Fibonacci retracement is among the arsenal of tools that forex traders use when performing technical analysis. It is a very useful tool that helps a trader to more accurately predict how a market is likely to go following a swing high and a swing low. Armed with this information, the keen forex trader stands a greater probability of trading profitably since in many cases, the market prices tend to retrace from one Fibonacci level or another.
A trader who places a trade with the expectation that the price will retrace to one of these Fibonacci levels, can often make profits from doing so. This tends to work because since many traders use the Fibonacci tool, they will all tend to place orders with the expectation of retracement at one of these Fibonacci levels. This mass action tends to cause the price to actually move in accordance, which is why this tool is so effective in forex trading.
Fibonacci retracement is useful for trading any currency pair. The tool is named after Leonardo Fibonacci, the famous mathematician who discovered that there is a series of numbers that will always produce the same ratio if one number in the series is divided by the number just before it.
This series of numbers is first derived by starting with zero and then one, and then adding those two numbers together to get the next number which would be 1. Then that number would be added to the previous number to get the next number in the series which would be 2 (1 + 1 = 2). Then the series would continue by adding one to 2 to get the next number, which would be 3. To complete the series, you would always add up the last two numbers. So, the next number in the series would be 5. The series that you would end up with would be:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233 …….
Starting at about the 21, Fibonacci found that the ratio of any number in the series to the number directly after it, would work out to be approximately 0.618. Also, if you measure the ratio of each number to the next alternate number, the ratio would calculate to approximately 0.382. These ratios are referred to as the golden ratios and these provide the basis for the Fibonacci retracement levels that traders use in forex trading today.
Some of the common Fibonacci levels used by traders are:
0.236, 0.382, 0.500, 0.618, and 0.764
When traders use this tool, they expect retracement of prices to one of these levels. The points indicate the percentage price rebounds that are likely to take place following a swing high or a swing low. The following chart demonstrates how Fibonacci levels are used in trading:
Notice that there was an uptrend in the market. If there is an upside move, we always start drawing the Fibonacci retracement at swing low - where the upside move begins, and end at swing high - where the upside move ends. The price seeks to retrace at the 61,8% Fibonacci level (red horizontal line). That level acts as a support point very nicely. Some other nice market reactions happened at 50%, 38,2% and 23,6% levels. These acted as a S/R zones as well.
If there is a downtrend in the market, we always start drawing the Fibonacci retracement at swing high, and end at swing low.
Notice very nice and accurate bounces from the 38,2% Fibonacci level in the chart above.
When using Fibonacci levels in trading, remember that the longer the time frame, the stronger will be the support or resistance than for shorter time frames. One of the ways that is recommended for deciding where to place your Fibonacci points, is to place it at the next lower high following a major high in the case of a high swing, and at the next higher low following a major low in the case of a swing low.
When used in conjunction with other trading strategies such as support and resistance zones, trendlines or other forex indicators, a trader stands a higher probability of profiting from a trade.
The Fibonacci tool is useful for helping traders to pinpoint where currency prices are likely to retrace following a swing high or a swing low. The longer the time frame, the more reliable the Fibonacci tool tends to be and this is also true when it is used in conjunction with other trading strategies.