The mathematician Fibonacci or Leonardo of Pisa in 1202 first published his Fibonacci sequence. In order to calculate the number of pairs of rabbits he would have at the end of a year based on their behavior of breeding, Fibonacci developed this famous sequence of numbers. Forex traders find this type of no-nonsense approach very profitable.
So you see, what many people mistakenly take as a mere mathematical abstraction, just “fooling around” with numbers, is rooted in very real-world applied mathematics. To state things very basically, the Fibonacci sequence can be used to detect and describe otherwise hidden patterns in the world around us.
How can this be applied to investing? Very astute investors understand that there are hidden patterns in the stock market–based on the mass of investors’ behavior. “Buy low and sell high” and “The best time to buy is when there’s blood in the streets” are but two investment aphorisms that not only work, but also come from understanding hidden patterns of the investment markets.
These patterns cannot be seen by a day to day observation of market conditions, but reveal themselves when you step back and take a look at the big picture. Short term fluctuations in the market are nearly impossible to accurately forecast. However, the trends which occur over time most certainly are predictable. Investors of all stripes, including Forex traders have used the Fibonacci sequence to plan their investments and make large profits in the currency exchange markets.
The Fibonacci sequence is a series of numbers in which each successive number is the sum of the two previous numbers. So it goes 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, and into perhaps infinity. There are a number of interrelationships held within these numbers; for instance, any given number is approximately 1.618 times the preceding number, and 1.618 happens to represent the ancient Greeks’ “golden ratio”–considered to be the supreme essence of balance (and balance is the ultimate key to successful investing).
Of all the Fibonacci series the two applications in wide spread use by Forex traders and investors are arcs and retracements.
Fibonacci charts are created through a technique comprising three curved lines that are drawn for the purpose of anticipating key resistance and support levels as well as areas of ranging. First, an invisible trendline is drawn between two points (typically these are the high and low for a given time period). Then, three curves are drawn so as to intersect this trendline at the key Fibonacci levels of 38.2%, 50%, and 61.8%. Transaction decisions are made at the point where the price of the asset crosses through these key levels.
Now, a retracement, in investing, refers to a reversal in the movement of a stock’s price–a reversal which is enough to counter the stock’s prevailing trend. Advanced successful investors pay intense attention to retracement possibilities and patterns. The Fibonacci retracement analyzes the likelihood that a financial asset’s price will see a larger than average retracement and then come to support or resistance at the key Fibonacci levels before it then continues on in its original direction. A trendline is drawn between two extreme points; then, its vertical distance is divided by the key Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8%, and 100%.
Traders use Fibonacci retracements to determine strategic points for placing their transactions, target prices and stop-loss points. There are other tools which use retracement techniques, chief among them Elliott Wave Theory, Gartley patterns and Tirone levels.
The reason that the Fibonacci sequence is used in investing is simple: it works! Forex traders in particular in particular seem to find it useful in making profitable trades.
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