Fibonacci

Fibonacci tools utilize special ratios that naturally occur in nature to help predict points of support or resistance. Fibonacci numbers are 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, etc. The sequence occurs by adding the previous two numbers (i.e. 1+1=2, 2+3=5) The main ratio used is .618, this is found by dividing one Fibonacci number into the next in sequence Fibonacci number (55/89=0.618). The logic most often used by Fibonacci based traders is that since Fibonacci numbers occur in nature and the stock, futures, and currency markets are creations of nature - humans. Therefore, the Fibonacci sequence should apply to the financial markets. There are many Fibonacci tools used by traders, they include: 

• Fibonacci Retracements 
• Fibonacci Arcs
• Fibonacci Fans
• Fibonacci Time Extensions

I. Fibonacci Retracements

Arguably the most heavily used Fibonacci tool is the Fibonacci Retracement. To calculate the Fibonacci Retracement levels, a significant low to a significant high should be found. From there, prices should retrace the initial difference (low to high or high to low) by a ratio of the Fibonacci sequence, generally the 23.6%, 38.2%, 50%, 61.8%, or the 76.4% retracement.

For the examples of this section, the S&P 500 Depository Receipts (SPY) will be used based on the logic that the S&P 500 is a broad measure of human nature, thus the Fibonacci sequence should apply very well. Nevertheless, the Fibonacci sequence is applied to individual stocks, commodities, and forex currency pairs quite regularly. The chart above shows the 38.2% retracement acting as support for prices.

Note that a trendline was drawn from a significant low (beginning of trend) to a significant high (end of trend); the trading software calculated the retracement levels. 

The chart below of the SPY's shows that Fibonacci Retracements can be used to retrace downtrend moves as well:

Notice after the bottom in the S&P 500, that price rallied to the 23.6% retracement level and then was promptly rejected downwards. After breaking resistance a few months later, the 23.6% retracement became support (see: Support & Resistance). Price rallied up to the 50% retracement level, where it ran up against resistance. Price continued to fluctuate between the 38.2% retracement level (acting as support) and the 50% retracement level (acting as resistance).

There are many other Fibonacci tools available to stock, forex, or futures traders. Fibonacci Arcs are discussed next.

II. Fibonacci Arcs

Fibonacci Arcs are percentage arcs based on the distance between major price highs and price lows. Therefore, with a major high, major low distance of 100 units, the 31.8% Fibonacci Arc would be a 31.8 unit semi-circle. 

The chart below of the S&P 500 exchange traded fund (SPY) shows an example of a Fibonacci Arc:

III. Fibonacci Fans

Fibonacci Fans use Fibonacci ratios based on time and price to construct support and resistance trendlines; also, Fibonacci Fans are used to measure the speed of a trend's movement, higher or lower. 

• If prices move below a Fibonacci Fan trendline, then price is usually expected to fall further until the next Fibonacci Fan trendline level; therefore, Fibonacci Fan trendlines are expected to serve as support for uptrending markets (see: Support & Resistance). 

• Likewise, in a downtrend, if price rises to a Fibonacci Fan trendline, then that trendline is expected to act as resistance; if that price is pierced, then the next Fibonacci Fan trendline higher is expected to act as resistance. 

The chart below of the S&P 500 exchange traded fund (SPY) shows an uptrend that retraced to the 38.2% Fibonacci Fan:

The Fibonacci ratio is also used to predict areas of time in which price might change course; Fibonacci Time Extensions are discussed next.

IV. Fibonacci Time Extensions

Fibonacci Time Extensions are used to predict periods of price change (i.e. lows or highs). For example, after a downtrend, a reversal might be expected at a significant Fibonacci Time Extension line. Similarly, after an uptrend, a reversal warning might occur if a Fibonacci Time Extension was soon approaching. 

The Fibonacci Time Extension tool is created by locating a significant high (low) and finding a significant retracement or extension low (high). The major Fibonacci ratios are then calculated and plotted by charting software.

An example of a Fibonacci Time Extension is shown below in the chart below of the S&P 500 exchange-traded fund (SPY):

Fibonocci Tools are often used by traders. Whether or not a trader believes Fibonacci ratios work beyond nature and into the financial markets, traders should be aware of Fibonocci Retracements (most often used) and the other Fibonocci Tools. 

Because there are many traders out there who do believe that the Fibonacci ratios apply to the financial markets, that presupposes that there might be real supply and demand forces working on the markets at these important Fibonacci junctures. This would be important because, after all, supply and demand is theconcept that moves the markets.

(Source: onlinetradingconcepts.com)