Introduction:
Learning simple technical analysis takes you miles ahead in your journey of stock market trading/investing.
Technical analysis is very similar to leading a successful life. It focuses on strategy plus execution. Moreover, like a mentor, you just have to follow the trend line to stay afloat in the market.
Today, we talk about one of the most important ratios in technical analysis.
There are some financial ratios that can help you study the stocks at the micro level, one such ratio is the Fibonacci also called the golden ratio. This ratio is symbolized using the greek capital “Φ” or with a small “φ”. We use these symbols instead of “PHI” because “π”. is an irrational number, that has no end. This formula was given by Leonardo Fibonacci, in his book ‘Liber Abaci’ that he published in 1228.
He mentioned a new number system that was different from the Roman numeral system that was prevalent during that era. This number system was eventually named after him.
This is the Fibonacci number sequence
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987, 1597…etc.
This sequence starts from 0, 1, 1, and every third number is the sum of its previous two numbers.
In the above case 1+1=2, then 1+2=3, 2+3=5 etc.
What is the golden ratio?
So one might wonder what is the Golden Ratio. The golden ratio is derived from the Fibonacci sequence.
If we divide any number by its previous number, we always get 1.618033988749895… However, if we multiply any number in the sequence by 1.618…….. we always get the next number in the sequence.
Fibonacci and the Golden Ratio
One might wonder what is so important about the golden ratio. Well, several natural things adhere to the ratio of 1.618. It is believed that the Fibonacci ratio is one of the fundamental building blocks of nature.
Golden Ratio Examples:
Here are some examples of the Fibonacci golden ratio from our day-to-day life. Have you ever seen a bee hive? Did you know that if you divide the total number of female bees in the hive by the total number of male bees, you get a number around 1.618? This ratio can also be observed in several different components in nature.
Besides this, some of the most renowned pieces of art are made on this golden ratio. The pyramids of Giza incorporate triangles whose dimensions are based on the golden ratio. Some other example of such a monument is the Parthenon in Athens.
The golden ratio Fibonacci seems like a naturally occurring phenomenon that is unavoidable. But this ratio works equally well for financial markets as they have the same mathematical base. Let us now understand the use of the golden ratio in the technical analysis of stocks:
How to use Fibonacci Retracement Levels in Trading
This golden ratio when further translated into percentages can be used for measuring the support and resistance levels of stocks. When the golden ratio is used for stock analysis there are four techniques that are mostly used. Fibonacci retracement, arcs, fans, and time zones.
Here the golden ratio is converted into percentages. Typically, 3 percentages are widely used, to calculate the retracement levels of stocks. These are 61.8%, 38.2% and 50%. However, if required the other multiples like 23.6%, 161.8% and 423% can also be used.
- Fibonacci retracement
It uses vertical lines to indicate support or resistance. The retracement levels of 38.2%, 50% and 61.8% are the key support and resistance indicators in the financial markets. The retracement is drawn using the high and low points of the chart. These lines help in recognizing the buying and selling momentum in the market. Typically, these retracements are plotted on a daily, weekly and monthly basis.
- Fibonacci Arcs:
Arcs can be another way of plotting the support and resistance levels of stocks. This compass-like movement is represented in the form of half circles that intersect the high and low lines at 38.2 percent, 50 percent, and 61.8 percent. When the rally is big, the circle formed is wider. Since it is circular the price of the stock shows similar moves at support and resistance levels. These lines help in anticipating the trading ranges
- Fibonacci Fans
Fibonacci Fans are composed of diagonal lines that are spread within the high and low. After the highs and lows, an invisible horizontal line is drawn from the rightmost point of the chart. These lines are plotted on 38.20 percent, 50 percent, and 61.80 percent retracements. When the stock moves out of these lines, it indicated a strong breakout of a trend. Hence these lines indicate the areas of support and resistance.
- Fibonacci Time Zones:
Unlike other methods, Fibonacci Time Zones is a series of vertical lines that analyze the time period when the price momentum was maximum. They are made by dividing the charts into vertical segments that are spaced according to the Fibonacci sequence (1, 1, 2, 3, 5, 8, 13, etc.). Fibonacci Time Zones can span a longer period, more the duration more potent the momentum. The analysis of these time zones can help eradicate the drastic volatility and results in a steady price movement.
Conclusion:
The Fibonacci studies in general are not intended to provide you with the entry and exit points in any given trade. The idea behind the use of this ratio is to determine the support and resistance levels of stocks. This ratio helps in making the appropriate buying and selling behaviour of the traders.
Golden ratio when combined with other technical indicators, helps in giving a more accurate forecast of the trade. For example: When the Fibonacci ratio is studied in conjunction with the candlestick patterns it can help one determine the right entry and exit points from a medium-term perspective.
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