Let’s start with looking at support and resistance. Support and resistance levels on bar charts are a major component in the study of technical analysis. Many traders use support and resistance levels to identify entry and exit points when trading markets. When determining support and resistance levels on charts, you should look at the key Fibonacci percentage "retracement" levels.
Two Fibonacci percentage retracement levels that are most important in market analysis are 38.2% and 62.8%. Most market technicians will track a "retracement" of a price uptrend from its beginning to its most recent peak. Other important retracement percentages include 75%, 50% and 33%. For example, if a price trend starts at zero, peaks at 100, and then declines to 50, it would be a 50% retracement. The same levels can be applied to a market that is in a downtrend and then experiences an upside "correction."
These numbers were derived by Leonardo Fibonacci da Pisa, a famous 13th century mathematician. Fibonacci discovered a number sequence called "the Fibonacci sequence." That sequence is as follows:
1,1,2,3,5,8,13,21,34 and so on to infinity. Adding the two previous numbers in the sequence comes up with the next number.
Importantly, after the first several numbers in the Fibonacci sequence, the ratio of any number to the next higher number is approximately .618, and the next lower number is 1.618. These two figures (.618 and 1.618) are known as the Golden Ratio or Golden Mean. Its proportions are pleasing to the human eyes and ears. It appears throughout biology, art, music and architecture.
Here are just a few examples of shapes that are based on the Golden Ratio: playing cards, sunflowers, snail shells, the galaxies of outer space, DNA molecules… Even our own body has Fibonacci numbers, (2 hands, 5 fingers each segmented into 3 parts), the size of fingers, limbs, facial features have Fibonacci relationships. William Hoffer, in the Smithsonian Magazine, wrote in 1975: "The continual occurrence of Fibonacci numbers and the Golden Spiral in nature explain precisely why the proportion of .618034 to 1 is so pleasing in art. Man can see the image of life in art that is based on the Golden Mean."
The element that is most fascinating about Fibonacci numbers and the Golden Ratio as they are applied to technical analysis of markets, is that these principles are a reflection of human nature and human behavior. Successful traders realize that trading is both art and science. The longer you are trading and the more you study the behavior of markets, the more you should realize that human behavior patterns and market price movement patterns are deeply intertwined.
Why Fibonacci Analysis Works.
Let’s look at risk and greed. Each person has his or her own tolerance for risk and level of greed. If a trade is losing value and the loss becomes unbearable, we close the trade and stop the pain. At that point we have reached our risk/pain tolerance.
The same applies to profits. In a winning trade, we eventually reach a point when we must close the trade, the profits are too great to be risked, so we lock in our profits when we reach our greed tolerance level. Our risk/greed tolerance is different from most other traders, and can also vary based on many factors.
If we take a crowd of traders, say 50,000 of them, and get an average of their risk/greed tolerance, we would arrive a defined risk/greed tolerance value for that group. We can only guess, but if we did the same for a different group of 50,000 traders we would probably arrive at a very similar average risk/greed tolerance value. Because most traders are human, we could rationally conclude that the average risk/greed tolerance level for any large group would be about the same as another group.
If we do the same for large groups of short-term traders and then large groups of long-term traders, we would have some valuable information about where these groups would translate their risk/greed tolerance into action. Knowing where the short-term and long-term traders' risk-greed tolerance coincides is very valuable. Where they coincide would be a profitable place to trade, since the market action would be more predictable.
That is exactly how successful traders apply Fibonacci ratios to trading.
The markets tell us where the groups of traders have reached their risk/greed tolerance levels - these levels are reflected in the prices of trading instruments very clearly. With that information, we can calculate the probable future action of traders. This helps determine optimum entry points and profit objectives.
Fibonacci analysis therefore is a leading indicator. Applying fibonacci analysis properly you should be able to determine probable turning points in the market before the price gets there.
Conclusion
Why does Fibonacci analysis work? Because we are human, part of nature, and because Fibonacci numbers are everywhere in nature. The more you study the behavior of markets, the more you should realize that human behavior patterns and market price movement patterns are deeply intertwined. At least as a minimum, the Study of Fibonacci techniques will help you become a much better and rounded trader.
It is easy to find Fibonacci ratios in price charts, however one warning: knowing which ones are more likely to be profitable is not as easy. Trading with only a basic understanding of Fibonacci techniques is dangerous.
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