For years, the basics of Fibonacci have been the cornerstone of technical analysis for many traders and investors. Fibonacci studies remain a powerful analytical tool that can be used across all tradeable asset classes and timeframes, suitable for all trading styles, from the short-term scalper to the longer-term position trader.

Fibonacci numbers are derived by the sum of the two preceding numbers, starting with 0 and 1. So, 0+1 equals 1; 1+1 equals 2; 1+2 equals 3, and so on. Through these numbers, ratios form – not only prevalent in nature but have also proven to serve as robust support and resistance areas in the financial markets.

Identifying a trend is required to successfully apply Fibonacci on a price chart. Explaining the process of classifying a trend is beyond the scope of this article, though to serve as a basic demonstration, identifying an uptrend through price action relies on a series of higher highs and higher lows, as shown in Figure 1 below. As illustrated in Figure 2 below, a downtrend is derived through a series of lower lows and lower highs.

Figure 1 – Chart Created by TradingView

Figure 2 – Chart Created by TradingView

### The Basics: Fibonacci Tools

Before exploring beyond the basics, one must understand four Fibonacci components: the retracement ratio, the extension ratio, the projection ratio, and the expansion ratio.

The foundation of Fibonacci studies lies in Fibonacci retracement ratios, where most traders begin their Fibonacci journey. These ratios consist of 23.6%, 38.2%, 61.8% (the inverse of 0.618 is used to obtain 1.618, which is Fibonacci’s Golden Ratio), 78.6% (square root of 61.8%), and 88.6% (square root of 78.6%); the 50.0% ratio is not a Fibonacci number, though it is often used to help add weight to an area. The ratios are shown as horizontal levels found from applying the Fibonacci retracement tool to either a higher low and higher high or a lower low and lower high (only two contact points are required to apply the Fibonacci retracement tool).

As its name suggests, a Fibonacci retracement tool is generally employed in an uptrend or downtrend. Figure 3 demonstrates a 61.8% Fibonacci retracement line on the price chart of Apple (AAPL) at \$123.81, found in a moderate uptrend using a clear higher low and higher high at approximately \$115.00 and \$135.00, respectively. Price can (and often does) find support at the key ratios. Below, you will note that the stock found support at the 61.8% Fibonacci retracement ratio, offering either an entry or exit point.

Figure 3 – Chart Created by TradingView

The Fibonacci extension is an ‘extension’ of the Fibonacci retracement tool. When price exceeds 100% of the retracement, traders begin looking at the Fibonacci extension ratios, such as the 1.272% and 1.618% ratios. The New Zealand dollar (NZD) versus the US dollar (USD) currency pair (NZD/USD) on the H1 timeframe (Figure 4) exhibits an example of price action exceeding 100% of the retracement zone (orange) and proceeding to retrace to the 1.618% Fibonacci extension ratio at \$0.5854.

Figure 4 – Chart Created by TradingView

The Fibonacci projection and expansion ratios are similar. However, the former requires three contact points while the latter needs two.

Figure 5 shows a 1.272% Fibonacci projection ratio at \$0.6042 on the NZD/USD currency pair, formed from the low at \$0.5852, a high at \$0.5985, and a subsequent higher low from \$0.5874. If you had applied a Fibonacci expansion tool, the low at \$0.5852 (1) and the high at \$0.5985 (2) would still be used, only you would be required to drag the indicator back to the initial low (1). The 1.272% Fibonacci expansion ratio, in this case, is lower at \$0.6020 (Figure 6).

Figure 5 – Chart Created by TradingView

Figure 6 – Chart Created by TradingView

### Fibonacci Clusters

Fibonacci clusters represent a ‘tight’ area of support and resistance formed by converging multiple Fibonacci ratios. How many Fibonacci ratios are required to create a ‘cluster’? Unfortunately, there is no defined answer, though many Fibonacci traders and investors seek more than three ratios to form an area of interest. Traders will look for the most straightforward opportunities and usually position protective stop-loss orders beyond other technical structures; this could be another support and resistance zone, a simple moving average (SMA) or another Fibonacci cluster.

As you can see from the EUR/USD H1 chart (euro versus the US dollar) below, there are two Fibonacci retracement ratios – 61.8% and 78.6% at \$1.0659 and \$1.0653, respectively – and a 1.272% Fibonacci projection ratio at \$1.0657 (Figure 7). Traders could have entered long (bought) from this area and positioned their protective stop-loss orders beyond the low of around \$1.0640 (23 April).

Figure 7 – Chart Created by TradingView

### Harmonic Patterns

Fibonacci ratios help form a wide array of Harmonic patterns and are the foundation of all harmonic structures.

Harmonic patterns offer a clear, repetitive structure to work with and produce what’s referred to as a Potential Reversal Zone, or ‘PRZ’, composed of several Fibonacci ratios.

The simplest of all the Harmonic patterns is the equal AB=CD bullish or bearish pattern. As shown in Figure 1A, the AB=CD arrangement is a four-point structure composed of an initial leg, a retracement or pullback (depending on whether the formation is bullish or bearish), and an equal leg to the initial leg.

