How to use Fibonacci levels in trading

As many of my posts refer to Fibonacci levels, I thought I should take the time to explain how to use the Fibonacci sequence when trading. 

Image courtesy sigusr0: http://www.flickr.com/people/14319985@N07

The Fibonacci sequence is expressed throughout nature

Leonardo Fibonacci was an Italian mathematician who lived in the Middle Ages and theorized about numbers and how they applied to nature. 

Fibonacci numbers, sometime known as the Fibonacci sequence or series, are numbers in the following integer sequence: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55 etc… What’s so special about this sequence?

Notice that if you add any two integers to the left they equal the sum on the right. This Fibonacci sequence is found throughout the natural world – including in charts. 

When referring to Fibonacci levels within financial charts there 3 common price components – retracements, extensions and projections. 

Retracements: are the percentage ratios from the High to the Low or from the Low to the High of the previous wave, also referred to as the A-B swing. These levels are support or resistance at the following percentage ratios: 0.382, 0.50, 0.618, 0.786 and 0.86.

Extensions: using the same previous wave uses the ratios of 1.272 and 1.618 to find the support or resistance level.

Projections: are the calculation of the two to find the price target.

Traders have various ways to use Fibonacci levels depending on their trading style. I’m going to run through my personal style with which I’ve found great success. 

First I only use the extension and retracements on the A-B swings to forecast price.

Let’s run through an example of a downward trending stock. The best chart type to use for Fibonacci extensions is the candlestick chart.

The first step is to learn how to draw the Fibonacci retracements on the chart. Start by drawing the Fibonacci starting at the high of the wave to the bottom of the wave. 

It’s important to note some charting systems present Fibonacci numbers slightly differently. Also note how price ran to the extension and pierced the level. You need to wait for two more candles to confirm the low and that price is ready to start the new wave.

Notice the two sections. The first section is within the wave containing the retracement levels of 0.382, 0.50, 0.618, 0.786 and 0.86. The second section is below the wave or the extension containing 1.272 and 1.618.

The A-B section of the wave is what we are measuring from a percentage standpoint from 0% to 100%. The retracements are a percentage of that 100% range such as 0.382%, 0.50%, 0.618%, 0.786% and 0.86%.

Step 2 is the price prediction phase. The way I use the Fibonacci tool is by looking to where the price retraces within the wave. The common retracement levels are at the 0.382, 0.50, 0.618. If price retraces to one of these levels I then look for price to move to the extension level of 1.618. Where price turns at one of these levels is known as the C. It’s possible to have price bounce around inside the A-B wave at which time the C is the highest point in the retracement.

If price retraces deeper to the 0.786 or 0.86 level, I then look for an extension move to the 1.272 or ##, the theory behind this is price has lost energy and will to have strength to move to the extension.

Finding the Fibonacci wave for a downtrend:

Start with highest high on the chart and draw the Fibonacci retracements. Find where price hits the extension. Draw a new set of Fibonacci retracements from the C to the extension, also known as the D extension. At this point the second wave has been identified; continue this process until the current wave is found. Reverse the process for an uptrend chart. Once traders run through this exercise a few times, finding the Fibonacci waves will become easy.