3 Simple Fibonacci Trading Strategies [Infographic]
More than any other indicator, people place Fibonacci on a pedestal in my opinion. At times it feels like traders give Fibonacci an almost mystical power.
At the end of the day, Fibonacci is nothing more than simple retracement levels. These levels are only representative of where a security could have a price reaction, but nothing is etched in stone.
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Before we go into the gritty details about Fibonacci trading strategies, check out three Fibonacci trading personas and their strategies. While fictitious, they do an awesome job of summarizing common trading practices.
After reading this article, take a minute to think through which persona best aligns to your trading style.
Chapter 1: Origin of the Fibonacci Sequence
Does this numbering scheme mean anything to you - 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377? Not really, right?
Well you are in the right place if it doesn't. These numbers are the root of one of the most important techniques for identifying psychological levels in life and in trading.
Behold the mighty Fibonacci ratios!
Hundreds of years ago, an Italian mathematician named Fibonacci described a very important correlation between numbers and nature. He introduced a number sequence starting with two numbers - 0 and 1.
Have a look below, as we build a Fibonacci sequence.
Again, we start with 0 and 1.
The sequence requires you to add the last two numbers to get the next number in the sequence. Following this logic, we get the following equation:
0 + 1 = 1
Now we have our third number in the sequence - 1. See below for the updated sequence.
0, 1, 1
Now we add the last number in the sequence to the previous number once again:
1 + 1 = 2
We again update our sequence with the number 2.
0, 1, 1, 2
1 + 2 = 3
0, 1, 1, 2, 3
0, 1, 1, 2, 3, 5
0, 1, 1, 2, 3, 5, 8
0, 1, 1, 2, 3, 5, 8, 13
Chapter 2: Key Fibonacci Ratios
Fibonacci discovered every number in the sequence is approximately 61.8% of the next number in the sequence.
55 / 89 = 0.6179775280898876 = 61.8%
233 / 377 = 0.6180371352785146 = 61.8%
144 / 233 = 0.6180257510729614 = 61.8%
This is not the only correlation. Fibonacci also uncovered that every number in the sequence is approximately 38.2% of the Fibonacci number two steps ahead.
(13, 21, 34)
13 / 34 = 0.3823529411764706 = 38.2%
(21, 34, 55)
21 / 55 = 0.3818181818181818 = 38.2%
(55, 89, 144)
55 / 144 = 0.3819444444444444 = 38.2%
(144, 233, 377)
144 / 377 = 0.3819628647214854 = 38.2%
Also, we have another ratio! Every number in the Fibonacci sequence is 23.6% of the number after the next two numbers in the sequence:
(55, 89, 144, 233)
Chapter 3: Fibonacci Ratios Everywhere
Fibonacci Sea Shell
The volume of each part of the shell matches exactly the Fibonacci numbers sequence. Thus, each part of this shell is 61.8% of the next. It works the same way with this aloe flower:
If we separate the aloe flower into even particles, following the natural curve of the flower, we will get the same 61.8% result.
This ratio is not only found in animals and flowers. This ratio is literally everywhere around us. It is in the whirlpool in the sink, in the tornados when looked at through satellite in space or in a water spiral.
The Fibonacci ratio is constantly right in front of us and we are subliminally used to it. Thus, the human eye considers objects based on the Fibonacci ratio as beautiful and attractive.
Chapter 4: Fibonacci Ratios in Trading
Trading with Fibonacci isn't complicated.
A logical method for entering a trade is when the stock is going through a pull back.
Well where would you think to place your entry?
Without knowing anything about Fibonacci, you would likely say 50%.
That my friend makes you a Fibonacci trader.
That's what Fibonacci is about, understanding stocks do not move in a linear fashion. Fibonacci helps new traders understand that stocks move in waves and the smaller the retracement, the stronger the trend.
Now, it's time to take you to the level of an intermediate Fibonacci trader. To do this, you need to know the other two critical levels - 38.2% and 61.8% retracement.
Price action must be analyzed at these levels to understand if the countertrend move will stop and the trend will resume.