Figure 1A – AB=CD Structure

The C-point retracement (or pullback), from B to C, must form within the 38.2% and 88.6% Fibonacci retracement ratios (Fibonacci retracement tool applied to legs A to B). It is at this C point that we can begin formulating the PRZ. The value of leg A to B is first extended from point C to help define the structure.

The pattern completion (C to D) must be between 1.13% and 3.14%, which is the projection ratio from A, B, and C. An equal AB=CD structure will always have a 100% projection ratio (there are ‘alternate’ AB=CD patterns that use the 1.272% and 1.618% Fibonacci projection ratios). Some traders also employ what are referred to as BC Fibonacci extension ratios; these are based on the ratio the C point forms at, a term primarily coined by Scott Carney (albeit Carney confusingly refers to these extension ratios as projections). Figure 1B is a copy of the AB=CD reciprocals from Carney’s book, Harmonic Trading: Profiting From The Natural Order Of The Financial Markets. Carney also states that a perfect AB=CD pattern consists of a C point that should be a precise 0.618 retracement of the AB leg. The 0.618 C point retracement sets up the 1.618 BC extension. They also generally possess an equivalent time duration for each leg.

Figure 1B

Figure 1C is a 5-minute AUD/USD (Australian dollar versus the US dollar) chart showing an equal AB=CD bearish pattern. Note that the pattern terminated directly at the 100% projection ratio and was aided by a 1.618% Fibonacci extension ratio at \$0.6697 derived from legs B and C (this is because the C-point retracement terminated near the 61.8% Fibonacci retracement ratio of legs A and B).

Figure 1C – Chart Created by TradingView

If you are interested in learning more about harmonic patterns, FP Markets analyst Aaron Hill covered harmonic formations in detail in a previous webinar, covering the AB=CD structure, as well as Gartley and Bat patterns.

### Fibonacci Time Zones

Knowledge (and the application) of Fibonacci time zones can provide traders and investors with areas where price action may reverse. Unlike Fibonacci clusters or Harmonics shown above, Fibonacci time zones are based on time and are derived from a significant high and low, and extended to the right side of the chart in vertical lines.

This indicator also has no formula as it is based on Fibonacci numbers and time (according to the chart’s x-axis). In Figure 1D, the EUR/USD H1 chart, the trader has applied the Fibonacci time zone indicator to a swing low occurring on 23 December and a swing high on 28 December (approximately 12 days). Therefore, 12 days equates to 1 area or session. So, from the Fibonacci time zone tool, you will note that the area marked ‘3’ will incorporate 3 of these trading sessions.

The idea is that the areas between these vertical lines can provide a space for a reversal. A reversal could be a minor swing high or low or a major trend reversal. Fibonacci time zones are often merged with other Fibonacci techniques to help confirm/validate a potential trading zone.

Figure 1D – Chart Created by TradingView

### Test Before You Apply

Fibonacci ratios can provide high-probability trading methods. Some traders rely solely on trend direction and Fibonacci clusters; others look at Harmonic patterns and combine these formations with Fibonacci time zones. Most successful traders seek areas of confluence, the convergence of multiple technical tools in one price area, adding weight to a potential reaction.

Technical analysis is a comprehensive field of analytical techniques, some of which can benefit Fibonacci studies. These include candlestick patterns, chart patterns – think bullish and bearish engulfing patterns, morning and evening star configurations – and technical indicators, like the Moving Average Convergence Divergence (MACD) or the Stochastic oscillator.

The point to remember is that as with any trading strategy, it is important to test it before committing. So, if this strategy involves Fibonacci clusters coupled with harmonic patterns, it must be backtested to help ensure it provides an edge over a sample of trades.

### Fibonacci FAQs

1. What are Fibonacci ratios?

Fibonacci ratios are derived from performing simple math using the Fibonacci sequence. For example, to produce 1.618, you divide one number by the preceding number, and to produce 0.618 within the Fibonacci sequence, you can divide a number by the subsequent value. Check out this article to learn more about Fibonacci ratio. Alternatively, consider viewing one of our previous webinars on the subject here.

2. What are the most widely followed Fibonacci strategies?

Some of the most popular Fibonacci-driven strategies focus on Fibonacci clusters and Harmonic patterns.

3. Are there many Fibonacci strategies?

This article has only scratched the surface regarding Fibonacci and its many uses. As you can see, Fibonacci is a diverse field of study. If you want to explore beyond Fibonacci clusters, Harmonics and Fibonacci time zones, consider checking out Fibonacci Channels, Fibonacci Fans Fibonacci Spirals, and Fibonacci Circles.

in Minutes

Access 10,000+ financial instruments
Auto open & close positions
News & economic calendar
Technical indicators & charts
Many more tools included

By supplying your email you agree to FP Markets privacy policy and receive future marketing materials from FP Markets. You can unsubscribe at any time.

Source - cache | Page ID - 40587