HOW DOES IT WORK?
The famous Fibonacci sequence states that a number in the sequence is always calculated by adding the two previous numbers.
A widely known tool today in the FX and equities market is the Fibonacci retracement which relates the ratios of the numbers in the sequence.
The most important of which is 0.618 (known as the golden ratio) and it is calculated by dividing a number by the immediate following number after the first six numbers.
There are also other ratios like 0.382, which is found by dividing a number by the second following number. For example, 34/89=0.382.
Now, why are these ratios important?
There are retracements or reversals in the market that indicate a stock or currencies’ tendency to go against the trend before following the trend again.
If you notice how the general trend is upwards, but it is not a straight line and it dips every once in a while on its way up. That is reversal or retracement and why the Fibonacci sequence is useful.
In order to utilize the Fibonacci sequence, traders must take two extreme points(peak and trough) and divide the vertical distance by the Fibonacci sequence in order to draw horizontal lines on the graph. These lines are used to identify support and resistance levels in the market. Most stock programs nowadays contain a tool that will draw the horizontal lines for you and identify the support levels for you. These lines can also help to identify stop-loss orders or target prices.
IS IT RELIABLE?
The Fibonacci sequence is claimed to be great and reliable by the people who profit from it and terrible by those who lose money. These ratios are a very subjective tool because different interpretations lead to different results. There is no mathematical proof behind the rationale of the Fibonacci ratios on the market.
It only provides possible correlations and does not provide any signals for the trader. The Fibonacci ratios should be looked at as a potentially useful tool depending on whether one is successful at interpreting the results.