Fibonacci numbers are based on the actual sequence of numbers, as defined by Fibonacci himself. The theory says that a series of numbers 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89 etc, is a series where each number is the sum of the two previous number. The rest of the theory has to do with the ratios between these numbers, and these ratios tend to approach specific numbers. And it has been confirmed that these ratios exist profoundly in nature too. Each number divided by the one before it, comes to a ratio of 1.618, rounded off to 1.62. And its inverse comes to 0.62. There are also ratios between numbers that are two places apart, or 3 places apart. These result in smaller ratios, for example 13/34, and 13/55, where the ratios tend to 0.38 and 0.23 respectively.
These ratios are used to calculate retracements and extensions of market price based on a price range. This price range is a distance from a high to a low, or from a low to a high on a chart, and it’s the reference range. Most of the time the market tends to retrace 38% of the reference range, but it can also retrace 50% of the reference range, which is not a Fibonacci number. In general, traders watch for these retracements, and they also watch for extensions of 1.62 and 2.63, these extensions provide targets for exiting a trade, and they are calculated as follows: Reference range multiplied by extension number. So if for example the reference range from a low to a high is 200 pips, the expected 1.62 and 2.63 extension targets will be 200*1.62 and 200*1.63 or 324pips and 526 pips, these numbers are then added to the reference range low and indicate where you can expect to see market price making the next high.
On the above chart we have a GBPUSD daily chart, we take the most profound range, the one with the highest high and lowest low around the area of interest, and we calculate 2 price projections based on extension numbers of 1.62 and 2.63, the range is 560 pips, and the 2 price targets are 1.3030 and 1.3600. And the market later on does reach the 1.3030 target, while it may or may not reach the 1.3600 target.
You could have chosen the biggest possible range in the chart, to use a reference range, the range seen around the month of September where the market declined, and then use retracement number to estimate possible turning points of price, that can also work with some degree of success.
Problems with Fibonacci Numbers
Traders use Fibonacci numbers in many different ways, and as you can see it is possible to detect some turning points in market price, especially on the daily and weekly charts. The problems arise when one applies the theory too often, on shorter time frame charts, it’s no longer possible to choose a correct reference price range, because there are too many of them. And things start to become ambiguous. In other cases you will find that retracements especially are very ambiguous, the market does turn at the 0.38 (or 38%) retracement of a reference range, but if you choose any other random number, say 0.40 or 0.56, you will find market price turning points, which perfectly match these numbers, and these are not Fibonacci numbers.
In any case, it is strongly recommended to base your Fibonacci analysis on the daily chart first, before you make any observations on shorter time frames, such as the one hour chart. The daily chart is more reliable, more solid, and immune to market noise and many false signals arising from the different trading time zones.
The problem of ambiguity and conflicting signals exists around all market indicators, not just Fibonacci numbers, and traders need to be careful in how they use each and every trading tool and indicator. Even classical swing trading theory which analyzes highs and lows, to determine the trend of the market, is a slow, often lagging indicator, and does have ambiguities which confuse market analysts. Some of these ambiguities can be removed if you use a trend strength indicator, such as ADX, or apply trendline theory to your market charts.
As far as stock trading is concerned, Fibonacci numbers do work but not to the degree of accuracy that they tend to work in the forex market. This is because the forex market is more liquid and more traders watch out for these numbers. Whereas a stock, can often trade too much up or down, because of poor liquidity, thereby defying all technical signals.
The Big Picture
Fibonacci numbers used in trading are part of a larger effort which attempts to explain market movements in terms of waves. Some theorists go further, by investigating both Fibonacci numbers, and also Fourier analysis theory, which makes it possible to analyze certain types of waves, into individual component smaller waves. And both these theories exist in nature, where various phenomena do obey Fibonacci numbers or Fourier wave theory.
In actual trading, you will only be successful using Fibonacci numbers on the daily chart, if you use them in day trading or other short time frame charts. You will see that the market does react to these retracements and extension levels, but it often does not change direction, so it leads to false signals. Remember this is because other traders have chosen a different reference price range, and so they have gotten different retracement and target prices.
