Of all the strategies for navigating the treacherous financial markets, Fibonacci Trading stands out as one of the most widely used, and for several reasons. First of all, it works – as long as it is properly applied of course. More importantly, it sounds a lot smarter and more complex than it actually is. All these terms: Fibonacci series, Fibonacci sequence, Fibonacci retracement, Fibonacci levels etc. sound really smart and scientific, but the trick is learning to apply all that knowledge and make some money.
In any case, Fibonacci trading is based on something called Fibonacci retracement. Basically, there is an area that can be seen on some charts where support and resistance areas can be identified. Fibonacci trading (well, Fibonacci retracement, at least) is all about using horizontal lines across certain areas in order to identify their support and resistance, i.e. places where prices stop falling / rising and the trend reverses. In essence, if you draw a line between two extreme points you have identified on a chart and divide the distance by the key Fibonacci ratios, you get one of Fibonacci levels. In other words, your Fibonacci trading can commence.
The importance of Fibonacci trading lies in the fact that it can help you identify the exact places for some strategic transactions, or indicate where to place a target price or a stop loss. If you want to boil down modern trading to raw science, Fibonacci series is a good start.
By allowing you to take two extreme points on a chart and divide the (vertical) distance between them using Fibonacci ratios, you can start drawing horizontal lines in order to identify where to expect support and resistance. These ratios are: 23.6%, 38.2%, 50%, 61.8% and 100%. Each of them has a meaning and a function. But the actual Fibonacci series of numbers goes like this: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89…
This mathematical principle in Fibonacci trading is applied to find the golden ratio (61.8 %) and it is calculated by dividing the number in the series by the number that is next in line, and Fibonacci series is the perfect example of this relationship. The 38.2% ratio should be between a number on the list and the number that is two spaces to the right. The first example would be between numbers 21 and 34 and the second would refer to, say numbers 21 and 55. Another place to the right and you get 23.6% (e.g. 13/55).
The thing is, Fibonacci trading takes this principle and applies it on stock markets. Nobody knows why it works – probably because of the self-fulfilling prophecy paradox. If everyone believes it and they have similar predictions, saying that support and resistance are at a certain point, their actions alone will make it happen, regardless of other factors. In other words, it is probably traders themselves that make this work in real life unknowingly. If a Fibonacci retracement indicates that a support/resistance will set in at a certain price, a mass of traders acting independently of each other will reach the same conclusion and start trading in the same direction, causing the price to rise / fall, as predicted.
For more information, see the following video.