Aside from having fun, traders are always on a quest to capitalize on financial market inefficiencies. It’s this never-ending hunt for profits that lead them to innovation.
Of the many trading strategies and indicators, traders incorporating Fibonacci tools into their charts will have an edge. There are several reasons why market participants place this tool on a pedestal.
What is Fibonacci Trading?
Understandably, the incorporation of Fibonacci ratios in trading charts can be due to the ever-evolving market conditions or the improvement of existing strategies with the overarching objective of better understanding the trading landscape.
Taking into account that a timely entry or exit can make a marked difference between profit and loss, this decades-old technique finds widespread use in asset trading. And it doesn’t matter which security or asset you’re using. Fibonacci-derived tools are cross-cutting, practical, and useful in every technical trading chart as long as the market is open.
The Fibonacci Trading Sequence Indicator
The Fibonacci tools and methods can be traced back to a mathematical theory based on the work of Leonardo Fibonacci, who lived in the 12th century. Today’s Fibonacci indicators are based on the Fibonacci sequence of numbers. In this series, each number after 0 and 1 is the sum of the previous two.
It goes like this:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610….
And it is generated as follows:
- 0 + 1 = 1
- 1 + 1 = 2
- 1 + 2 = 3
- 2 + 3 = 5
- 5 + 8 = 13
Dividing any two subsequent numbers yields approximately 0.618, meaning every two numbers in this series is spread out at a ratio of around 1.618. The 1.618 ratio is also known as the Phi or golden ratio:
- 55 / 89 = 0.617
- 233 / 377 = 0.618
- 144 / 233 = 0.618
But wait, there’s more. There’s also a correlation between every number in the sequence with the one two steps ahead in the series:
- 13/34 = 0.382
- 21/55 = 0.381
- 55/144 = 0.381
Fibonacci went even further and also noted that every number in the series was roughly 23.6% of the third number to its right:
- 21/89 = 0.235
- 55/233 = 0.236
Surprisingly, the golden ratio frequently pops up in nature. Perhaps that’s why 1.618 is called an irrational number. It has been found that the shells of mollusks grow annually following the golden ratio. The same applies to the arrangement of leaves on a stem, the spiral on sunflower seeds, and even the cardiac cycle of the human heart. Bizarrely, it seems like nature likes the 62/38 arrangement, and considering the duplicative nature of humans, the golden ratio is a prominent fixture in trading.
Building on the above, the Fibonacci levels used in trading are derived from the relationship of the numbers in the Fibonacci sequence. Basically, there are three important levels used in the Fibonacci retracement: 23.6%, 38.2%, and 68.2%.
Although not one of the numbers in the Fibonacci series, the 50% level is nonetheless critical and therefore part of the retracement ratio widely used by traders.
Common Fibonacci Indicators
Out of these Fibonacci sequences, popular Fibonacci-based indicators include:
Fibonacci Arcs, which are dynamic half circles or arcs that extend from the baseline to the defined swing high and low, intersecting with the line at 23.6%, 38.2%, 50%, 61.8%, and 78.2% levels. This indicator is a function of price and time. The longer the baseline, the wider the arc. Like Fibonacci retracement levels, each point of the arc is a potential support or resistance.
Fibonacci Fans consist of trend lines drawn according to the Fibonacci ratios. The trend lines pass through reference points determined by the Fibonacci retracements. Used correctly, Fibonacci fans can be timely in projecting possible price retracements or extensions within a channel.
Fibonacci Time Targets are vertical lines spaced out according to the Fibonacci number sequence (0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987), starting either from a trough or peak and subject to the prevailing trend. Each number represents a period. In the daily chart, the first time zone (or period) is one day, and in the hourly chart, it’s one hour. Different from other Fibonacci-based indicators, this indicator eliminates price and instead uses time as a basis for projection.
How to Trade Using Fibonacci Levels
As mentioned above, the Fibonacci levels are linked with potential support or resistance. Over time, traders tend to use them because they are aesthetically pleasing and when used correctly, Fibonacci-based indicators often eliminate subjectivity.
Drawing a Fibonacci retracement tool between a given trade range creates potential reaction levels, derived from the aforementioned Fibonacci ratios.
The retracement levels are generated when the trend baseline is divided by the Fibonacci ratios of 23.6%, 38.2%, and 61.8%. Afterward, horizontal lines are drawn from these points of intersection, generating a grid that aids traders in determining possible reversal points. Traders can then subsequently use these levels to either make a profit or place stop-loss orders.
