A Fibonacci Trading Strategy Explained

Posted By: Steve Burnson: March 27, 2019

There are many indicators and methods used by traders all over the world, but few are used more often
than those based upon Fibonacci numbers. From forex traders to institutions, Fibonacci is a mainstay of
market analysis, and an important tool when trading or investing in stocks.

As with any tool we use though, it is very important to understand what it is, what it does, and how to use
it in trades before ever adding it to your trading strategy.

About Fibonacci
Using the Fibonacci sequence within trading uses indicators that are based upon the number sequence
identified by Italian mathematician Leonardo Pisano Bigollo, who was nicknamed Fibonacci. The son of a
trader, he traveled the known world, leading to him studying the Hindu-Arabic numerical system in
relation to mathematics.

Figure 1: A painting of Fibonacci.

Image Source: Sapaviva.com

He built on that knowledge in a book he wrote in 1202, titled Liber Abaci (the book of the Abacus). In that
book, he documented a numerical sequence that we still use as a base for market analysis today. That
number sequence now bears his name, and it starts with 0, then 1, and then in sequence, the previous two
numbers added together.

The first 10 numbers are therefore as follows: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34.

Each number, once past the first 3, is approximately 1.618 times greater than the one that preceded it, and
this ratio is significant. It is often known as the “golden ratio” or Phi, and it appears throughout nature and
in human creations. It can be found in the spirals of a galaxy, the shape of seashells, flower petals, the
Mona Lisa, human faces, the Parthenon and tree branches among others.

Figure 2: This image portrays the way Fibonacci looked at the Golden ratio as in different aspects of
nature.

Image Source: ResearchGate.Net

Fibonacci Analysis
Because that golden ration appears everywhere, both natural occurrences and within some of our greatest
man-made achievements, the idea that they also apply to the markets gained traction, in particular, the
relationship between the golden ratio and how markets move.

We know that markets never truly go straight up and down, they go up, retrace a bit, then go up some
more, and vice-versa, but what if you could predict in advance how far back those retracements would go?
That is the idea behind the Fibonacci analysis, that retracements and further advances would approximate
to the golden ratio rules.

We know that Phi is 1.618, which we can view as 61.8% of the current level. However, traders quickly
started using other aspects of the Fibonacci sequence too. For instance, a given number in the sequence is
approximately 38.2% of the following number, and 23.6% of the number 2 ahead in the sequence.

Using these percentages, Fibonacci analysis works with the theory that a retracement can reach a number
of levels, conforming to 76.4% (100% – 23.6%), 61.8%, 38.2%, and 23.6% of the previous move. This is
applied to retracements and projections using specific analysis tools built into most charting systems. To
understand how you can build a trading system from this number sequence, we need to see how those tools
work for us.

Figure 3: This image shows the different Fibonacci levels mapped out on the TrendSpider platform. Each
retracement level is highlighted in the yellow boxes.
 Fibonacci Retracement Levels
While Fibonacci levels can be used to predict support and resistance levels in many ways, retracement
levels are by far the most common used. TrendSpider includes a tool that will do this for you, however, it
is important to understand the idea behind things to ensure you use the tool properly and also understand
what you are seeing afterward.

The idea of a Fibonacci retracement is to apply those Fibonacci percentages to as price move to set
probably support levels as the price retraces. The question is, what are the percentages taken from? They
key to retracements is establishing the move that generates them.

That means you want the whole of the initial move up (or down), so the lowest point to the highest point of
the upward move, and the highest point to the very lowest point of a downward move. That gives you a
number of points the move covers. Fibonacci retracements levels are placed at 76.4% 61.8%, 38.2%, and
23.6% of that move, working backward from the high point in an uptrend, and low point of a downtrend.
The images below show how the TrendSpider platform automatically performs this process for the user,
saving time and questions about where to draw the measured move.

Figure 4: This image shows how Fibonacci retracement levels from the October 24th to the 26th acted as
support and resistance zones for over a half month!
Figure 5: This image shows how the TrendSpider platform automatically updated the new Fibonacci
retracement level without having to do anything manually on the users end other than pressing “refresh”.

Fibonacci Extension
So far, we have spoken about Fibonacci as a way of establishing support levels that show where a
retracement may change direction. However, Fibonacci levels also apply to future moves after a
retracement has completed. For instance, in an uptrend, the price stalls and retraces, then turns back
upwards, going beyond previous highs. The question you are asking at that point is how far the stock will
continue to rise to. This is where Fibonacci extensions come in.

Again, your charting platform such as TrendSpider includes a tool for this, knowing what the lines it
produces are and how to plot them correctly is really important though. The basic principle of using
Fibonacci percentages of a move to create levels where a move may stall still applies, except here, of
course, they will be resistance levels for the future move upwards.

