How to use Fibonacci in trading

Trading based on the Fibonacci method is a unique way of analysing markets. The Fibonacci hypothesis that was developed by the famous mathematician, Leonardo de Pisa, has stood the test of time.

Even to this day, traders apply the concepts of Fibonacci and the golden ratio; represented by the number 1.618, in various forms of technical analysis. Fibonacci methods, however, are most commonly applied to identify support and resistance levels.

Traders use the Fibonacci numbers in order to estimate where prices might retrace or reverse by measuring the most recent leg of an uptrend or downtrend.

Fibonacci-based trading methods work due to the fact that they’re widely practiced. So, despite the mysticism attached to this form of technical analysis, it is, in fact, a self-fulfilling prophecy. To put it in other words, given the widespread use of Fibonacci-based methods of analysis, traders tend to watch these levels and trade based on the Fibonacci levels, making them into forms of support and resistance that simply work.

Before we get into more detail on the subject of Fibonacci trading, a bit of history and context is required.

Where did the Fibonacci numbers come from?

It is said that in the year 1202, Leonardo de Pisa, or Leonardo Pisano, who was born in Pisa, discovered the Fibonacci sequence of numbers. Although the Fibonacci sequence is largely attributed to Leonardo, his knowledge came from his travels to the Far East. Having learned about the Hindu-Arabic numeral system, Fibonacci documented his discovery in his famous work; "Liber Abaci", which eventually led to his nickname as Fibonacci.

The works of Leonardo eventually gave way to the discovery of what is called "the golden ratio."

The golden ratio has been proven to appear, not just in the financial world of trading, but in every aspect of life; from famous pieces of Ancient Greek architecture, to nature. The most famous example of the golden ratio is the nautilus shell. The golden ratio can be seen in the nautilus shell, which expands in a logarithmic spiral. By connecting the arcs with squares, or Fibonacci tiling, the sizes of the squares follow the Fibonacci sequence of numbers.

Understanding the Golden Ratio or Phi

The golden ratio, or phi, is the number 1.618. The inverse of this is 0.618. Phi (pronounced “fi” or “fy”) is the ratio of the length of one line segment to another, which results from dividing the original line at a certain point. For example, the distance from point A to point C in the line below is said to be 1.618 times that of the distance from point B to point C, and the distance from B to C is 0.618 times that of A to C. In mathematics, phi with an upper-case 'P' represents 1.618, while phi with a lower-case 'p' represents the inverse, which is 0.618.

Source: "How to use Fibonacci in trading"