Fibonacci retracement levels are used by many retail and floor traders, therefore whether you trade using them or not, you should at least be aware of their existence.
Some advanced traders will take it a step further and add Fibonacci arcs and Fibonacci fans to their trading arsenal in search of an edge.
Chapter 5: How to Interpret Fibonacci Levels
Defining the Primary Trend
Defining the primary trend with Fibonacci requires you to measure each pullback of the security. If you see a series of new highs with retracements of 50% or less, you are in a strong uptrend.
The above chart is of Alphabet Inc., on a 5-minute chart. Notice how Google does not have any retracement greater than 50%. These successive new highs with minor pullbacks is the sign you are in a strong uptrend.
Here is another example of a trend with Chipotle (CMG).
Do you see how each pullback is greater than 78.6%? This level of retracement repeatedly produces a choppy pattern. Therefore, you would not want to have lofty profit targets on a trade while the stock is in a tight trading range.
78.6% is not a hard-fast rule. If you see retracements of 61.8% or 100%, the stock is likely in a basing phase before the next move.
That's it, you now understand how to use Fibonacci to define the strength in the market.
Remember, the market is either trending or flat.
Chapter 6: Three Simple Fibonacci Trading Strategies
#1 - Pullback Trades
First you want to identify a security in a strong trend.
A strong trend can be defined as a stock with successive highs with pullbacks of less than 50%.
If you are day trading, you will want to identify this setup on a 5-minute chart 20 to 30 minutes after the market opens.
After identifying a strong uptrend observe how the stock behaves around the 38.2% and 50% retracement levels from the morning highs by looking at the time and sales and Level 2.
Once you see the trading activity slowing down or turning, enter the trade.
You can use the most recent high or a Fibonacci extension level as a target point to exit the trade.
In the above chart, notice how Alteryx stays above the 38.2% retracement level before making a higher high.
Where Can Things Go Wrong?
Therefore, you need to prepare for when things go wrong. In a pullback trade, the likely issue will be the stock will not stop where you expect it to. It may pullback to a full 100% retracemenet, or it could even go negative on the date.
I have had situations trading the Nikkei where a stock will have a 15% or greater swing from the morning highs.
You can protect yourself from this scenario by doing the following:
Trade Low Volatility Stocks
Penny stocks look great when a trader is discussing their 30% gain in one hour. However, it's brutal if you are on the other side of the trade. Trade stocks with high volume and some volatility because we need to make a living, but don't feel like you must trade with the other gunslingers.
Max Time Loss
I am always preaching this to anyone that will listen. Look back over your winning trades and determine how long it takes you to turn a profit with 85% confidence.
If that is 5 minutes or one hour, this now becomes your time stop. If there is only a 15% chance you will walk away a winner, just exit the trade with a predetermined allowable loss percentage or right at market.
Max Stop Loss
There is no way around it, you will have blowup trades. I do not care how good you are, at some point the market will bite you. To this point, have a max stop loss figure in mind.
For me it is 10%, but since I only use a small portion of my account size, this keeps me under a total portfolio loss of 2%. Since I trade lower volatility stocks, this may occur only once or twice a year.
The point is you need to be prepared for the inevitable.
#2 - Breakout Trades
Breakout trades have one of the highest failure rates in trading. I'm going to give you a few things you can do to up the chances of things working out.
Clearing a Fibonacci Extension Level
Fibonacci extensions are just that, once price clears the 100% retracement and presses on.
You want to find a stock clearing this extension level with volume.
It's not enough to just buy the breakout.
Therefore, you want to make sure as the stock is approaching the breakout level, it has not retraced more than 38.2% of the prior swing. This will increase the odds the stock is set to go higher.
Where Can Things Go Wrong
In terms of where things can go wrong, it's the same as we mentioned for pullback trades. The one difference is you are exposed to more risk because the stock could have a deeper retracement, since you are buying at the peak or selling at the low.
So, to mitigate this risk, you will need to use the same mitigation tactics as mentioned for pullback trades.
