What is a Fibonacci channel?
The Fibonacci channel is a technical analysis tool used to estimate support and resistance levels based on Fibonacci numbers. It is a variation of the Fibonacci retracement tool, except that with the channel the lines run diagonally instead of horizontally.
- A Fibonacci channel provides the same retracement and extension levels as the Fibonacci retracement and extension tools.
- With a Fibonacci channel, the lines are diagonal and run parallel to two selected highs in a downtrend, or two selected lows in an uptrend.
- Once the Fibonacci channel has been identified, the diagonal lines indicate future areas of support and resistance.
Understanding Fibonacci Channels
To draw a Fibonacci channel, the trader must first determine the direction of the trend. The Fibonacci channel can be applied to both short-term and long-term trends, as well as bullish and bearish trends. The lines are drawn at 23.6%, 38.2%, 50%, 61.8%, 78.6%, 100% and the extension levels of 161.8%, 200%, 261.8%, 361 , 8% and 423.6%, at the discretion of the merchant.
A Fibonacci channel does not require a formula. Channels are drawn at certain percentages of the price movement selected by the trader.
- In an uptrend, select a starting point (a low) and then another higher swing low. These create the zero line, as this is where the channels start. This line creates the angle of the channels. All other lines are drawn parallel to this line.
- Also, select the high swing between the two lows.
- The distance between the low point and the high point is 100%. The 100% line will extend to the right at the same angle as the zero line drawn.
- The distance between the start point and the top is used to create the additional percentage levels. If the distance is $ 1, the 161.8% level will start at $ 1.62 above the starting point and then begin to slope upward at the same angle as the zero line drawn. The same concept applies to all other percentages.
The same concepts apply to a downtrend.
- Select a starting point (a high) and then another lower swing. These create the zero line.
- Select the swing low between the two highs.
- The distance between the high point and the low point is 100%. The 100% line will extend to the right at the same angle as the zero line drawn.
- The distance between the starting point and the minimum is used to create the additional percentage levels. If the distance is $ 1, the 38.2% level will start at $ 0.38 below the starting point and then begin to slope downward at the same angle as the zero line drawn. The same concept applies to all other percentages.
Traders can create Fibonacci channels on most major charting software platforms, although the implementation of them is subjective as traders have discretion on which ups and downs to use to draw their Fibonacci channels.
How to use the tool
The tool is used to help identify where support and resistance can develop in the future. If the uptrend is expected to continue, 100%, 161.8% and other higher levels are possible price targets. The same concept applies to downtrends if a downtrend is expected to continue.
In an uptrend, the zero line is like a normal trend line, which helps to assess the general direction of the trend. If the price falls below it, it may need to be adjusted based on the most recent price action, or it could indicate that the uptrend has ended and the price is declining.
In a downtrend, the zero line also acts as a trend line. When the price is below it, it helps to confirm the downtrend. If the price moves above it, the indicator may need to be redrawn or the price may move higher out of its downtrend.
A price moving to the 161.8% level or higher shows that the current trend is accelerating as it is making larger moves than when the indicator was drawn. If the price action is largely contained between the zero line and the 100% level, the trend is roughly as strong as it was when the indicator was drawn. If the price starts to fail to reach the 100% line and moves through the zero line, both are indications that the current trend has slowed down and may be reversing.
Fibonacci Channel vs. Andrew’s Pitchfork
Both indicators attempt to predict future support and resistance levels based on past price levels. Fibonacci channels attempt to do this with percentages of a selected price movement. Then those percentages are projected into the future. Andrew’s Pitchfork is simpler in a way as the angled lines are based on three price levels selected by the trader and then extended into the future.
Limitations of using Fibonacci channels
While multiple Fibonacci levels and indicators can be added to a chart, they can quickly saturate it. As each price wave forms, a new Fibonacci channel will provide new information.
Fibonacci channels are very subjective. The trader chooses three points that he considers important, however, it is possible that the market does not consider them important and therefore does not respect or react as expected to the levels drawn.
One of the complaints with Fibonacci analysis in general, especially on short-term charts, is that there are so many levels that the price is likely to reverse or hit one of the levels. The problem is knowing which level will be important in advance.
For this reason, traders are encouraged to use other forms of analysis, such as price action and other technical or fundamental indicators, to assist them in their trading decisions.