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Understanding Fibonacci Levels

BALTIMORE ( Stockpickr) -- One of the most frequently mentioned -- and perhaps most frequently understood -- concepts in technical analysis is the Fibonacci ratio. Technical traders use Fibonacci ratios to determine key buying and selling points, as well as to predict a stock's upcoming price action. But what exactly do numbers developed by a 13th-century Italian mathematician have to do with today's complex financial markets?

Today, we're going to look at how Fibonacci levels work, and how you can trade off of them.

In his 1202 A.D. tome, Liber Abaci, an Italian mathematician named Fibonacci identified a sequence of numbers whose patterns frequently appear in nature. Today, the Fibonacci sequence is taught to most middle-schoolers, but its more complex applications take place in the world of finance. Simply put, the Fibonacci sequence is a pattern (starting with 0 and 1) in which each subsequent number is the sum of the previous two.

It starts off like this: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89 ...

In the sequence above, the third number is the sum of the first two -- and the 10th is the sum of the 8th and the 9th, the two numbers that preceded it. What makes the Fibonacci sequence significant is its existence in nature: The arrangement of leaves on a stem, the spirals of a shell and the arrangement of a pine cone are all examples of naturally occurring items that exhibit Fibonacci patterns.

Related: Understanding Candlestick Charts

For traders, the real significance comes from the behavior of tradable instruments, such as stocks, commodities and bonds, at key Fibonacci levels.

Finding Fibonacci Ratios

To adapt the Fibonacci sequence to trading, technicians use the Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8% and 100% (these ratios are found by dividing a Fibonacci number by the series of numbers that follow it in the sequence -- it's worth noting that the 61.8% ratio, known as the Golden Ratio, is the most critical). By converting Fibonacci levels to percentages, they become relative and can be applied to stock charts.

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