If you are an active day trader, you are probably aware that Fibonacci recovery and extension levels are some of the most important and useful tools at all prices.
Daily traders and technical analysts can use analysis of Fibonacci levels to confirm entry level, target profit and determine your level of breakout.
In this guide we will explain exactly how to pull Fibonacci levels so that you can make better decisions about when to enter and exit trades.
What are Fibonacci numbers and ratios?
Fibonacci sequence, also sometimes called The Golden Ratio, is a series of numbers where each number is a sum of the previous two numbers.
For example, with the string 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, if we add 0 + 1, we get 1. If we add 1 + 1, we get 2. If we add 1 + 2, we get 3, and so on forever in sequence.
The resulting sequence is known as the Fibonacci sequence and each of numbers in the sequence is called a Fibonacci number. The Fibonacci ratios are then calculated by dividing numbers through the sequence. These calculations then give us the following ratios used in the Fibonacci levels.
0, 0.236, 0.382, 0.5, 0.618, 0.786, 1, 1.618, 2.618
The ratios translate into percentages – 23.6%, 38.2%, 61.8%, 78.6%, etc. – which are then applied to the chart to try to identify potential hidden support or resistance levels in the market.
The Fibonacci sequence was discovered in 1202 by an Italian mathematician known as Leonardo of Pisa, considering a practical problem with the growth of a hypothetical population of rabbits based on idealized assumptions.
This sequence dominates many aspects of life; from the creation of flowers, the formation of waves, to a proportion of the human body. It also provides the information that traders and technical analysts need to form resistance and support levels that can be used within a risk management framework.
You can use Fibonacci levels yourself or combine them with other trading methodologies.
The Fibonacci sequences were used to formulate other theories such as the Elliot Wave Principle and Dow Theory. You can also use Fibonacci relationships with other technical analysis tools.
How Fibonacci levels are calculated
One of the most common technical analysis tool derived from the Fibonacci gold ratios is the Fibonacci levels.
The Fibonacci ratio of 61.8% and the Fibonacci ratio of 32.8% are calculated by subtracting the recent high from the recent low and targeting the near-term rebound. Most of these points can be calculated using graphical software.
The Fibonacci Retracement levels usually behave like magnets creating a self-fulfilling prophecy as shown in the top S&P 500 index.
As you can see from the chart, the realization that the coronavirus pandemic would hit the U.S. economy has triggered an immediate bear market since February and reached a bottom in March. Prices fell from about 3,400 to 2,200 and then rebounded to the 38.2% retracement level.
If we take the decline and multiply it by 38.2% and then add that figure to the low (2,200), we would get the 38.2% Fibonacci level which is 2,647. The index began to consolidate at this point.
After the consolidation period, prices retested the retrograde level of 38.2% and broke down to the next level, which was the 50% advertising level. The consolidation was short-lived. The S&P 500 index then moved to test the 61.8% level and consolidated around that region.
When you draw Fibonacci lines, you will measure the peak to barter of the movement you are aiming for. The difference between high and low then multiplies by 61.8% and 38.2%.
These results add to the low if you measure a drop, or subtract from the high if you measure growth. These levels will become your target support during correction or resistance as the price bounces.
How to draw Fibonacci levels on a chart for trading decisions
The Fibonacci retracement tool is designed to help traders know where and when a retracement will end. This tool is similar to support and resistance, as it marks levels where the price of a security could reverse during a retreat. But the main difference is that it does this automatically, by using a tool, instead of you setting the levels manually. So, how can you draw it on a diagram?
Drawing Fibonacci retracements in a senior trend
The first thing you need to do is examine the most recent price and identify a significant swing high and a swing low.
After you place these two points on the diagram, select the swing low and drag the cursor to the swing high point. You can then use the two reference points as a basis for the Fibonacci levels, which will then be graphically automated on the chart.
Drawing Fibonacci retracements in low trend
To conspire Fibonacci levels in a downtrend in a low trend market state, you need to choose the most recent significant highs and lows.
Start with the swing high point, and then drag the cursor down to the swing low point. After selecting these two points, your Fibonacci recovery tool will then automatically generate the relevant Fibonacci levels.
Fibonacci extensions simply refer to levels exceeding the 100% level. These levels work just like retreat levels, but mappers only use them to map how future swings are likely to occur instead of retreats.
Fibonacci extensions also follow the same numerical sequence; 23.60%, 38.20%, 50%, etc. However they all have 1 front – so 38.20% is 382.00% – because they appear beyond 100% of the swing instead of inside.
Drawing Fibonacci extensions
When designing Fibonacci extensions, the first thing you need to do is find a trend or swing that you want to use as a basis. So find and select two swing points, and stretch the Fibonacci extension tool between the two edges of that swing.
If you are measuring an bullish swing, you should tighten the indicator starting from the lowest to the highest point of the swing. On the other hand, if you measure a bearish swing, then you extend the tool starting from the top to the bottom of the downward shift.
Basically the idea is to have the 0.00% level at the end of the swing that you take as a basis. After you stretch the tool, the Fibonacci extension levels will be plotted automatically on the chart.
Learning to trade the market at Fibonacci levels is not really difficult.
They are one of the most useful technical analysis tools you can use for day trading stocks and other financial securities.
Traders primarily use Fibonacci levels to identify resistance and support levels. When a stock has a high trend or a low, it usually retreats slightly before continuing the trend.
Often the stock will reappear at a key Fibonacci level such as 61.8% or 38.2%. These levels offer signals for traders to enter new positions towards the original trend.
If the stock has a high trend, you may be looking to buy with a backlash to a key support level. If the stock goes down, you could sell when it returns to its key resistance level. Simply put, Fibonacci levels work best when a stock has a high or low trend.