Summary - The Fibonacci sequence is one of the key mathematical concepts used by traders when executing a channel trading strategy. In a Fibonacci channel, a series of diagonal lines – representing the key Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8%, and 100% extend outward from a base channel that traders select based on their confirmation of an upward or downward trend.
When prices move above or below these key Fibonacci channel lines, traders can execute a buy or sell strategy based on anticipated price movement.
The Fibonacci sequence and corresponding Fibonacci ratios have long provided traders with clearly defined support and resistance levels. It is not clear why this connection exists. However, the answer may lie in the fact that the Fibonacci sequence draws close parallels to the golden ratio of 1.6 that is used in architecture and biology.
A Fibonacci channel is just one indicator of price movement based on the Fibonacci sequence. Fibonacci retracement creates price channels using horizontal, rather than diagonal, lines. Fibonacci arcs use half circles to represent the key Fibonacci ratios.
What do rabbits and rectangles have to do with investing? The answer lies in a mathematical concept known as the golden ratio which appears in everything from architecture to biology. However, the golden ratio extends to investing as well through the work of an Italian mathematician known simply as Fibonacci. In attempting to explain and predict the breeding habits of rabbits, Fibonacci created a sequence of numbers that has become famously known as the Fibonacci sequence.
This sequence and its relationship to an idea that creates the aesthetic known as the golden ratio has lent itself to a series of ratios known as the Fibonacci ratios. These ratios have proven to be remarkably accurate predictors for investors in developing a channel trading strategy based on defined levels of support and resistance. These ratios have subsequently been used to create a number of technical analysis tools which are commonly used by traders. One such tool is known as a Fibonacci channel.
In this article, we’ll break down what a Fibonacci channel and how one is created. Along the way, we’ll take a deeper dive into what the Fibonacci sequence is (if you don’t already know) and how the Fibonacci sequence and the golden ratio are related. We’ll also go into brief detail about some of the other technical analysis tools based on the Fibonacci sequence as well as the limitations of Fibonacci channels.
What is a Fibonacci channel?
A Fibonacci channel is a technical indicator of price movement. Lines that form inside a Fibonacci channel estimate likely areas of support and resistance. The lines that make up the channels are based on ratios created by using common numbers from the Fibonacci sequence. A Fibonacci channel is a variation of another popular technical analysis tool, the Fibonacci retracement. The major difference is that in a Fibonacci channel the parallel lines that are drawn run diagonally across a price chart. Fibonacci retracement lines move horizontally.
What is the Fibonacci sequence?
The Fibonacci sequence is a mathematical sequence that starts with the numbers zero and one. The sequence continues by adding the previous two numbers together. The initial numbers in the Fibonacci sequence therefore are:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377… and so on.
Why is the Fibonacci sequence significant?
To understand the significance of the Fibonacci ratio to investors, it’s critical to understand the golden ratio. The golden ratio dates back to the ancient Greeks and specifically a sculptor and architect named Phidias (we’ll get back to the significance of his name in a little bit). It is theorized that Phidias used the golden ratio to design the sculpted statues he created for the Parthenon). The golden ratio is an attempt to determine the ratio of the “most beautiful” rectangles height to its width.
Here’s how it works. If you were to measure the sides of a random “beautiful” rectangle and divide the longest side by its shortest side, the ratio will be approximately 1.6. This is known as the golden ratio – or phi (which goes back to the architect Phidias) – rounded to the nearest tenth. The actual golden ratio is 1.618. If you draw a line inside the rectangle to make a square and another smaller rectangle, the smaller rectangle will also have the golden ratio.
So how does the golden ratio relate to the Fibonacci sequence? If you were to divide every number in the Fibonacci sequence by its previous number, the resulting sequence is as follows:
1, 2, 1.5, 1.666, 1.6, 1.625, 1.615, 1.619, 1.617, 1.6181, 1.6179
As you’ve probably noticed, after the initial Fibonacci numbers, the remaining numbers are remarkably close to the golden ratio of 1.618 – the value of Phi. When this number is expressed as a ratio, it is approximately 61.8%. Technical analysts have since expanded the golden ratio to create what are called Fibonacci ratios. These ratios are found by dividing two numbers in the series in a specific pattern. For example, dividing any number in the Fibonacci sequence by the number three places to its right creates a ratio of 23.6%. Dividing any number in the sequence by the number two places to its right creates a ratio of 38.2%. Continuing on creates what is called the key Fibonacci retracement ratios of:
23.6%, 38.2%, 50%, 61.8% and 100%
Fibonacci ratios, for reasons that are not clear, act as support and resistance levels for asset prices. This allows traders to use these ratios to identify price trends and initiate trades when a price hits one of these key ratios. In an upward trending market, a trader that sees a stock start to move downward after hitting the price that corresponds to the 38.2% ratio will identify the price at the 23.6% ratio and set a buy order at that price. This is where the trader will expect the stock to start to climb again. In addition to being used to construct Fibonacci channels, the Fibonacci ratios are used in Elliot Wave theory. The ratios are instrumental in measuring the target of the wave's movement in an Elliot Wave structure.
