In the financial markets, how can we predict support and resistance levels, and how can we determine price objectives by using Fibonacci retracement and extensions? Let’s dig into it!
Fibonacci studies encompass a series of analysis tools based on sequence and Fibonacci ratios representing geometric laws of nature and human behaviour, applied to financial markets.
In general, these studies are used to predict levels of support and resistance through relationships between Fibonacci numbers. These are the most used relationships:
- 0.618 (61.8%): A Fibonacci number divided by the number that follows is approximately 0.618.
- 0.382 (38.2%): A Fibonacci number divided by the number occupying two later positions is approximately 0.3820.
- 0.2360 (23.60%): A Fibonacci number divided by the number occupying three later positions is approximately 0.2360.
- 0.764 (76.4%): Obtained by adding the difference of 38.2% and 23.6% to 61.8%, that is, 76.4% = 61.8% + (38.2% – 23.6%).
- 0.5 (50%): Half the progress of the main trend. It’s the average between 38.2% and 61.8%.
- 0.0 (0%): Beginning of a market movement.
- 1.9 (100%): End of a market movement.
To understand Fibonacci studies, it’s necessary to remember the concept of support and resistance.
- Support: The valleys (or minimums) of the graph below. These are the points at which the buying interest is strong enough to overcome the selling pressure. As a result, the decline is suspended and the price rises again.
- Resistance: The peaks (or highs) of the graph below. These represent a price level or area above the market where the selling pressure exceeds the purchase pressure. When a resistance acts on more than one occasion to curb the rise in price, a double roof occurs. A double roof is a sign of weakness in the bullish trend, showing a critical level that the price is unable to overcome.
Most Fibonacci analysis tools use ‘Candlestick Graphs’ and are based on a three-wave corrective pattern (‘A-B-C Pattern’). The first wave, A, is impulsive; followed by wave B, a corrective character wave that goes in the opposite direction to wave A and does not exceed the beginning level of wave A; and finally wave C, which is again impulsive, goes in the same direction as wave A and reaches beyond the final point of wave A.
Fibonacci retracements are not useful for determining market trends, but help predict support and resistance levels.
To draw Fibonacci retracements you must first identify the extreme points of a strong market movement (impulse wave). Next, draw a vertical line that joins the two previously located points. Once drawn, this line will be divided by horizontal lines separated by the previously named percentages.
Once the market movement has been defined and the Fibonacci levels drawn, we must wait for the regression channel to be activated. This occurs when the sale’s closing price is between the horizontal lines marked by 38.2% and 61.8%.
When the price enters the retracement channel, there are four possible cases (we will call wave A the wave from which we obtained the Fibonacci retracement).
- If wave A moves down and the entire wave is below the level marked as 61.8%, we can define the wave as impulsive. As the wave A trend is bearish, we have the signal for a possible sale.
- If wave A moves up and the entire wave is below the level marked as 38.2%, we can define the wave as corrective. As the wave A trend is bullish, we have the signal for a possible sale.
- If wave A moves up and the entire wave is above the level marked 61.8%, we can define the wave as impulsive. As the wave A trend is bullish, we have the signal for a possible buy.
- If wave A moves down and the entire wave is above the level marked as 38.2%, we can define the wave as corrective. As the wave A trend is bearish, we have the signal for a possible buy.
The Fibonacci extensions are used to determine price objectives after you have discovered the correction levels indicating the initial trend has resumed.
It’s necessary to identify three points in order to draw the Fibonacci extensions. In a bullish trend, these are; the minimum point (beginning of the trend), the maximum point (end of the momentary tendency) and the minimum point reached by the pullback. In a bearish trend the logic is the same but in reverse.
First, the line of the first wave is drawn, considering its height as the unit segment. The end of the second wave serves as the reference point for drawing an invisible vertical line. The corresponding horizontal lines are drawn, taking into account the unit segment, with respect to the reference point in the distance that is equal to 61.8%, 100% and 161.8% of the unit segment. The third wave will be finalized near those levels.
Although these are the most widespread studies, there are numerous additional tools…which we will leave for future blog posts to talk about!
If you liked this post, don’t forget to take a look at Fibonacci Numbers.