Fibonacci Lines, A Brief History
Fibonacci is considered to be the “greatest European mathematician of the middle ages.” He was born in Pisa, Italy about 1175 AD and was raised in what is now Bejaia, Algeria. His actual name is Leonardo Pisano and his father was Guglielmo Bonacci, hence, Fi’Bonacci, a shortening of the Latin “filius Bonacci” meaning “the son of Bonacio”.(1)
The French mathematician Edouard Lucas (1842-1891) attached the name “Fibonacci Numbers” to the sequence.(2)
By definition, the first two numbers in the Fibonacci sequence are either 1 and 1, or 0 and 1, depending on the chosen starting point of the sequence, and each subsequent number is the sum of the previous two:
It is related to the Golden Ratio (a+b is to a as a is to b). Since this subject is beyond the scope of this article, if you want more information about the Fibonacci numbers in nature, see here.
Image By 克勞棣 (Own work) [CC BY-SA 4.0 (http://creativecommons.org/licenses/by-sa/4.0)], via Wikimedia Commons
After you get into the sequence a little ways, you will see there is a relationship between each pair of numbers. The ratio of any number to the next number in the sequence is 0.618. For example 34 / 55 = 0.61818.
The next relationship you discover is the ratio of any number to the second number away is 0.382. For example: 34 / 89 = 0.38202. These are what we call the “Golden Mean”.
For the purposes of our discussion, that is all we need to know. For more information on all this mathy stuff, here is an interesting place to learn way more than you wanted to know.
How Can You Profit With Fibonacci Lines?
Fibonacci numbers and “Golden Ratios” appear to have magical properties, right? Well, that has nothing to do with trading.
We use Fibonacci ratios to measure price action retracements. So, if a significant group of traders believe the retracement will stop and resume its original direction at a certain Fibonacci Retracement Level, they’re going to lay down money on that price.
The more money that is put down on a reversal at that price, the higher probability that the price action will turn at that price.
Of course, some traders want to get ahead of the game, so they lay down their money ahead of the Fibonacci number and others want to get the best possible price on the reversal, so some of them lay the money down after the Fibonacci number.
And thus we have a zone around a Fibonacci Retracement Level.
As you probably already know, the market breathes in and out. Price will move in one direction in a trend for a period of time, but once in awhile it has to take a breath and will retrace a portion of the prior move.
The amount of retracement of the move is a good measure of the strength of the original trend.
Typically traders will use the Golden Ratio numbers (we just call them Fibonacci numbers) of 0.382 and 0.618. As well as derivative numbers (0.236, 0.764, 1.000, 1.382, 1.618, etc.) to determine a reasonable location for price to bounce and possibly reverse to continue its original trend.
Fibonacci numbers can also be used for targeting with other support and resistance levels.
A good example of this is when the Brexit announcement was made in June. The GBP pairs dropped to price levels that had never been seen before. In the absence of historical support/resistance levels, Fibonacci extensions can be used for targeting trades.
How Do You Draw Fibonacci Lines?
To begin an explanation of how to draw Fib Retracement Lines (we sometimes say “pulling Fibs”), we must start by briefly explaining Fractals.
A Fractal is a candle that sticks up with a higher high than the two prior candles. And two subsequent candles or sticks down with a lower low than the two prior and two subsequent candles.
In the image, you can see fractal candles marked by the Williams Fractal indicator. Which puts a caret above each up fractal and a reverse caret below each down fractal. The Williams Fractal indicator is a standard indicator included in most trading platforms.
Setting up the Fibonacci Lines
When you “pull” your Fibonacci lines using the Fib Retracement tool, you pull from a prior low fractal to the most recent high fractal.
Or from a prior high fractal to the most recent low fractal.
Always start from the older candle.
You will then pull it forward to be sure the retracements are set up in the correct direction.
When price retraces, it should encounter the 38.2% line before it reaches the 61.8% line.
In the image you will see three “lower” fractal points and one “higher” fractal point.
You should pull from one of the lower points to the upper point for correct orientation of the retracement tool.
There are many fractals from which and to which you can pull the Fibonacci.
You should use “the most obvious” of the fractals to start pulling your Fib Retracement tool.
The lowest points and the highest points.
The second point for your Retracement tool should be the most recent obvious high or low.
Fibonacci Lines Trading Strategy
A simple buy/sell of the 61.8% retracement of the prior move looking for a turn or bounce is typically a great Fib strategy to use.
Not all moves will retrace to the 61.8%.
Those that do will turn and move back to the prior high/low to which you pulled the Fibonacci Retracement tool.
This strategy will work on any instrument on any time frame.
The longer the time frame, typically the higher probability of success, but the larger the stop loss.
You can use a limit order to enter the trade.
You may want to only close ½ the position at 0% and let the rest of it run at break-even.
Don’t risk more than 2% on the trade.
Never bet the farm.
Another great strategy using Fibonacci Retracement lines can be found here.