So what is Fibonacci, and how do we use them for trading the markets?
Fibonacci’s root stems from around the year 1202, in which Leonardo da Vinci made public of the mysterious number that seems to be found everywhere.
This is called the Golden Ratio or coined “Phi”. The sequence of each number is the sum of the two prior numbers. This leads to an approximate number of 1.618 in difference to the prior number.
(you don’t need to bang your head around for this..)
This number appears everywhere life exists. Even more so, it can be found in our everyday lives such as construction, art, and anatomy.
Although the .618 level is most relevant, there are other ratios that are used when trading. The most important Fibonacci levels are the following:
[.382, .50, .618, .786, .886, 1.27, 1.414, 1.618]
When it comes to trading with Fibonacci, there are two types of “Fib’s” to utilize.
1. Fibonacci Extensions –[1.27, 1.414, 1.618]
2. Fibonacci Retracements –[.382, .50, .618, .786, .886]
The biggest issue and question when it comes to these special indicators is; how do you plot the Fibonacci indicator on the chart?
ANSWER: It’s very simple, and I suggest you don’t over complicate it right from the beginning…
Also remember, this is not a science when it comes to trading. Two different people can plot different Fibonacci levels and yet both can be right or wrong.
What’s really important is to make sure that you can find other nuances or factors that are supporting those levels.
How to Plot:
One must plot both the extensions and retracements so they can get a full scope of what lays ahead. You must find a “Swing Low” and a “Swing High” or vice versa.
A swing high/low is basically when a previous trend has flattened out and decided to reverse, thus creating a new higher/low or lower/high.
Here is an example:
As you can see, all you need to do is find a reversal at highs and a reversal at lows.
I provided a great example of how ‘FIB’s’ can be used to locate support and resistance levels for gauging entries, stops, and targets. Let’s check out Ctrip.com International Ltd (NASDAQ: CTRP) below:
So let’s go through how I traded CTRP, and how I used the Fibonacci levels to execute the position from beginning to end.
First, we entered off of an Alpha 7 Setup coined “Mini PUP” which was located on the 5-minute chart at around 1:00 pm (EST). As you can see this is the .786 Fib levels which also gave us an indication of a resistant level (Green Arrow). Our stops were the Fib level below that on the .886% Fib level (Orange Arrow).
I had our targets set at the Upper BB of the 5-minute and 15-minute chart (Green Circle). My last target was based on the $58.21 Fibonacci level. It is not smart to use the exact Fib level price and is best to plan ahead of the price support or resistance. As you can see, my last target was perfect. Once it reached that upper Fibonacci level, it immediately rejected to go higher and continued to move lower for the remaining trading day.
This doesn’t mean you should set it and forget it. A trader should always gauge the current market climate and make sure that the position is still in good standing as it was initially when you first entered. If it looks like it is losing steam in your direction, then you must evaluate the playing field and adjust when appropriate.
This is just one of hundreds of examples I can provide on why Fibonacci’s are a crucial technical study that should be used at all times.
Also, you can see that I have two Fibonacci plots; the extension and revision so that way I can have a full scope of ‘what lurks beneath’ in the stock and the overall market.
If you liked this article and Fibonacci’s seem interesting to you. Go to our Youtube page and look for my short Fibonacci video lesson for FREE! –Alpha 7 YouTube Page