 per cent, and 61.80 per cent are considered as key support and resistance in the financial market. These assist in delivering conviction, by identifying support and resistance levels of a trend. The retracement is drawn considering the high and a low points of a rally. These are horizontal lines which guide in recognizing the buying and selling momentum. Typically, this phenomenon is plotted on daily, weekly, and monthly charts.

Another way of plotting the support and resistance levels is through 'Arcs'. This structure represents half circles that intersect with the high and low line at 38.2 per cent, 50 per cent, and 61.8 per cent. The shape of a circle is wider when the rally is big. As this form is in a circular shape, the price indicates similar move on support and resistance.

Fibonacci fans are diagonal lines spread within the high and low. These lines look like trendlines plotted on 38.20 per cent, 50 per cent, and 61.80 per cent retracement. Whenever the stock moves out of those diagonal lines on the higher side, the trend is set to be on strong breakout.

Fibonacci Time Zones are vertical lines that analyse the time period or duration where the maximum price momentum can be visible. This can span to a longer period, and the bigger the duration more potent is the momentum. The analysis of Time zones enables one to eradicate drastic volatility, resulting in a steady price movement.

The idea behind the Fibonacci sequence is to determine the support and resistance levels as this enhances the conviction and develops appropriate buying and selling behaviour. When combined with other technical indicators, it helps in furnishing a substantial view on the trade. In a trending market, candlestick patterns evolving around these ratios assist in entering and exiting trades from a medium-term perspective. When volume shows volatility around support and resistance, the strength and momentum appears to enter a new phase.

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