What Is a Fibonacci Channel?
The Fibonacci channel is a technical analysis tool that is used to estimate support and resistance levels based on the Fibonacci numbers. It is a variation of the Fibonacci retracement tool, except with the channel the lines run diagonally rather than 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
In order to draw a Fibonacci channel, the trader must first determine the trend direction. The Fibonacci channel can be applied to both short-term and long-term trends, as well as to uptrends and downtrends. 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 trader.
A Fibonacci channel doesn't require a formula. The channels are drawn at certain percentages of the price move selected by the trader.
- In an uptrend, select a starting point (a low) and then another higher swing low. These create the zero-line, since this is where the channels start from. This line creates the angle of the channels. All other lines are drawn parallel to this line.
- Also, select the swing high in between the two lows.
- The distance between the low point and high point is 100%. The 100% line will extend out to the right at the same angle as the drawn zero-line.
- The distance between the starting point and the high 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 angling upward at the same angle as the drawn zero-line. The same concept applies to all the other percentages.
The same concepts apply to a downtrend.
- Select a starting point (a high) and then another lower swing high. These create the zero-line.
- Select the swing low in between the two highs.
- The distance between the high point and low point is 100%. The 100% line will extend out to the right at the same angle as the drawn zero-line.
- The distance between the starting point and the low is used to create the additional percentage levels. If the distance is one $1, the 38.2% level will start at $0.38 below the starting point, and then begin angling downward at the same angle as the drawn zero-line. The same concept applies to all the other percentages.
Traders can create Fibonacci channels on most major charting software platforms, although the implementation of them is subjective since traders have discretion on which highs and lows to use for drawing their Fibonacci channels.
How the Tool Is Used
The tool is used to aid in identifying where support and resistance may develop in the future. If the uptrend is expected to continue, the 100%, 161.8%, and other higher levels are potential 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 trendline, helping to assess the overall trend direction. If the price falls below it, it may need to be adjusted based on more recent price action, or it could signal that the uptrend is over and that the price is breaking lower.
In a downtrend, the zero-line also acts like a trendline. When the price is below it, it helps confirm the downtrend. If the price moves above it, the indicator may need to be redrawn or the price is moving higher out of its downtrend.
A price that moves to the 161.8% level, or greater, is showing that the current trend is accelerating, as it is making bigger moves than it did when the indicator was drawn. If the price action is largely contained between the zero-line and the 100% level, the trend has about the same strength as it did when the indicator was drawn. If the price starts failing to reach the 100% line, and moves through the zero-line, these are both indications that the current trend has slowed and may be reversing.
Fibonacci Channel vs. Andrew's Pitchfork
Both these indicators attempt to predict future support and resistance levels based on price levels from the past. Fibonacci channels attempt to do this with percentages of a selected price move. Those percentages are then projected out into the future. Andrew's Pitchfork is simpler in some ways as the angled lines are based on three price levels selected by the trader and then extended out into the future.
Limitations of Using Fibonacci Channels
While multiple Fibonacci levels and indicators can be added to a chart, they can quickly clutter it. As each price wave forms, a new Fibonacci channel will provide new information..
Fibonacci channels are highly subjective. The trader chooses three points they deem to be significant, yet the market may not view these points as significant and thus may not respect or react as expected to the drawn levels.
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 at or reach one of the levels. The problem is knowing which level will be important in advance.