How to use Fibonacci Retracement in Crypto Technical Analysis
Suppose the prevailing Bitcoin trend is bullish and the XBTUSD prices are correcting. If a Fibonacci retracement is drawn between a given trade range, a trader can project possible support based on any of the above three Fibonacci ratios and plan accordingly. A reaction at 38.2% may prompt the trader to place limit orders around this reaction level. As a safety net, the stop loss would just be below the 50% Fibonacci mark.
If the retracement is deep, and assuming the prices sink more than 50% from the recent swing high, then traders are safe placing limit orders between the 50% and 61.8% Fibonacci retracement levels with fitting stop-loss orders just below the 61.8% retracement mark.
However, note that the risk-reward ratio should ideally be 1:3, with a maximum recommended risk of 5%, when trading derivative products. The general rule of thumb is that traders should place their profit targets at the 131.8% extension level if the reversal was from 31.8% Fibonacci retracement. In the same vein, profit targets should be at the 161.8% extension mark if the prices found support from the 50% and 61.8% Fibonacci retracement levels.
While it has been irrevocably proven that Fibonacci retracement levels can aid traders, traders must take it upon themselves to complement this tool with other indicators. Since trading is all about supply and demand, studying candlestick arrangements, trading volumes, trend lines, and moving averages further helps traders identify potential entry or exit points.
Fibonacci ratio trading or Fibonacci pattern trading is all about capitalizing on trend continuation. It has been found that any retracement that is 38.2% or less indicates strong underlying momentum. On the other hand, deep corrections beyond the 68.2% level lead to a ranging or choppy market.
Traders relying on the Fibonacci tool, either alone or in tandem with other technical indicators, can either adopt an aggressive or a conservative trading style. In adopting an aggressive trading approach, traders with hindsight and confidence in trend resumption can place a limit order at any of the three key Fibonacci retracement levels in anticipation of trend continuation. More conservative, risk-averse traders should first align with the prevailing trend before placing short or long limit or market orders once the prices recoil from the key retracement levels.
Combining Fibonacci Trading Tools with Other Indicators
Reiterating the above point, given that Fibonacci tools can only guide entry and exit points, this is how you can use Fibonacci retracement and extension tools in combination with other technical indicators, such as moving averages, Elliot Waves, MACD, and more.
1. Using Fibonacci and MACD:
For better entry, traders must first identify the current trend. If it is bullish, then in a retracement, the entry points would likely be around the 23.6% or 38.2% zone if the trend is strong and around 50% and 78.2% levels if the retracement is steep.
Bullish entries will print once there is a bullish crossover on the MACD. Depending on the reversal points, stop-loss orders will be below either the 50% or 78.2% level, with targets at the 138.2% or 161.8% Fibonacci extension levels.
2. Using Fibonacci and Stochastic Indicator:
Like the MACD, the Stochastic is a momentum-based indicator. To fine-tune trade positions, the entry and exit points will depend on whether the reversal is printing at the overbought or oversold territory.
Any bullish (or bearish) signal that forms around the Fibonacci reaction points at the oversold (or overbought) territory will hint at demand (or supply). As such, traders can buy (or sell) dips (or pullbacks), with the first target at either the recent swing high or the 138.2% or 161.8% Fibonacci extension level, depending on the initial Fibonacci retracement level.
3. Using Fibonacci and Trading Volumes:
The cool thing about trading volumes in cryptocurrency trading is that they are real time and do not lag like, for example, the MACD or moving averages. Demand is marked by swelling trading volumes, while periods of accumulation or distribution are shown by shrinking volumes.
To combine this useful indicator with Fibonacci tools, traders must first identify the swing high and low from the existing trend. Afterward, any price reversal at the 38.2%, 61.8%, or 78.2% levels accompanied by a sharp increase in participation hints at a possible main trend resumption.
In that case, the trader would trade in the direction of the trend with a fitting stop-loss order determined by the Fibonacci retracement levels and profit-taking order generated from the Fibonacci extension levels.
It is clear that trading based on Fibonacci ratios can be immensely beneficial. With proper use of Fibonacci ratios, traders can determine possible reaction points where they can place entry orders or take profits when they sync with the main trend. However, this is not to say that the tool is infallible. Like other strategies and tools, Fibonacci indicators have their pitfalls.
Sometimes, the Fibonacci indicators can lead to unwarranted expectations, and when traders throw caution to the wind by adopting an aggressive strategy, they will be unknowingly exposed to risk. Therefore, prudence demands Fibonacci-based indicators be used in conjunction with other tools or signals for the best results and ultimately the best ROI gauged over time. On Xena Exchange, aside from support for a number of Fibonacci indicators, there are other platform-specific indicators that can further help traders make better trading decisions. Traders can combine any of these readily available indicators with any of the Fibonacci tools and comfortably trade derivative product(s) or supported cryptocurrency pairs with confidence.