Fibonacci Chart
James Gillock
Casey Murphy has fanned his passion for finance through years of writing about active trading, technical analysis, market commentary, exchange-traded funds (ETFs), commodities, futures, options, and forex (FX).
A technical analyst looking for potential support and resistance levels will select two prominent points from a stock's chart, typically the highest and lowest points over a set period of time, and divide the vertical distance by key Fibonacci ratios. With the levels identified, horizontal lines are drawn, enabling market makers to identify trading opportunities.
All 3 point retracements are emerging four-point ABCDs, and many 4-point ABCDs are also emerging five point Gartlies or butterflies. This is because the patterns with more points contain or are made up from patterns with fewer points.
The way to recognize that you are looking at an emerging Fibonacci pattern is also the color of the direction arrow. If it is grayed out, the pattern is emerging, but a more obvious feature is the pink dot on emerging patterns.
Unlike with chart patterns or emerging patterns that can be straightforward opportunities to trade, with Fibonacci patterns they really are just an early warning signal. Because for the opportunity to realize (complete pattern), two things still need to happen. First, the price has to rise to the level of the pink dot. Time is not that important. It can reach the level before or after the dot, as long as it is on that level. Second thing that needs to happen is that price should encounter support or resistance at the level of the dot, depending on whether it is a bullish or bearish pattern. Only if the price reaches this level and turns around at this level, then the expectation is that there will be support or resistance at the Fibonacci levels that follow.
Because of the many requirements for a Fibonacci emerging pattern to complete, there are many of them that never do. As a trader, the ones that will be of more interest to you would be the higher-order ones: the five point Gartley and butterflies, because they are more valuable patterns. And the way they fit with the Fibonacci theory by meeting a considerable number of requirements, you are increasing your odds for trading in the right direction.
Leonardo Fibonacci was a mathematician who worked on the "golden ratio" and developed the Fibonacci sequence. Many technical traders use what's known as a Fibonacci retracement to identify support and resistance price levels.
In the 1970s, some investors theorized that buying and selling in the stock market might follow patterns similar to those of a natural ecosystem. They began applying Fibonacci numbers to their charts in the form of Fibonacci retracements.
The 38.2% comes from dividing a number in the series by the number found two places to the right, and 23.6% comes from dividing a number by the number found three places to the right. The 50% level isn't really a Fibonacci number, but many traders still consider it a significant level.
To view these Fibonacci retracement levels, traders can access the Charts tab on the thinkorswim trading platform. After selecting a chart, the trader selects the time frame to analyze and then identify a high or low point. Select Drawings > Drawing Tools > % (Fibonacci Retracements) and place the cursor on the high or low point, click once, move to the next high or low point to the right, and click again. The tool automatically calculates the corresponding Fibonacci levels based on percentage retracements as seen below.
In the chart of the S&P 500 index (SPX) above, the top level is 100% and the bottom level is 0%. The retracement levels in between are areas traders can watch for potential technical support or resistance levels. Fibonacci retracements can also be used in the opposite way, from a low point to a high point (as long as the high point is to the right of the low one). In this scenario, retracing a move higher, the Fibonacci series frequently acts as key points of support in the pullback or correction.
When the SPX started to move above its March low, it met slight resistance at the 23.6% level. Even though it broke above it, the close was right around that level. The SPX then continued moving toward the 38.2% level, hesitated there for a few days, and then went back toward the 23.6% level. When reviewing the price chart, it's possible to see how the different retracement levels acted as support and resistance levels.
Fibonacci retracements are accepted and used by many traders, including some who trade for large institutions and hedge funds. There's no guarantee that using Fibonacci retracements will work effectively as part of a trading strategy, but they can provide some levels to watch when engaging in technical analysis.
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The topic of Fibonacci retracements is quite intriguing. To fully understand and appreciate the concept of Fibonacci retracements, one must understand the Fibonacci series. The origins of the Fibonacci series can be traced back to the ancient Indian mathematic scripts, with some claims dating back to 200 BC. However, in the 12th century, Leonardo Pisano Bogollo, an Italian mathematician from Pisa, known to his friends as Fibonacci discovered Fibonacci numbers.
The ratio of 1.618 is considered as the Golden Ratio, also referred to as the Phi. Fibonacci numbers have their connection to nature. The ratio can be found in the human face, flower petals, animal bodies, fruits, vegetables, rock formation, galaxy formations etc. Of course, let us not get into this discussion as we would be digressing from the main topic. For those interested, I would suggest you search on the internet for golden ratio examples, and you will be pleasantly surprised. Further into the ratio properties, one can find remarkable consistency when a number is in the Fibonacci series is divided by its immediate succeeding number.
It is believed that the Fibonacci ratios, i.e. 61.8%, 38.2%, and 23.6%, finds its application in stock charts. Fibonacci analysis can be applied when there is a noticeable up-move or down-move in prices. Whenever the stock moves either upwards or downwards sharply, it usually tends to retrace back before its next move. For example, if the stock has run up from Rs.50 to Rs.100, it is likely to retrace back to probably Rs.70 before moving Rs.120.
Here is another example where the chart has rallied from Rs.288 to Rs.338. Therefore 50 points move makes up for the Fibonacci upmove. The stock retraced back 38.2% to Rs.319 before resuming its up move.
The Fibonacci retracements can also be applied to falling stocks to identify levels upto which the stock can bounce back. In the chart below (DLF Limited), the stock started to decline from Rs.187 to Rs. 120.6 thus making 67 points as the Fibonacci down move.
After selecting the Fibonacci retracement tool from the charts tool, the trader has to click on trough first, and without un-clicking, he has to drag the line till the peak. While doing this, simultaneously, the Fibonacci retracements levels start getting plotted on the chart. However, the software completes the retracement identification process only after selecting both the trough and the peak. This is how the chart looks after selecting both points.
Think of a situation where you wanted to buy a particular stock, but you have not been able to do so because of a sharp run-up in the stock. The most prudent action to take would be to wait for a retracement in the stock in such a situation. Fibonacci retracement levels such as 61.8%, 38.2%, and 23.6% act as a potential level upto which a stock can correct.
By plotting the Fibonacci retracement levels, the trader can identify these retracement levels, and therefore position himself for an opportunity to enter the trade. However please note like any indicator, use the Fibonacci retracement as a confirmation tool.
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