Fibonacci techniques refer to trading strategies based upon technical analysis involving Fibonacci numbers. If the current price movements of a given stock or commodity progress in a recognizable pattern, it is believed that future price movements can be extrapolated (and therefore exploited for a profit) by using Fibonacci numbers to predict the next turning point in the price of the stock or commodity. The Fibonacci sequence is determined by starting with zero and adding one, with each subsequent number being equal to the sum of the two previous numbers. The sequence begins zero,one, one, two, three, five, eight, 13, 21, 34, 55 and so on.
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History
Leonardo of Pisa, also known as Fibonacci (Latin for "son of Bonaccio"), is largely credited with discovering the sequence of numbers bearing his name. However, he merely translated and published the sequence from the Hindu and Arabic mathematics texts of his time (early thirteenth century). It is now known that the Fibonacci sequence was in use as far back as the ancient Inca civilization that used the sequence to determine the best way to plant crops. Today, the Fibonacci sequence is used as a technical trading tool to determine likely retracement levels and upward price swings in stocks and commodities.
Function
By taking a snapshot of the market during a given time frame and determining critical "pivot points" (points like the opening and closing price, daily highs and lows, among others) likely retracement levels can be determined by applying the Fibonacci sequence to the price movement during the selected time frame and applying the ratio to discover what price points equal a 38.2 percent, 50 percent and 61.8 percent move. The ratio of the Fibonacci sequence is 1.618:1, also known as the Golden Ratio or phi, and is the most frequently recurring ratio in the natural world.
Time Frame
The time frame selected for applying Fibonacci techniques to a trade is critical. Too large a time frame will make the pivot points vague, and too narrow a time frame will make the price moves too erratic to capitalize on for a profit. Most commonly, day traders will analyze the 15-minute chart of a given stock and will use this time frame for Fibonacci analysis.
Considerations
In a fast-moving market, only someone with savant-like math abilities would be able to calculate accurate Fibonacci progressions fast enough to capitalize on them for a profit. Therefore, many computer programs are now commercially available to calculate the progressions for traders. If an investor is considering using Fibonacci techniques to assist in his technical trading, he must ensure that his calculations are correct or he will increase his risk exposure exponentially.
Warning
Fibonacci techniques are just another arrow in an investor's quiver. They certainly do not guarantee any sort of profitability or eliminate any of the risks inherent in trading. They simply help an investor to make a more educated guess about the direction of a given price movement.
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