FIBONACCI TRADING

But that's not the important part! There are regularities in relationships among these numbers. For example, if you divide any number in the series by the immediately preceding number, starting with the small numbers and working higher, then you converge upon an number around 1.618 which is referred to as the golden ratio. The inverse is 0.618.

There are other ratios that become important, too, with the implication being that these values are important in natural processes including, by extension, price data. Fibonacci trading is the application of these mathematical discoveries to the world of trading, whether commodity futures, options, forex or stocks. While Fibonacci analysis can be applied in a variety of ways, the most prevalent is using the particular set of ratios shown below as price retracement values.

When expressed as a percentage price movement relative to the recent high and low range, they represent possible support levels for a retracement of a generally bullish market and possible resistance levels for a retracement of a generally bearish market.

Consider the following example:

You can see that May corn, after having fallen from 432 cents to 363 cents rallied or retraced back to touch the 389-cent level which represented a Fibonacci retracement of 38.2%. A trader who is bearish on corn and who wants to sell on a technical retracement can thus use Fibonacci analysis as a way to identify these important price levels.

How Useful is Fibonacci, Really?

Even though Fibonacci is readily referenced by traders and technical analysts, the value of Fibonacci analysis from a practical viewpoint is not clear. For example, one limitation of relying on Fibonacci analysis is that, without further or outside analysis, there is little way of knowing in advance which Fibonacci level will provide the anticipated support or resistance level. While it may seem obvious by looking at an historical chart, the trader really has no way of knowing on a real-time basis which level will hold.

Another problem is that the choice of a recent high and low from which to measure the Fibonacci ratios are not always obvious and, in part, will depend upon the trading time horizon. For example, a day trader that relies on 5-minute bar charts may identify a local high and low over the last 6-hour period but neither of these points may be a high or low as seen on a daily chart or weekly chart.

Despite these drawbacks, Fibonacci analysis can be a useful technical tool. The reason is that traders all over the world watch these levels and place buy and sell orders accordingly. Consequently, price behavior around Fibonacci levels can become self-fulfilling.

Fibonacci analysis should probably not be relied upon exclusively for trading but rather, be one of several analytical tools and techniques in the technical arsenal of the trader. An example of this is PivotFarm's Technical Analysis Data Sheets that integrates Fibonacci with other technical indicators to determine probable market turning points. (Free 30-day trial is available.)

The key to designing an effective trading system is often to integrate a few indicators in a novel and synergistic way and Fibonacci analysis may very well play an important role. For more information on trading systems and their design, request our free brochure, How to Invest.