Use Fibonacci analysis to identify key levels

STERLING’S dramatic drop against the dollar last week hit headlines across the world as traders feared that the pound would hit parity against the euro and fall to new lows against the greenback. But for some, the move was simply an extension of an ongoing drop. Traders who pay attention to Fibonacci levels were prepared for the move, which they saw as an extension of the retracement that has been in place ever since the pair broke through the 38.2 per cent level in mid-February.

Fibonacci analysis is a controversial subject among traders – some will religiously use these techniques while others think that they are total rubbish. But last week’s sterling move seemed to vindicate the Fibonacci followers. Its fall stopped at the critical 61.8 per cent retracement level before rebounding. Of course, there can be straightforward reasons for this – if enough people are using Fibonacci analysis, the technique can become self-fulfilling. For this reason, it is worth having at least a basic grasp of what it entails and how it is relevant to the markets.

It is based on a ratio of 1.618 to one, or its inverse 0.618, which is derived from the Fibonacci sequence. Followers point to the occurrence of this ratio in nature – from the number of bees in a hive to the proportions of the human body – and argue that because human nature drives markets, you can apply Fibonacci to trading.

The simplest way to use Fibonacci is to identify support and resistance levels when prices are reversing long-term, substantial moves. If a pair is retracing lower, then the key supports will come at 23.6 per cent, 38.2 per cent, 50 per cent, 61.8 per cent and 76.4 per cent.

Traders look for the price to bounce off the 23.6 level – if it is successful, then the correction was probably a blip. But should it break through, then the next support is 38.2 per cent. When prices fall decisively through this level, the theory is that they are likely to fall back to the 61.8 per cent retracement point, which sterling did last week. This is the critical point, says David Jones at IG Index. “If the pair falls below there, then theory says it is going to go back to where it started last year,” he says.

You might be sceptical about using Fibonacci to trade but last week shows that – for whatever reason – it’s worth keeping an eye on those levels.