In 1202, Leonardo of Pisa, also known as Fibonacci, introduced to western European mathematics what today, is called the Fibonacci sequence. It is also related to the golden ratio.
Simply put, the Fibonacci sequence is an integer sequence that builds on itself in he following manner. It starts with 0 and 1. Then 0 and 1 are added to get the next number, then the next number is added to the previous number, in this case 1, to get the following number. Each subsequent number is the sum of the previous two. This picture shows the sequence as found in nature.
Photo Credits: http://www.flickr.com/photos/93452909@N00/184343329
Using Fibonacci to Trade
There are five trading indicators built on the premise of Fibonacci’s integer sequence, Fibonacci arcs, Fibonacci extensions, Fibonacci fans, Fibonacci retracements, and Fibonacci time zones. The integer sequence is used to forecast changes in trends as the asset price moves closer.
Fibonacci Arcs are used to forecast times of price ranging and support and resistance as well.
Fibonacci Extensions are used in conjunction with Fibonacci retracements to identify those levels beyond the key levels of retracement where the price might extend to. They are often used as take profit levels.
The Fibonacci fan extends three lines wide and is primarily used to identify the next area of support and resistance as the price moves in time. It is also used with the Elliot Wave Principle to forecast market trends.
Fibonacci Retracements are generally used to identify key support and resistance levels where the price will retrace, before moving on, either higher or lower.
Fibonacci Time Zones
The Fibonacci time zones are most accurate to longer term analysis of price variation and offer insight into general changes in trend areas in relation to time.
Using the Fibonacci Sequence
In order to increase their accuracy, traders typically use them in conjunction with another technical tool to boost confidence in the price movement that they are predicting.
And because they are used by so many traders, they begin to fulfill their own prophecy. Because trader psychology tells us that traders tend to think alike, the Fibonacci predictions will hold true in most cases.