In any case you should avoid mixing too many different indicators together, and keep your trading approach simple. This is in order to avoid ambiguities and conflicting signals. Basic forex trading tips can help you avoid many losing trades and a lot of frustration. For example, you can safely use Fibonacci numbers on the daily chart, and also use the 200 day simple moving average, or the Parabolic SAR indicator, all on the daily chart, to confirm the daily trend and the progress o the market. If your Fibonacci price targets are correct and the market is approaching these, you are on your way to making profitable trades. There’s no need to watch the daily confusing market news, or other confusing forex stories. In some cases where a currency pair is moving as expected, and you believe you can time the move, it’s worth considering trading One Touch binary options, because if the trade goes well, which on the daily chart can, the payouts will be massive, often 300% to 500%. In actual binary trading tests it was possible to go from $500 to $5,000 in less than 2 months, all through One Touch trades, and carefully selected forex trades on EURUSD. These trades used projections on the daily chart, very similar to the ones identified by Fibonacci numbers. We also used theory of trendlines and parallel channels to estimate the exact time the market would reach a particular level.
Fibonacci theory is unproven as to why it does or does not work, but as far as the daily chart is concerned, it does work well enough. And it may be possible some day to explain market movements in more detail, using both Fibonacci theory and Fourier theory. Just remember to keep the market noise out, and to focus on the daily chart first and foremost, and ignore all news. You could further investigate Fibonacci numbers and their inverse numbers, remember that the 2.63 extension number is the inverse of the 0.38 retracement number, is not something directly out the original Fibonacci number sequence. So it may be possible to expand upon this theory and identify other inverse numbers or patterns of numbers on the charts.
You can further refine your forex trades by hedging risk, especially risk arising from fast market movement in the undesired direction, using binary options. And by gauging probability outcomes. By doing these two things around the time the market is approaching a Fibonacci number, you can stay protected, in case the market ignores the target price and moves beyond that target. And here is one more difference between stocks and currencies, stocks tend to fall faster than they rise, whereas currency pairs move at the same rate, whether rising or falling. If you apply all of these tips to stock trading, just remember that stocks tend to fall faster than they rise, so a turning point at a Fibonacci number will likely result in different rates of movement, depending on the trend of the stock, this is important for using hedging protection through binary options.
As far as forex trading goes, you will have no problems applying Fibonacci targets to your trading plan, just remember that many reports and daily articles tend to disagree with one another, and each one has different Fibonacci analysis. You should watch the ones covering the daily and weekly charts of the currency in question, not the one hour and 15 minute charts.
Fibonacci theory is part of the broader wave analysis theory, and quantitative funds and hedge funds are secretly funding research into new trading algorithms, focused on artificial intelligence. Their methods are top secret, but wave analysis and pattern recognition are used, along with other fields of mathematics, so Fibonacci theory should not be totally ignored, even if you are a non believer. On the other hand, if you are already a believer, you should believe less than the forex industry pushes you to believe, and use Fibonacci theory on the daily and weekly charts only. This is the tricky balance you have to keep in order to be a profitable trader through this methodology.
You can improve your use of Fibonacci theory further, by taking the following tip into account. It comes from trendline theory, and it’s about identifying false breakouts out of trendlines. Basically you need to watch the trendline which forms a resistance or support on a chart. A valid breakout move can only occur in one of two ways, 1) as buy signal, where market price breaks out to the upside, through a falling trendline. 2) as a sell signal where market price breaks out to the downside, through a rising trendline.
If for example the market is rising, and the supportive and resistive trendlines are kept intact and rising, and the market breaks out to the upside, through this rising resistance, it’s bound to be a false buy signal.
If the trend had been downwards, a valid buy signal would occur through the breach of a falling resistance only. After all, all valid signals are expected to change the daily trend. By taking this tip into account, when assessing possible Fibonacci reversal levels, you will be able to avoid many false signals. This analysis requires the study of the daily chart, and looking at trendlines and channels. It’s possible for some narrow parallel channels to expand, despite the presence of a false signal, and the market to move as much as 300 pips against you, as part of a false signal. This is possible, but when the parallel price channel is quite wide, this is less likely to happen, and false signals can be identified.
It’s worth assessing Fibonacci levels, and signals given by the market at those times, because you can figure out the validity of that Fibonacci reversal level through the study of these other signals. In the case of the above chart, we have a valid sell signal, which instantly, from day one would have warned us about forgetting any Fibonacci targets on the upside, and focusing on Fibonacci targets on the downside, it’s that simple! And you can also learn about swing trading theory, and combine that with Fibonacci targets, this is quite a powerful indicator, slow and lagging at time, but very useful in assessing the validity of price reversals. Because remember that most losing trades that traders make, are because of mistaking false breakouts for solid trends, this is how they lose most of their money. And you can avoid these mistakes by a factor of 80% using these indicators.