The key to getting the right levels is making sure you are using the right initial move to base those
percentages from. That means the entire initial move as you did with the retracement, but instead of
applying it from the top of that move, you set the levels from the low of the retracement itself.

Figure 5: This image shows the initial move found by TrendSpider with the Fibonacci extension all the
way up to the 1.68 level.

The idea is that the new move that started as the retracement ended will find resistance at levels based on
that initial move. Once plotted, the various levels should indicate areas where resistance causes the new
move to slow or turn, and combined with the retracement support levels, can give a good picture of current
market ranges and turning points.

Using Fibonacci Fans

The final use of the Fibonacci levels is known as the Fibonacci Fan. These are a variation on trendlines
based on Fibonacci retracement points.

As upward fans rise, they can be used to identify retracement support levels and potential areas for
reversals as the market progresses back to its uptrend.
Downward fans, in a falling market with a downtrend, can be used to identify potential resistance levels
from those upward retracements and subsequent reversals to return to the downtrend.

They are based off the same percentages that have been used throughout, 76.4% 61.8%, 38.2%, and
23.6%, and as with the retracements and extensions, are simple to use. The new trendlines represent the
support or resistance levels depending on the direction of the trend, as price moves towards these lines,
traders can look for signs of change in market direction.

Figure 6: An example of Fib Fans manually drawn on the SPY daily chart from the TradingView platform.

Fibonacci Technical Analysis

Using Fibonacci within your trading analysis is, therefore, a combination of all of these concepts,
establishing support levels for retracements through other Fibonacci retracements and fans, and then
combining those same fans and Fibonacci extensions to spot areas of resistance for the next upwards move,
with the reverse for downtrends.

Because all three Fibonacci tools provide a very visual display for potential areas of interest, they are a
great way to see market direction changes early, and that is perhaps part of the reason they are so popular.
However, in the early days, the process of performing Fibonacci analysis could be very time-consuming,
with percentage calculations and chart plotting having to be done manually.

Today, with automated levels from TrendSpider, any trader can quickly use Fibonacci retracement levels
on any stock chart and in any timeframe, enabling them to be incorporated into a complete strategy without
needing to spend a long time on calculations. Just a few clicks to set the move in question into the system,
and retracement and extension levels are automatically generated.

Figure 7: Before. This image shows a measured move found by the TrendSpider system but has not been
updated in a couple days. Therefore, the price action shown by the orange box has not been input into the
automated platform until the user clicks “refresh”.
Figure 8: After. This image shows the same chart above but with a new Fibonacci measured move found
by the TrendSpider system after pressing “refresh” in the “truth in analysis” highlighted in yellow outline.

That makes Fibonacci much more practical, but how does that transfer into a strategy for trading?

Fibonacci Trading Strategy

If you look at Fibonacci levels, whether they are retracements, extensions or fans, in a historical chart, they
show remarkable accuracy in displaying support and resistance levels where markets change direction.
However, in real time on a developing chart, they are not as easy to trade as that may appear, so how do
you use them effectively?

First, let’s talk about timeframes. Fibonacci levels can work on all timeframes, but they are better suited to
longer periods, daily and weekly charts for instance. In fact, even for those trading daily, using Fibonacci
across several timeframes can pinpoint levels even more accurately, when your weekly, daily and 5-minute
chart all generate a retracement level at the same point, and that is supported by a Fibonacci fan, it’s a good
sign it will offer the support to the move you are looking for.

The basic idea behind a Fibonacci trading strategy is to look for a retracement to lose inertia and turn back
to the initial trend direction, so you buy into the dips and exit at the higher highs on an uptrend and the
reverse on a downtrend. However, as retracements can be breached several times before settling and
reversing, it can be difficult to find entry points. This is why as a trading strategy, other indicators, such as
candle patterns and other technical analysis can help establish entry points to trades.

Once in a trade, Fibonacci extension levels and fan-generated resistance levels can be used as exit points
for trades when trends show signs of slowing and reversing. Again, Fibonacci levels by themselves are not
the ideal solution for setting exit strategies, and it should be used with other technical tools such as chart
patterns to establish exit points more accurately.

Conclusion
In conclusion, the unique set of numbers found by a mathematician many centuries ago is still being used
today through different aspects of life and trading. There is a good reason Fibonacci analysis is popular,
levels for support and resistance have historically proved accurate, and as a platform to build a trading
strategy from, using other tools to confirm entry and exit points, these Fibonacci tools can prove invaluable
in your trading approach. As more and more traders and large computerized platforms have this feature, it
will become even more self-fulling than it already is. Make sure to try out TrendSpider to save time and
automate a process that has done manually for centuries!