The Fibonacci analysis technique is used by traders to understand support and resistance levels of a stock price. By mapping these highs and lows, traders can contextualize stock price movement and be able to respond appropriately.
Fibonacci Sequence
The Fibonacci sequence is the underlying principle behind the Fibonacci analysis. The sequence is one of the most famous mathematical theories and is derived by adding the first two numbers of the sequence. The Fibonacci sequence has been observed in nature and is regarded as an important component in the evolution of life. Proponents of the Fibonacci analysis have argued that because stock market prices are driven by the desires and motives of traders, this collective psychology can be mapped (and thus predicted) by the Fibonacci sequence.
How it Works
The Fibonacci analysis method is based on the principle that markets will retrace a portion of a price movement. These price shifts follow a certain known pattern and thus can be predicted. Fibonacci retracement is calculated by taking the vertical distance between the highest point and the lowest point and dividing it with the Fibonacci ratios. The two polar ends of the retracement are 0% which is considered the start and 100% that is considered the complete reversal of the earlier movement.
Support and Resistance Levels
The key purpose of doing Fibonacci analysis is to determine support and resistance levels. The resistance level refers to the highest point a stock price reaches before market forces exert downward pressure on it. Similarly, support level refers to the lowest point a stock price will go before new traders entering the market exert upward pressure on the stock price. Traders use these levels to help stop losses and to help them determine the best price for a stock at various points of the cycle.
Advantage of Fibonacci Analysis
The Fibonacci retracement levels tend to be static and so allows for easy analysis of the movement of a stock price. The analysis also helps traders identify price targets of the stocks they want to sell or buy. The other advantage of using the Fibonacci analysis is the fact that it allows a trader to analyze price movements across different periods. For example, you can you the analysis across daily, weekly or even cross-year trading.
Key Factors to Note
When people are analyzing markets using the Fibonacci analysis, there are some mistakes that they should try and avoid. These include mixing up Fibonacci reference points, ignoring long term trends of the stock price movement and relying on the Fibonacci analysis alone to make stock price decisions. Traders using this analysis method must also be careful not to overuse this analytics approach for analyzing short term trends. This is because the shorter the period of analysis, the less accurate the retracement levels become.
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