14. Fibonacci Analysis

No, it's not a type of pasta

Fibonacci analysis is a great way to improve your analytical skills when trying to identify support and resistance levels. Fibonacci analysis is based on the Fibonacci series of numbers. These numbers have been developed and explored by mathematicians for centuries and are named after Leonardo of Pisa (Fibonacci) who did a lot of work to popularize them in 13th century Italy.

The number series starts with 0 and 0 and then is continued by summing the previous two numbers in the series. For example, here are the first few Fibonacci numbers.

0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987, 1597, 2584…

As traders we are not actually interested in the numbers in the series. What is important to traders are the ratios or differences between the numbers in the series. These are called Fibonacci ratios and can be used to identify likely support and resistance levels.

The most popular Fibonacci ratios or levels are 23.6%, 38.2% and 61.8%. There are other ratios that can be used but it is up to you to decide how far you want to take the analysis. In addition to the Fibonacci ratios there are two other levels, 50% and 100%, that are often included in the analysis, although they only appear as a Fibonacci ratio at the very beginning of the series. If you are interested in learning more about the historical origins and other uses for these levels, click here for a great background article.

Fibonaccis on the chart

When drawn on a chart the Fibonacci levels divide a trend into segments. Each of these segments become likely support or resistance levels. In the chart below you can see a Fibonacci retracement applied from the bottom to the top of a recent trend on the EUR/USD. You can see that the market has been bouncing up from the 23.6 and 38.2% retracement levels for a few months. These were identified in advance and are excellent guides for placing stops or entry orders. 

In the chart above, you saw how Fibonacci levels can be used to divide a trend into horizontal support and resistance levels but it can also be used to create diagonally trending support and resistance levels. Diagonally trending Fibonacci levels are called Fibonacci fans, and are applied the same way that the horizontal versions are.

In the chart, you can see the market channeling between the 50 and 38.2% lines for nearly a month. This kind of Fibonacci analysis is helpful when trying to establish where trending market is likely to begin consolidating or encounter a support or resistance level.

Fibonacci levels can be spectacularly predictive but there is a danger here as well. Like all support and resistance analysis, it can aid predictions but is not foolproof. Breaks happen and you should be prepared to handle a bad trade just as you would with any other analysis.

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