The Elliott Wave Theory is an approach in market analytics that looks at patterns in stock price movement. These patterns then allow analysts to predict the future direction of the market. The theory contends that markets move in predictable waves based on the collective psychology of the traders.
The Fibonacci Sequence is a famous mathematical progression that lists numbers as the sum of the first two numbers on the sequence. The sequence thus starts as 0, 1, 1, 2, 3, 5, 8 and so on. When Elliott first wrote his theory, he didn’t realize that the wave pattern followed the Fibonacci sequence as well. The sequence is used to derive the so-called Golden Ratio (1.618) which market analysts use to check resistance and support levels for market waves.
Application to Markets
The Fibonacci sequence is used in conjunction with the Elliott Wave theory to test financial markets. The basis of this is the fact that a stock price trend to retrace an earlier trend when the price reaches one of the important Fibonacci retracement ratio points. Fibonacci retracement ratios are derived by calculating a stock price’s past and present movement. Fibonacci retracement of a stock is obtained by taking the highest and lowest price point of a particular stock and dividing the vertical gap between the two by various Fibonacci ratios namely 23.6%, 38.2%, 50%, 61.8%, and 100%. These levels are then used to determine support and resistance levels.
What are Support Levels
Support levels are a price level where the price of a stock does not go below for a period of time. Support levels come by due to the entry of new buyers into the market to counter a price drop. If you chart the trajectory of a stock over time, you can easily work out the support level by drawing a straight line along the lowest points for the time period you are analyzing.
What are Resistance Levels?
Resistance levels are the opposite of support levels and they mark the highest point the price of a stock rises before a variety of factors prevent it from going above that point. Resistance levels can easily be calculated by drawing a horizontal straight line over the highest price points of a stock. Support and resistance levels are used by market analysts to determine entry and exit points for trading activities. For example, if the price of a stock goes below a set support level, it might signal to the traders that is time to sell the stock.
Fibonacci Retracement Ratios
For reasons that are not still clearly understood, there is a connection between Fibonacci ratios and the behavior of stock prices. Although their use is sometimes controversial, Fibonacci ratios are widely used to predict the movement of stock at certain levels and to determine how analysts will respond to the movements.
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