FIBONACCI TRADING STRATEGY — RETRACEMENTS

 FIBONACCI TRADING STRATEGY — RETRACEMENTS

Tools derived from the Fibonacci number sequence are among the most effective in the field of Forex technical analysis. This is unsurprising, as they can show key inflection points where price is likely to reverse. Forex Fibonacci levels are widely used by retail Forex traders as well as by the traders at major banks and hedge funds. The article represents how to use Forex Fibonacci retracements in your trading. We’ll explore the origins of the numbers and show how to apply Forex Fibonacci levels on your charts.

Who is Fibonacci? Introduction of the Liber Abaci

Born in Pisa around 1170, Leonardo Pisano is better known by his nickname Fibonacci. He was educated in North Africa, travelled widely and studied different numerical systems and methods of calculation. At the time the Roman numeral system was most popular, but Fibonacci recognised the enormous advantages of the mathematical systems used in the countries he visited. He started working on the new system and presented it in his famous book ‘Liber Abaci’ in 1202. He introduced the modus Indorum (method of the Indians), today known as the Hindu–Arabic numeral system.

It made a profound impact on European thought because making arithmetical operations with Arabic numerals was far quicker and more efficient than the old Roman system. The book was widely copied and drew the attention of the Holy Roman emperor Frederick II, who granted a salary to Fibonacci in recognition for the services he had given.

The book comprises three sections, the first covering numbering from 0 to 9, as well as positional notation. He showed the practical use of the numeral system by applying it to commercial book-keeping, interest calculation, money changing and similar topics. The second section deals with a range of issues faced by merchants such as goods pricing, profit calculation and currency conversion. The author is mostly famous for the Fibonacci numbers and the Fibonacci sequence, which are introduced in the third section.

The Fibonacci sequence is a series of numbers where each number is equivalent to the sum of the two numbers previous to it. 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144… and on to infinity.

This sequence ties directly into the ‘golden ratio’, because if you take any two successive Fibonacci numbers, their ratio is very close to 1.618. Hence this figure 1.618 is called ‘phi’ or the golden ratio.

The golden ratio appears frequently in nature, architecture, fine art, biology and even the financial Forex markets. Examples of where the golden ratio occurs include the Great Pyramid of Giza, Leonardo da Vinci's Mona Lisa, nautilus seashells, spiral galaxies, sunflowers, tree branches, beehives and human faces.

Introducing Forex Fibonacci in the Markets

You will see the 61.8%, 38.2%, 23.6% Forex Fibonacci levels being used most commonly in the financial markets. These numbers are not directly from the sequence, they are derived from mathematical relationships between numbers in the sequence.

The basis of the 61.8% ratio comes from dividing a number in the Fibonacci series by the number that follows it. For example: 34/55 = 0.6181.

The 38.2% ratio is derived from dividing a number in the Fibonacci series by the number two places to the right. For example: 34/89 = 0.3820.

The 23.6% ratio is derived from dividing a number in the Fibonacci series by the number three places to the right. For example: 34/144 = 0.2361.

Drawing Forex Fibonacci Retracements in MT4

To draw Fibonacci retracements you need to click on the Fibonacci retracements icon in the toolbar in the top left of the screen. 

Fibonacci Retracements - Icon

In the case of a down move, double click from the swing high (highest recent high) and drag to the swing low (lowest recent low). From there you will see the grid of 23.6%, 38.2%, 50% and 61.8% levels on the chart. These represent levels where price might find resistance - in other words where price might bounce and reverse lower.

Fibonacci Retracements - Down Move Resistance Levels

In the case of an up move, double click on the swing low and drag to the swing high. From there you will see the grid of 23.6%, 38.2%, 50% and 61.8% levels on the chart. These represent levels where price might find support - in other words where price might bounce and reverse higher

Fibonacci Retracements - Up Move Resistance Levels

Fibonacci Retracements strategy for the Forex Trading

Fibonacci Retracements - Zone of Market Retracements

Forex Fibonacci retracement levels are depicted by using the high and low points on a chart and marking the key Fibonacci ratios of 23.6%, 38.2%, 61.8% horizontally in a grid. These horizontal lines represent potential reversal levels. Fibonacci retracements can determine where to place orders for market entry, for taking profits and for stop-loss orders. They can also pinpoint key levels of support and resistance.

Usually retracements are calculated after the market has moved significantly either up or down, and seems to have flattened out at a particular price level. The most popular Fibonacci retracements levels are 61.8% and 38.2%. These are used by drawing horizontal lines across a chart at those price levels to define zones of market retracement, before resuming the general trend formed by the initial large price movement. Those can be very exponential when a market has reached a major price support or resistance level.

