How to utilise fibonacci

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The Fibonacci sequence first appears in the book on arithmetic “Liber Abaci” by Leonardo of Pisa – better known as Fibonacci. The calculation is used in this book to describe the growth of rabbit populations (assuming starting with one male & one female, producing a line of mating pairs of rabbits).

• The sequence is: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377 etc.

Something magical happens when you get past 89. Every time you divide a number in the sequence by the previous number you get the same value: 1.618 (the golden ratio)

• 89 / 55 = 1.6181818
• 144 / 89 = 1.6179775
• 233 / 144 = 1.6180555

The further along the sequence, the closer to 1.618 whole number. This pattern appears in nature all the time. For example, the display of a sunflowers florets are in perfect spirals of 55, 34 & 21. The same is true for pine cones, pineapples and multiple other plants/flowers/fruits etc. 

This "magic ratio" is also present throughout the human anatomy. For example, the distance from your shoulder to finger tips is 1.618 times greater than the distance from your shoulder to your elbow. (also applies to the geometry of your hands, face, fingers, spine, legs etc.) 

Now, how is this applied to trading? Consider this... Markets are made up of market participants. Most of these participants are human. Humans are part of nature and work/trade in ways which would suggest this. Their psychology, behaviour and emotions are some of the main drivers in the financial markets. The reason these Fibonacci ratios are adhered to could be explained by suggesting that humans subconsciously seek out the Fibonacci ratios. This might in fact be true because traders (humans) aren't, psychologically, comfortable with excessively long trends. Chart analysis has a lot in common with nature in the sense that things that are based on certain ratios are beautiful and shapely and, on the other hand, things that don't contain these ratios look ugly and seem suspicious and unnatural. As humans, we like order… We DO NOT like disorder or chaos. The Fibonacci sequence/ratios/levels are a way to ensure order.

It is important to note that these levels act as “zones” in the market. They are NOT exact and most definitely should be not used as a standalone trading system. Like everything else, they should be used as another tool in your trading toolbox.

The Fibonacci Levels can be split into two groups - Fibonacci Retracements & Fibonacci Extensions. There are several different levels within these two groups which can be classed as "Fibonacci Levels" however, for the purpose of this article, I shall only focus on the ones which I personally use and find to be the most effective. 

 Fibonacci Retracements:

• 0.618 – This is the most significant Fibonacci level and it is derived by dividing one number in the sequence by the following (i.e. 89/144)
• 0.382 – Another important level derived by dividing one number in the sequence by the number two places to the right (i.e. 89/233)
• 0.500 – This is not really a Fibonacci level but it represents 50% of a given value. This tends to be powerful in an “orderly” world.
• 0.786 – This is the square root of 0.618
• 0.886 – This is the square root of 0.786
• 0.236 – This is derived by dividing one number in the sequence by the number three places to the right (i.e. 89/377) (not commonly used - I personally do not use this but I feel as though it should be included) 

Fibonacci Extensions: 

• 1.618 – This is the most significant Fibonacci level and its derivation has been described above. However, it can also be calculated as 1 / 0.618
• 1.000 – Again, not really a Fibonacci level however, it represents one whole. A nice round number. Very orderly.
• 1.272 – This is the square root of 1.618
• 1.382 – This is the addition of 0.382 to 1.000 (one whole or 100%) 
• 1.130 – This is the fourth route of 1.618 or square root of 1.272
• 1.414 – This is the square root of 2.000
• 2.000 – This is not really a Fibonacci level but it is double a particular value (200%)

Fibonacci Retracements

In order to incorporate these levels into our trading we must first identify a swing low and a swing high in which to stretch our Fibonacci tool to and from. This is to identify the base and peak of a price “swing” or “rally”. 

Fibonacci levels can be used in conjunction with other levels in the market. Most commonly they will be used to further emphasise the strength of certain support or resistance levels. In this instance, they would work well in trending markets. For example, if you are a trend trader (most beginners will be as the odds are stacked up against you when trying to trade counter trend) you could use previous structure alongside Fibonacci levels to determine a zone of entry during a retracement/pullback in the opposite direction of the trend, in order for you to enter in the same direction as the trend. (see examples below & lecture) 

Fibonacci Extensions

For Fibonacci Extension levels, we must again identify a swing low and a swing high in which to stretch our Fibonacci tool to and from. This is to identify the base and peak of a price “swing” or “rally”. 

Fibonacci Extensions are slightly more advanced than Fibonacci Retracements with regards to trading ranges. The Fibonacci extension tool is used to project price in the direction of the “trend”, rather than counter “trend”. 

This might be useful in projecting profit targets or stop loss levels. For example, if you enter a trade based on a retracement lower into support/Fib Retracement levels during an uptrend, you could then set targets based on Fibonacci Extension levels. If you’re entering a counter-trend trade, then it is ideal for stop loss placements above/below the highs/lows formed by the recent trend. Rather than placing stop losses a generic number of pips above/below a price extreme, you are now taking into account recent price action to consider stop placements. (see examples below and lecture)

Advanced & Harmonic Patterns 

These patterns are not the purpose of this article and therefore, I will only provide a brief overview of how the patterns are formed. For more information see the "Patterns" tab to understand how these patterns are formed and how they should be traded. 

Firstly, there is a reason they are called advanced patterns. These should be one of the last things that a beginner trader attempts to understand. In my opinion, it is important to understand price action, how the markets move, the concepts of support and resistance levels, how & when to use certain tools & indicators, structure, trend and market conditions before learning these patterns. The patterns require at least a basic understanding of all of the above before they can be utilised to their maximum potential. 

The important thing to understand about these levels is that, like most things in the trading world, nothing is exact. Fibonacci levels should be treated as zones rather than exact prices. These zones work well in trending markets as has previously been shown. However, the market is only trending around 30% of the time so how can we take advantage of the other 70% of the time it is in consolidation? This is where advanced and harmonic patterns come in handy, enabling us to trade the majority of the time (although not catching as big a swings). Advanced and harmonic patterns are created by a series/sequence of price swings and retracements to and from certain Fibonacci levels. This is quite simply the definition of consolidation – trading within a limited price range, creating a number of price movements up and down. 

It is important to understand that the following is a basic, short coverage of these patterns. There are significantly more factors involved and this should be considered when reading this.

These patterns are essentially formed by connecting 5 points, 3 of which have certain characteristics relating to specific Fibonacci levels or “zones”.

• The first two points are defined as the X point (where the pattern starts) and the A point (where the initial price rallies to). The line between these two points is just an initial price swing. These first two points are not dictated by any Fibonacci levels. Without the following three points completing their own price action, these first two points are essentially worthless.
• The next point is the B point. This is the first point to be dictated by certain Fibonacci levels. Each pattern has specific rules for the B point however, the Fibonacci levels will be determined by stretching the Fibonacci retracement tool from the X to A leg. 
• The next point is the C point. Again, this has a different set of rules for each pattern however, it is also dictated by specific Fibonacci retracement or extension zones using either the X to A leg as the swing points for the Fibonacci tool, or the A to B leg. 
• The final point is the D point. This marks the completion of the pattern and is, once again, dictated by different Fibonacci levels depending on the pattern.

For the purpose of this article I shall only use one example of a widely used pattern – The Advanced Cypher Pattern. 

See examples below however, for the best explanation watch the lecture!