Fibonacci was an Italian mathematician, born in 1170 AD in Pisa. He described how numbers and nature have a correlation. The Fibonacci sequence, starting with 0 and 1, builds a series. You add the last two numbers to get the next number in the series.
A significant aspect of the Fibonacci sequence is the idea of ratio. Every number in the sequence is roughly 61.8% of the next number, and 38.2% of the the number next to the next one. To jog your memory, let’s borrow a term from architecture—the golden ratio or 1.618.
Now, these ratios are everywhere—from the whorls of a flower petal to designs on a snail’s shell. It is so widely distributed that humans are subliminally conditioned to respond to the Fibonacci ratio. Unsurprisingly, this ratio makes an appearance in trading as well.
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The whole idea behind Fibonacci trading is that markets rarely move in a linear manner. There are waves and dips and, in between, the prices move closer to the original price. The smaller the variation in the departure, the stronger is the price trend. In essence, Fibonacci trading offers a more realistic reading of the market.
So, the key ratios of 23.6%, 38.2%, and 68.1% are used to produce a grid where possible price reversal points can be plotted. Now this is used as a strategy to read price trends. Traders tend to think that prices bounce from this point back to the initial trend. This gives them a point of entry or exit.
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The term ‘Fibonacci retracement’ is used to describe the strategy traders deploy to identify strategic price points, stop losses, or target prices based on the Fibonacci ratio.
A low-volatility trader may open at 50% or 61.8% and close trade at the high or low point of the day. A high-volatility Fibonacci trader may enter trade at 50%, hold back at pull-ups. and sell at Fibonacci extensions that may run up to 261.8%, for example. A skeptical trader, on the other hand, may use Fibonacci to confirm his reading of the market. But he may not base his decisions solely on this.
Here are some common strategies for trading Fibonacci retracements:
Identify a strong trend—that is, a stock that is consistently high with pullbacks that account for less than 50%. See how it behaves at key points of the 38.2% or 50% retracement levels. This should give you an idea of whether it would be worth your time and money to pursue the trade. If you decide to trade in the stock, set your exit point at a Fibonacci extension level. Enter the trade when the activity slows down and sell it when the price reaches, or at least, gets closest to the target exit point.
Say, a stock clears the 100% retracement level and carries on. You may want to buy more of this performer. But whether it will deliver as strong a performance after you buy it is the key question. So, look at the prior swing. If it did not swing beyond 38.2%, it is likely that the stock prices will maintain the overall upward trend. However, this is one of the riskiest strategies.
Here, the trader sets indicators of his own choice, like volume, to read the market. But he may use the Fibonacci retracements alongside, as a complimentary strategy for trading.
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Like any other strategy, the Fibonacci retracements are not 100% accurate nor are they failsafe. Be prepared to face losses and have your trading strategies in place. As a rule of thumb, avoid stocks that have deep pullbacks during retracement. This is a likely indicator that prices will not climb very high. Remember, this is like any other method of day trading. Apply skill, patience, knowledge, and practice, and you will be able to stay on top of the game.
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