How to Use Fibonacci for Forex Trading?
You might have heard of the Fibonacci sequence of numbers named after the person who discovered it, Leonardo Fibonacci, an Italian mathematician. A sequence of numbers, starting with 0 and 1, and then continuing as a list of numbers, where the following number is the sum of the previous two numbers. So, the list goes like 0, 1, 1, 2, 3, 5, 8, 13, 21… and so on.
Leonardo Fibonacci discovered this sequence while attempting to solve a rabbit population puzzle in Liber Abaci. Researchers have found that the sequence is prevalent in nature in many forms, such as the shape of seashells or the number of petals in a flower. It has also been found that drone bees or male honey bees that have the same parent (the mother bee), follow the Fibonacci sequence in their genealogical progression.
Traders also soon found that forex trading actually reacts to these numbers. If you calculate the ratio of each number to the next one, you will get these results – 0.236, 0.382, 0.500, 0.618… and so on. These ratios are used in the technical analysis of forex markets, and through appropriate trade tools that are often built into online trading platforms, we can calculate the Fibonacci levels. These Support and Resistance levels help us to analyze price charts, in order to know whether the market will reverse or continue with the existing trend.
Source: Wikipedia, USD/CAD Price Chart with Fibonacci retracement levels, 31/07/2018 https://en.wikipedia.org/wiki/Fibonacci_retracement
Plotting the Fibonacci Retracement Levels in Forex Trading
If you are using the MT4 platform, then this will come as an in-built technical indicator. Just go to the main menu and choose 'Insert'. Then choose 'Fibonacci' and then 'Retracement'. There are other tools like 'Fibonacci Spiral' and 'Fibonacci Arc' but the retracement technical analysis tool is the most popular.
After you have chosen these options, a dialogue box will appear that will require you to mention the levels, such as 0.618 or 0.382, and the tool will plot horizontal lines across your price chart, pointing out the price levels where the market may retrace to, before continuing on the original price trend.
Source: Fibonacci Retracement / YouTube / 31.7.2018 (https://www.youtube.com/watch?v=PqLOHa9WsjI)
You will first have to find an ongoing trend direction and then a strong rally or decline. Click on the starting point of this rally from the opposite direction of the trend, dragging the Fibonacci tool till the end. You will see that the retracement levels are usually 0.382, followed by 0.618. This means that you have plotted correctly.
The basic mathematical science here is taking two extreme points (peaks or troughs) and then dividing the vertical distance by the key Fibonacci ratios. This will create a retracement level. Once these levels are identified, the horizontal lines show possible support and resistance levels.
What Do These Levels Mean?
Through this tool, key levels of support and resistance can be identified. In case of an uptrend, these ratios (0.382, 0.618 and others) become potential support levels. In a similar way, they become potential resistance levels, in case of a downtrend. You can expect the prices to reverse or even break at these levels, to change direction.
Source: Fibonacci Retracement / Traders Place / 31.7.2018 (http://www.tradersplace.in/fibonacci-in-technical-analysis.html)
Many times, you will see that prices will revert to the 0.618 or 0.382 levels, and move towards the 1.618 level, which is also known as the Fibonacci extension level. Traders consider this as a forex trading strategy that actually works; they buy and sell at the retracement levels, and take profit at the extension levels. Some traders also choose the 0.50 level, though it is not actually a part of the sequence. This is because it has been seen that markets retrace by half of a major move, before resuming the earlier trend. The 50% level is considered as a significant reversal level.
Take a look at some of the strategies commonly used with these retracement levels.
Forex Trading Strategies Using Fibonacci Retracement Levels
For someone looking to enter the forex market that is currently showing an ongoing uptrend, an ideal strategy would be to buy near the 0.382 or 0.50 levels, placing the stop-loss levels below the following level in the sequence. For instance:
- Buy at 0.382 and place stop loss a little below 0.50.
- Buy at 0.50 and place stop loss a little below 0.618.
If after some time, you notice a market reversal in the ongoing uptrend and decide to enter a sell position, you can use the retracement levels as take profit targets. In case the market retraces near one of the Fibonacci levels and then resumes its prior direction, we can use higher levels of extension ratios like 1.618 or 2.618 to identify future support and resistance levels. This can happen only if the market goes beyond the previous high or low, reached before retracement.
Things to Remember when Using Forex Fibonacci Calculator
- The Fibonacci tool works best in trending forex markets. Traders should wait for a few sessions, till the time the retracement levels are in their early stages.
- Another thing to consider is that there is no guarantee that the price will continue in the direction of the trend as it retraces to a Fibonacci level.
- Using this tool is also quite subjective. As there are multiple price swings in a day, different traders may choose to connect different points. Traders usually tackle this by drawing retracement levels on all significant price trends. A cluster of Fibonacci levels may indicate an area of high importance.
- The tool will not exactly pinpoint a market reversal point. It will also not provide an exact entry point or exit point, but an estimated area.
- The retracement levels will act as a confirmation of trading signals in the area of Fibonacci levels.
Source: EUR/USD M15 Chart / Dolphin Trader / 31.7.2018 (https://www.dolphintrader.com/support-resistance-fibonacci-retracement-metatrader-4-indicator/)
The Use of Fibonacci Spirals in Technical Analysis
Another useful indicator that works on the Fibonacci sequence is the Fibonacci Spiral. The indicator makes it possible to forecast both time and price, providing a way to actually link them. Each point on the spiral represents an optimal combination of both factors.
A certain extreme point on the chart is taken to be the centre of this spiral, and then based on the golden ratio, an indicator is drawn out from the center.
The golden ratio is the magical number, 1.618, used widely in areas of engineering, architecture and paintings. If you take the Fibonacci sequence and divide a number by its predecessor, you will get this result. The further you go in the sequence, the higher will be the accuracy of the ratio. In all Fibonacci indicators, this golden ratio is expressed through the three percentages, 38.2%, 50% and 61.8%.
Technical analysts believe that certain points on the spiral could be strong indicators of significant market events, such as high levels of resistance or support or high price hikes.
However, the exact method of calculating these spirals is unknown to many. Although they are known to be extremely accurate in predicting market behaviour, their mysterious nature drives the average trader towards the Fibonacci Retracement indicator. But, this combination of time and price representation is absent in other Fibonacci tools.
Fibonacci indicators are apt examples of how science and mathematics influence day-to-day trading strategies and patterns.
This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.