The 50% retracement level is normally included in the grid of Fibonacci levels. It is not based on a Fibonacci number but it is widely recognized as an important inflection point.

Forex Fibonacci retracements often form important support and resistance levels and can be very accurate. Experiment with Fibonacci retracement levels across different markets and time frames to find what works best for your Forex trading strategy.

We have also prepared an article which covers more strategies you can use with forex Fibonacci Retracements. You will know how to combine Fibonacci Retracements with indicators, right time to enter the market and  how to define a trend across multiple time frames. Please, follow the link to access it.

FOREX STRATEGIES USING FIBONACCI RETRACEMENTS — PART 2

In the first part we discussed the origin of the Forex Fibonacci sequence, which was originally presented along with the Hindu–Arabic numeral system in the book ‘Liber Abaci’, by Leonardo Pisano, nicknamed Fibonacci. In Fibonacci’s original sequence each number is the sum of the two previous numbers: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, and so on. Dividing one number by the number that follows creates the ‘Golden Ratio’ (φ=1.618), for instance: 8/13 = 61.53%, 34/55 = 61.81%.  

23.6%, 38.2%, 50%, and 61.8% Fibonacci levels play important roles in the financial markets, and those are used to define critical points that cause price reversals. Fibonacci retracements help to indicate strategic places for market entries and stop losses, and also to determine areas of support or resistance.

This second part covers arguably the most powerful and easy to understand application of Fibonacci in trading on the Forex market.

TREND CONTINUATION STRATEGY USING FIBONACCI RETRACEMENTS

To begin with, let’s take a look at the Bitcoin four-hour chart:

Fibanacci retracements

Here we can see that price was in a downtrend before bouncing and retracing exactly 38.2% of the move from high to low.

After reaching the 38.2% Fibonacci level, the price reversed and traded lower, the direction of the overriding trend.

Looking at the chart you can see there are several different retracement levels marked: 23.6%, 38.2%, 50% and 61.8%.

They all represent potential resistance levels in the context of a retracement of the down move. As such these levels all represent potential entry points to rejoin the down trend. This means we have four potential reversal points to enter the market. But which level should you choose?

This is where knowledge of technical indicators and price action can help you.

CONFIRMATION FROM SECONDARY INDICATORS

Secondary indicators confirmation

Looking at the chart above, we can see that the stochastic oscillator gave us a clue that the market was going to reverse. Stochastics were above the 80 level and curving lower, which is a bearish indicator.

So with price up at the 38.2% retracement level and stochastics giving a sell signal, we’re starting to build a good case for placing a sell order, or ‘going short’ as it is called in the trading industry.

LOOKING AT THE TREND ACROSS MULTIPLE TIME FRAMES

A good trader is a bit like Sherlock Holmes, a detective building up a case based on multiple clues. We’ve uncovered two good clues for taking a short position, but we’re not done yet.

Downtrend

Zooming out for the bigger picture and looking at the daily chart above, we can see that the trend is broadly downward on this timeframe also.

This further supports the case for selling Bitcoin at the 38.2% Fibonacci retracement level.

For short positions (sell trades) we want to see that the market is in a downtrend across multiple time frames. For long positions (buy trades) we want to see that the market is in an uptrend across multiple time frames.

The bounce off the Fibonacci level on the four-hour chart was a relatively large one. The 38.2% level was at 9119 and price sold off all the way down to 8190, a move of over $900.

This is a Forex strategy that can be applied across different time frames. For example, you could look for similar set-ups on a 30-minute chart, instead of the four-hour chart we’ve used as an example.

Keep in mind that on the shorter time frames you’ll get more signals but they will be less reliable.

Conversely, on the longer time frames you will get fewer signals but they will be more reliable.

HOW TO ENTER THE FOREX MARKET

To enter the Forex market at the Fibonacci retracement levels you can place a sell stop order (in the case of a retracement of a down move) or a buy stop order (in the case of a retracement of an up move). Alternatively, you could opt to place the orders manually with a market order when the price reaches the Fibonacci levels.

TAKE PROFIT AND STOP LOSS LEVELS

A good rule of thumb is to set a profit target of at least three times your risk. So on the Forex trade described above, we could have set our risk to $200 with a profit target of $600.

Fibonacci retracements will help to estimate support and resistance areas, but the best use of the tool you can get by combining it with other indicators and Forex strategies. For instance, you can take advantage of the stochastic oscillator to define a trend and price reversal. Fibonacci retracements are a trend-following instrument, and looking at the trend across multiple timeframes will obtain a more accurate forecast. Fibonacci retracements make a great confirmation tool and can ensure high probability trades in conjunction with strategies presented in this article. We hope you’ll find the best way to trade using Fibonacci retracements.

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