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Fibonacci retracement. Sounds sophisticated? But what is he doing? And it works ?
Fortunately for traders, Fibonacci retracements are more than just a smart word. In fact, it is the name of a tool used to predict potential support and resistance levels for price action.
First, let’s define what this so-called “Fibonacci” is so that you have a better idea of why this is a relevant concept for cryptocurrency trading.
Leonardo of Pisa (aka Fibonacci) was a 11th century mathematician responsible for the introduction of a unique sequence of numbers in the West, now known as the “Fibonacci Sequence”.
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987, 1597, 2584 … (the pattern is repeated endlessly)
Each number in the sequence is derived from the sum of the two previous numbers. Smart, right?
Not only that, but each number is approximately 1.618 times greater than the number before it. This creates a value known as the “golden ratio” or “phi” and has a fascinating relationship with almost everything in nature.
To take flowers, for example, lily is arranged with three petals, ranunculus with five, chicory with 21, daisies with 34 and so on. Interestingly, the numbers follow the Fibonacci sequence and each petal is even placed at 0.618 per turn (on a 360 degree circle), allowing for optimal exposure to sunlight and other factors critical to survival. .
The examples of the Fibonacci sequence in nature are seemingly endless and this extends to trading when it comes to analyzing price action.
Specifically, a trader can derive the levels of a trend that the price is likely to meet by dividing a peak-to-trough or trough-to-peak distance by the golden ratio and other ratios in the sequence. Other important ratios include 0.382 which is any number in the sequence divided by the number two places to its right and 0.236, found by dividing one of the numbers by the three places to its right.
As you will notice, price reacts regularly to these levels, which can provide a trader with optimal entry and exit points, just as it provides a flower with the optimal structure to absorb sunlight.
Find support levels
Before using the Fibonacci tool to identify potential support or resistance levels, a trader must first be able to identify a “swing high” and a “swing low”.
A swing high is simply a candlestick at the top of a trend in any time frame that has a lower high directly to its right and left. Conversely, a swing low is the low candlestick of a trend with a higher low on either side.
Once these points have been identified, select the Fibonacci retracement tool in your trading software to connect a swing low to a swing high. Potential support levels will be generated, called retracements.
Each retracement is derived from the vertical distance “from the bottom to the top” divided by ratios in the Fibonacci sequence.
As you can see, the retracements of 0.236, 0.382, 0.5, 0.618, 0.786 were all respected as support, at least temporarily, as the price rebounded from its fall in September.
If a trader were to take advantage of this tool from November, they would have had an idea of where the price could land before making their next move, revealing the ideal entry or exit points.
Find resistance levels
The process for finding potential resistance levels is largely the same as before, except this time you will connect the swing high to the swing low.
Retracements will appear again by dividing the distance between the peak and the trough using ratios in the Fibonacci sequence.
In the chart above, the anticipated resistance levels for Stellar Lumens (XLM / BTC) were calculated using the Fibonacci tool by connecting the high swing of 0.00006335 / BTC to the low swing of 0.00002139 .
Once again, the price reacted to the announced levels.
The 0.786, 0.618, 0.5, and 0.382 retracements all provided resistance on multiple occasions which would have provided a trader with optimal targets to take profit on their position.
It is important to remember that while the Fibonacci tool can be useful in identity supports and resistances, results are not guaranteed. In order to increase the likelihood that some retracements will act as advertised, it is best to use the tool with other indicators such as moving averages or the Relative Strength Index (RSI).
For example, if a moving average is in the same spot as a Fibonacci retracement, the price is more likely to react at the level given that there are two obstacles of support or resistance, which when combined are more powerful than one.
If you have gone through the sequence of calculating each ratio, you may have noticed that 0.5 is not yet part of it, it shows up as a level in the Fibonacci Retracement tool. That’s right, 0.5 is not a ratio in the Fibonacci sequence but is included in the tool because it marks a 50 percent trend retracement, to which the price has a funny way of reacting as as support or resistance.
Disclosure: The author owns BTC, AST, REQ, OMG, FUEL, 1st, and AMP at the time of writing.