Crypto Trading 101: The Fibonacci Retracements Explained
The Fibonacci retracements represent a predicting tool used in trading strategies in order to determine potential support and resistance levels for price action.
Used in combination with other technical analysis tools, Fibonacci retracements can help a crypto investor get a better understanding of the market and predict price movements.
About Fibonacci the mathematician
Fibonacci numbers, or the Fibonacci sequence, came to light when Italian mathematician Leonardo of Pisa, popularly known as Fibonacci, was studying in 1202 how different sets of numbers related to each other.
One of his writings, The Book of Calculation or Liber Abaci”, introduced various practical mathematical systems that were related to merchant trading, price calculations, and other solutions to day to day problems. Another important discovery featured in his book was the decimal system which ended up replacing the Greek and Roman numerals in Europe.
He noticed that in a chain of numbers in which each new number is the sum of the previous two (1, 1, 2, 3, 5, 8, 13, 21, to infinity), a certain ratio links the numbers in the sequence. The ratio of 1.618, is also known as phi or the Golden Ratio.
The Golden Ratio has a remarkable relationship with many aspects of nature and its proportions. The shells mollusks have their spiral pattern based on Golden Ratio proportions, as do the spirals of sunflower seeds. Even in human anatomy, we can find examples of this ratio, including our DNA structure and the cycle of our heartbeat.
This application has expanded to trading for price action analysis. A trader can find levels in a trend which the price is likely to follow by dividing a peak to trough or trough to peak distance by the golden ratio and other ratios found in Fibonacci.
Other Fibonacci ratios that appear consistently in the sequence are between alternate numbers in the Fibonacci sequence, which is 0.382 to 1 and its inverse which is 2.618 to 1.
It has been noted that prices respond to these levels on a consistent basis, which can provide a trader with effective cues as to when to enter or exit a trade.
Fibonacci Trading Tools
Five types of trading tools are based on Fibonacci’s sequence and ratios: fans, extensions, retracements, arcs, and time zones. The lines which are resulted by applying the Fibonacci methods are thought to indicate future movements as the prices cluster near them.
How It Works
It is believed that when Fibonacci tools are used accordingly they can forecast market movements with a 70 percent accuracy, especially when focusing on a specific price. Some might believe that calculating multiple retracements requires too much time and is unnecessarily difficult.
It is true that the complexity of the resulted data from applying the Fibonacci method makes it almost impossible for many traders comprehend them entirely.
However, the Fibonacci levels should not be used as exact formulas to determine the price movements. They were most likely created to give the trader a sense of security as our brains actively seek and are comfortable with patterns, like the ones we see in nature. Therefore, one should not base their trading decision entirely on these studies.
Fibonacci levels actually work best when there are no trends driving the market in that particular market.
When employed by a great number of traders, the Fibonacci tools can influence the market’s outcome by themselves. The Fibonacci studies work in most cases because of the chain events which follow after the vast number of traders artificially generated the support and resistance levels.
Due to their wide use and appreciation, the buying and selling behavior of individual traders tends to form in patterns around these levels. This probably makes the market around these indicators without it knowing, but by actively using and acting around them these levels are supported.
Finding Support Levels
We must first get familiar with two terms before using a Fibonacci tool to find potential support or resistance levels: “swing high” and “swing low.”
A swing high represents a candlestick at the highest point of a trend in any time frame that has lower highs directly on either side of the said candlestick. A swing low is the lowest candlestick of a trend with a higher low directly located on both of its sides.
After identifying these points on the chart, select what Fibonacci retracement tool you want to use, or have available in your trading software, in order to connect the two points. This will lead to the generation of potential support levels that are called retracements.
Each retracement, or support line, is resultant from the vertical distance between the high and the low which is divided by ratios in the Fibonacci sequence.
Finding Resistance Levels
Finding potential resistance levels involves the same process as with support levels, the only exception being that you will be connecting the highest point (swing high) to the subsequent lowest point (swing low).
The retracements will result from the division of the peak-to-low distance to ratios in the Fibonacci order.
The Fibonacci method should not be used on its own but coupled with other analysis tools. The results you obtain from them should be useful in identifying supports and resistances, but outcome precision is not guaranteed. To boost the probability of certain retracements, you should combine Fibonacci resistances with indicators such as moving averages or the Relative Strength Index (RSI).