Oil Painting, Stock Trading, and This Tool
Dear Penny Stock Millionaire,
I keep getting questions about advanced and complex technical indicators like Fibonacci retracements.
What I’m about to write might come across as a little weird, but here goes …
I don’t use most of these ‘super advanced’ technical indicators in my trading. It’s not that I don’t respect them. Nor do I think they are completely worthless. For some traders, these indicators are really important. It’s part of their trading strategy. Which is why you should understand them.
Remember, there are winners and losers in every trade. Your goal is to be on the winning side often enough to grow your account. Rather than tell you what to do with Fibonacci retracement, I’ll explain it, and let you decide.
What is Fibonacci Retracement?
In a nutshell, these are support and resistance levels based on ratios created with numbers in the Fibonacci sequence.
The idea is, a trend is likely to continue once there has been a retracement to one of the Fibonacci levels
In case you don’t know, the Fibonacci numbers are a sequence described by the 13th-century Italian mathematician Leonardo Pisano Bigollo. Today he’s called Fibonacci because, in the 1800s, some historian called him Leonardo filius Bonacci — or Leonardo, son of Bonacci.
Onward. The sequence named after this really smart guy is pretty cool. Check it out: Start with zero and one, then add each number in the sequence to the previous number to get the next number. 0 + 1 = 1… 1 + 1 = 2… 2 + 1 = 3… 3 + 2 = 5… 5 + 3 = 8… and so on.
Here’s the sequence: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233… etc.
Right. So I can hear you asking, “Tim, what in the hell does this have to do with trading penny stocks, dude?”
I’m laughing right now because I sorta agree! But stay with me here, because this is good stuff to know.
A Little More Math for You
Here’s how it works: take any two adjacent numbers in the sequence and divide the lower number by the higher number. For example, 5 ÷ 8 = 0.625; 8 ÷ 13 = 0.61538; and 13 ÷ 21 = 0.61904.
Notice they are all very close to 62%? If you keep going like this, the numbers continue to approach 61.8% which is the number accepted as the average of this ratio. Keep 61.8% in mind; we’ll come back to it.
Back to those Fibonacci numbers …
Next, take a number in the sequence and divide it by the number which is two further along in the sequence. This equation gives you a number close to and approaching 38.2%. For example, 55 ÷ 144 = 0.3819. You can do this with any of the numbers in the sequence and you’ll get roughly 38.2%.
If you keep going, by dividing by the number which is three further along in the sequence, you get 23.6%. So far we have 61.8%, 38.2%, and 23.6%. Those are all the Fibonacci ratios used for retracement. However, the indicator uses 0% and 100%. And most of these retracements also include 50%, even though 50% is not one of the ratios.
Why 0%, 50% and 100%?
The 50% ratio has nothing to do with Fibonacci. It’s based on Dow Theory which says a trend has a good chance of continuing once there has been a 50% retracement (either a pullback or an impulse). 0% and 100% represent the high and low price used to create the Fibonacci retracement.
Before you think you need to be good at math for this, let me say this: I’m not good at math. You don’t have to be good at math. Pretty much every modern stock trading and charting platform has Fibonacci retracement built-in. (Phew!)
The levels are calculated in relation to the vertical distance between high and low — or the 0% and 100% lines.
The theory is, if a stock has shot up over a period of days and starts to pull back, there will be support at the Fibonacci levels below the high. Likewise, if a stock has fallen and bounces back up, you’d see resistance at the Fibonacci levels.
Why is 1.618 The Golden Ratio?
If you’ve read anything about the ancient Greeks, you’ve probably heard of the golden ratio. This was the name they gave to a ratio based on the inverse of our calculations above. How do you get it? Instead of dividing by the next higher number in a Fibonacci sequence, you divide by the number below.
For example: 8 ÷ 5 = 1.6; 13 ÷ 8 = 1.625; and 144 ÷ 89 = 1.6179. Like our ratios above, as you continue along the sequence, the numbers get closer to 1.618. This is considered the golden ratio.
To be clear, the Greeks — and other cultures — noticed the golden ratio in nature and started applying long before Leonardo Bigollo wrote about the sequence.
Artists have been utilizing it in oil paintings, sculpture, and architecture for centuries because it’s so visually appealing.
Hell, it’s found in everything! You can see it in the spirals of shells, the patterns in plants, and even constellations and galaxies. In 2010 it was announced in the journal Science Daily that the golden ratio is “present at the atomic scale.”
Very interesting. But can this help you be a better trader? Keep the golden ratio and how it’s calculated in mind, I’ll get back to it.
Benefits of Using Fibonacci Retracement
The greatest benefit of the retracement might be understanding the concept of the self-fulfilling prophecy.
What does that mean? One of the things you want to understand as a trader is human psychology. When it comes to using indicators like Fibonacci retracements, psychology comes into play.
It’s like this: If enough traders use that retracement indicator, then you can potentially predict buy or sell opportunities. And if enough traders act when price action reaches those levels, then it becomes a self-fulfilling prophecy.
Some traders use Fibonacci trading to determine automated stop losses. Be wary, however. There are dozens of possible indicators out there. Not every trader uses Fibonacci levels. But it pays to be aware what other traders might be thinking…
How To Use Fibonacci Retracement in Technical Analysis
Let’s look at Fibonacci retracement on a stock chart. Check out the Twitter ($TWTR) chart below. The time frame is the end of November 2018 to market close on December 14.
Twitter ($TWTR) chart with Fibonacci retracement lines.
Twitter ($TWTR) chart with Fibonacci retracement lines. Source FreeStockCharts.com
Looking at the chart above, you see I chose a recent high as one end of the trend line. Using Fibonacci retracement, once there has been a pullback to one of the retracement levels, the trend is likely to continue in the same direction. The levels act as both support and resistance, depending on who is winning the battle between buyers and sellers.
Notice on December 3, the price consolidated right along the 50% line. Then it dropped back and found brief support at the Fibonacci level of 61.8%. But then the theory falls apart because it dropped below support.
What happened? Lots of Fibonacci lovers consider one further level of support or resistance. They subtract 23.6% from 100% and get 76.4%. If you do the math on this chart, the support level on December 6 is just about where that 76% line would be.
OK, then the upward trend continues and this time the price goes up and finds resistance at our next Fibonacci level, 38.2%, on the 7th. Then it drops back to our 61.8% level which is now a support line. And so on, and so forth.
On the chart above you see support at Fibonacci levels after pullbacks. But what if the trend is moving down instead of up? It works the same way but in reverse. When you draw the trend line using the Fibonacci retracement tool, go from high to low. The support and resistance lines are reversed.
A word of warning: I found the above chart pretty fast. But I could also find a chart where the retracement doesn’t work — where price action is all over the place and doesn’t fit the Fibonacci levels in a clean way. Also, this chart is after the fact. You’ve heard the saying: hindsight is 20/20 vision.
So where does that leave us?
There are traders that swear by Fibonacci retracements. Me? I’m not one of them. But every trader is different. Just because I don’t use Fibonacci retracements, doesn’t mean that they aren’t something you should look into for your own trades.
Tomorrow, we’ll dive into exactly how you can use Fibonacci retracements in your own trading strategy now that you understand how they work!
Editor, Penny Stock Millionaires