How to build a Fibonacci channel
Before creating a Fibonacci channel, a trader must identify chart patterns which are signified by peaks and troughs. Assuming that an asset is not trading in a tight range, an uptrend is marked by higher highs (peaks) and higher lows (troughs). Conversely, a downtrend is marked by lower lows and lower highs.
For this example, we’ll assume that an upward trend has been identified. Here’s how to construct the channel.
Step One: Select a low price (yes, a low price) and then another low that is higher – this is called a swing low. Once this line is drawn it establishes the angle of all the subsequent channel lines which will be parallel to this line. This is called the zero line.
Step Two: Select a swing high – this will be a high price between the two lows.
Step Three:Draw a line extending out from the swing high that is parallel to the baseline. The distance between the low point and the high point is 100%. This 100% line extends to the right at the same angle as the zero line. This is called the base channel.
Step Four:Identify the distance between the starting point and the high. This will be used to create additional levels at percentages based on the key Fibonacci ratios: 23.6%, 38.2%, 50%, 61.8%, and 100%. For example, if the distance between the starting point and the high is $1, the 23.6% level will start at $1.24 above the starting point. The 38.2 level at $1.39 and so on. These lines are drawn on a parallel angle to the zero line.
Now let’s look at how to construct a Fibonacci channel for a downtrend:
Step One:Select a high price and then another swing high that is lower. Draw the zero line.
Step Two:Select a swing low between the two highs.
Step Three:Draw a line extending out from the swing low that is parallel to the baseline. The distance between the high point and the low point is 100%. This 100% line extends to the right at the same angle as the zero line.
Step Four:Identify the distance between the starting point and the low to create the additional percentage levels based on the key Fibonacci ratios.
Note: A Fibonacci channel can be calculated with most charting software packages. In this case, charting software establishes trendlines that are based on the analyzed market tendency. In a rising market, that means they will be set to mark two ascending levels. In a falling market, they will be set to two descending levels.
What does a Fibonacci channel signal to traders?
The trendlines created by the Fibonacci ratios are where a reversal of price action is likely. This allows traders to form a long or short strategy based on the anticipated price movement. Once the price moves inside one of these channels, the bottom line now becomes the new support level and the top line becomes the new resistance level. In an uptrend, the zero line helps to assess the trend direction. If the price falls below it, it could be a signal that a more recent low needs to be selected, or it could be an indication that the trend is reversing. The opposite is true in a downtrend. In this case, if the price rises above the zero line further assessment will be necessary to determine future price movement.
Other significant price moves include:
- If a price moves to the 161.8 level (61.8% ratio) or higher, it can be assumed that the price trend is exceptionally strong because the price is now making larger moves than when the channel was created.
- If the price action of a security stays consistently between the zero line and the 100% level, the trend is maintaining the same strength as when the channel was created.
- If the price action consistently fails to reach the 100% level and starts to fall through the zero line, it is a good sign that the current trend has slowed and may be reversing.
Limitations of Fibonacci channels
There are three primary limitations to Fibonacci channels. First, because a Fibonacci channel is constructed of multiple lines, a chart can quickly become cluttered and hard to read. Every time a new price wave forms, a new channel adds new information.
Second, the starting point for any Fibonacci channel is largely subjective. An investor or trader chooses their points to draw the zero line and top line. But these lines may not be supported by the prevailing market sentiment. This can create unexpected price movement.
Third, because there are so many levels, it is difficult to know which level will be important in advance. The price is likely to reverse at or reach one of the levels. This is particularly true of short-term charts.
However, these limitations simply point out that investors should use other technical indicators in addition to a Fibonacci channel to identify trading opportunities.
How does a Fibonacci channel relate to other Fibonacci indicators?
A Fibonacci channel is one of several technical indicators that allow for trading based on the Fibonacci sequence. Two of the most common are Fibonacci retracement and Fibonacci arcs. As mentioned earlier, a Fibonacci retracement pattern is similar to a Fibonacci channel. The difference is that Fibonacci retracement levels are represented by horizontal lines at each of the key Fibonacci ratios. With Fibonacci arcs are half circles (instead of lines) that extend outward from a baseline. The arcs cross over the baseline at the key Fibonacci ratio levels. The arcs, which represent possible support and resistance levels, grow wider as the baseline gets longer and narrow when the baseline is shorter.
The final word on Fibonacci channels
A Fibonacci channel is a technical analysis tool that uses the key Fibonacci ratios to identify likely areas of support and resistance. A Fibonacci channel is created by identifying an uptrend or downtrend and creating a base channel based on peaks and troughs in the chart that support the trend. From this channel, a series of diagonal lines are added at the key Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8%, and 100%. These are also called Fibonacci extension levels.