Identify Key Price Levels Using the Fibonacci Indicator
You may have heard the word Fibonacci in your school or college math class. Fibonacci was the name of a famous Italian mathematician who introduced the Western world with an interesting sequence of numbers called the Fibonacci sequence. The sequence is such that every number in the sequence is the sum of the previous two numbers. Additionally, the ratio between any two consecutive numbers in the sequence is the same.
The Fibonacci sequence is commonly found in nature, in the way plants grow, in the way honey bee families evolve, and even in the way cloud spirals are formed in hurricanes. Speaking of the connection between the financial markets and nature, famous American hedge fund manager Victor Niederhoffer believed that events in nature have a bearing on market patterns. Similarly, many traders also believe that the Fibonacci sequence which seems to act as a balance in nature also has significance in the market. Traders have figured out a way to use the Fibonacci ratio as a guide toward spotting important price levels.
In this article, we will take a detailed look at what the Fibonacci trading indicator is and how you can use it to identify key points on the cryptocurrency price charts to execute high-probability trades.
What exactly is the Fibonacci sequence?
The following is what the Fibonacci sequence looks like: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610…..
This sequence continues further. We have just listed the initial part for demonstration. If you notice, the third number in the sequence (1) is the sum of the first two (0 and 1). The fourth number (2) is the sum of the second and third numbers (1 and 2). Sounds interesting right? As a trader, we want you to focus on another aspect of this sequence, which is the ratio. Dividing the first number by the second gives you 0 (0 divided by 1). Dividing the next two numbers in the sequence (1 and 1) gives you 1. Similarly, dividing 1 by 2 gives you 0.5.
Now, ignore the first three numbers in the sequence and start with the fourth (2). If we divide it by the next number (3), then the ratio is roughly 0.6. This holds true for the rest of the sequence. Dividing one number by the very next one in the sequence will roughly work out to 0.618.
But wait, the Fibonacci sequence gets even more interesting. Instead of consecutive numbers, if you divide any two numbers that are two places apart, you get 0.38. So, for example, dividing the fifth number in the sequence (3) by the seventh one (8) roughly results in a ratio of 0.38. Take it a step further and divide any two numbers that are three places apart. You will consistently get a ratio of roughly 0.236.
These ratios – 0, 1, 0.5, 0.618, 0.38, and 0.23 are Fibonacci ratios. We will use them in the Fibonacci indicator and therefore, it is important to keep them in mind.
Finding support and resistance using Fibonacci ratios
As a trader, you are constantly trying to find important price levels. You want to go long when the price reverses from support or go short when the price reverses after facing resistance. The Fibonacci ratios (0.5, 0.618, 0.38, etc) can help you find those levels with a reasonable level of accuracy.
For example, if the price has been in an uptrend and then topped out, it will likely pull back to 61.8% of the total uptrend before perhaps finding support. By total uptrend, we mean the distance from where the current uptrend began (at the previous bottom) to the point where the top of the current uptrend occurred. If the price breaks the 61.8% level, then it could find support at the 50% level. If that breaks too, then the next possible support could be 38%. The Fibonacci indicator will show all the various ratio levels. You can simply use the indicator to superimpose these levels on the price chart.
After a downtrend, if the price finds a bottom after a strong down move, then it is likely to retrace back up. It may likely reverse to 61.8% of the total downtrend before finding resistance. By total downtrend, we mean the distance from where the current downtrend began (at the previous top) to the point where the bottom of the current downtrend occurred. If the price breaks through the 61.8% retracement level, then it could test the 50% level or the 38% level.
Estimating Possible Extension Levels
If you flip (inverse) the Fibonacci ratios, then you get some important numbers. The inverse of 0.618 is 1.618, the inverse of 0.5 is 2, and so on. You can use these numbers to estimate how far the price is likely to travel for you to exit your trade. The principle of measuring distances is the same as with retracement levels.
For example, if the price is in an uptrend and you identified support to enter a trade (buy on dips), then you can estimate another pullback or reversal at 161.8% of the original uptrend. By original uptrend, we mean the point from where the uptrend began (previous bottom) to where it topped out before the pullback when you entered the trade. The same concept can be applied to a down move to find out how far the price is likely to fall before taking a breather or reversing altogether. In the case of a downtrend, you will look for 161.8% of the original downtrend. By original downtrend, we mean the point from where the downtrend first began (previous top) to the point where it bottomed out temporarily before continuing the downward journey.
To summarize, if Fibonacci retracement levels were used to identify entry points, then Fibonacci extension levels can be used to identify targets and exit points.
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