#3 Trading with Indicators
You can use Fibonacci as a complimentary method with your indicator of choice. Just be careful you do not end up with a spaghetti chart.
Fibonacci Retracement + MACD
This Fibonacci trading strategy includes the assistance of the well-known MACD. Here we will try to match the moments when the price interacts with important Fibonacci levels in conjunction with MACD crosses to identify an entry point.
We hold the stock until we receive a crossover from the MACD in the opposite direction.
This is the 60-minute chart of Yahoo for the period Sep 25 through Nov 3, 2015.
The two green circles on the chart highlight the moments when the price bounces from the 23.6% and 38.2% Fibonacci levels.
At the same time, the green circles on the MACD show a cross up of the indicator.
Thus, we go long every time we match a price bounce with a bullish MACD crossover.
The red circles show the close signals we receive from the MACD.
We open two long positions with Yahoo and we generate a profit of $5.12 per share.
Fibonacci Retracement + Stochastic Oscillator + Bill Williams Alligator
If the price starts trending in our favor, we stay in the market if the alligator is “eating” and its lines are far from each other. When the alligator lines overlap, the alligator falls asleep and we exit our position.
This is the 30-minute chart of TD Bank for the period Sep 29 through Oct 14, 2015.
The price drops to the 61.8% Fibonacci level and starts hesitating in the green circle. Meanwhile, the stochastic gives an oversold signal as shown in the other green circle.
This is exactly what we need when the price hits 61.8% and we go long! A few hours later, the price starts moving in our favor. At the same time, the alligator begins eating!
Chapter 7: Advanced Fibonacci Trading Topics
Fibonacci Speed Resistance Arcs
Fibonacci Arcs are used to analyze the speed and strength of reversals or corrective movements. To install arcs on your chart you measure the bottom and the top of the trend with the arcs tool.
The arcs appear as half circles under your trend, which are the levels of the arcs distance from the top of the trend with 23.6%, 38.2%, 50.0%, and 61.8% respectively.
Each of the Fibonacci arcs is a psychological level where the price might find support or resistance.
This is the 30-minute chart of Apple for the period Oct 26 through Nov 3, 2015.
I have placed Fibonacci arcs on a bullish trend of Apple. The arc we are interested in is portrays 38.2% distance from the highest point of the trend.
As you see, when the price starts a reversal, it goes all the way to the 38.2% arc, where it finds support. This is the moment where we should go long.
Lastly, I recommend placing a stop right below the bottom created on the arc.
Fibonacci Time Zones
Fibonacci time zones are based on the length of time a move should take to complete, before a change in trend. You need to pick a recent swing low or high as your starting point and the indicator will plot out the additional points based on the Fibonacci series.
Notice in this case, Apple’s price undertakes a move based on Fibonacci numbers 0, 1, 2, 3, 5, and 8.
Do you remember when we said that Fibonacci ratios also refer to human psychology? This also applies to time as well.
Negatives of Trading with Fibonacci
The main rub I have with Fibonacci trading is you begin to expect certain things to happen. For example, if you see an extension as the price target, you can become so locked on that figure you are unable to close the trade waiting for bigger profits.
If you are trading pullbacks, you may expect things to bounce only for the stock to head much lower without looking back.
So, Fibonacci will not solve your trading woes, but it is important to know where price might move.
- The Fibonacci sequence starts from 0; 1; and every number thereafter is built by the sum of the previous two.
- Every number in the Fibonacci sequence is 61.8% of the next number.
- Every number in the Fibonacci sequence is 38.2% of the number after the next in the sequence.
- Every number in the Fibonacci sequence is 23.6% of the number after the next two numbers in the sequence.
- Fibonacci levels are critical in equity trading, because they represent a trader’s behavior and psychological reaction to price changes.
- The most common Fibonacci trading instrument is the Fibonacci retracement, which is a crucial part of the equity’s technical analysis.
- Other Fibonacci trading tools are the Fibonacci speed resistance arcs and Fibonacci time zones
- Whether you trade pullbacks, breakouts or indicators; you must have a trading plan to manage your position.