Fibonacci tools are constantly used by Forex traders. You’d better know them as well as your ten fingers since many analysts use these tools to identify support and resistance levels or to predict the potential scope of price movement.
Before telling you about the Fibo tools themselves, we’ve decided to introduce you to the man who came up with the idea of Fibo ratios – Leonardo Fibonacci. In his book “Liber Abaci” (1202), the scholar studied the growth of an idealized rabbit population in a sequenced manner. He managed to discover a simple series of numbers (0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, etc. Every number in this sequence is the sum of the two preceding ones. A wonderful thing is that the ratios of these numbers correspond to the natural proportions of things in the universe. Different movements of the market are often consistent with Fibonacci ratios as well.
The most important Fibo ratios are 161.8% (89/55 = 1.618 – the “golden ratio”), 61.8% (55/89 = 0.618), and 38.2% (derived from skipping 1 sequence in division e.g. 55/144 = 0.382). You can find several Fibonacci tools in your trading terminal: retracement, expansion, fan, arcs and time zones. All of these tools are based on Fibo ratios.
Fibonacci levels are so appealing because:
- They are geometric numbers – very pleasing ones to the human eye.
- They are objective price reference points (they remove subjectivity if used correctly).
Among the Fibonacci tools, we have mentioned the most useful for traders are Fibo retracement levels and Fibo expansions (also referred to as extensions).
The main purpose for using Fibo retracement levels is to determine the size of potential correction against the main trend.
How to apply Fibo retracement tool to the chart?
Select the ‘Fibonacci retracement’ tool and draw a trend line connecting 2 extreme points of a trend. For an uptrend, you’ll draw this line from minimum to maximum. For the downtrend, you’ll need to draw a line from maximum to minimum. Then 9 horizontal lines will automatically appear intersecting the trend line at Fibonacci levels of 0.0%, 23.6%, 38.2%, 50%, 61.8%, 100%, 161.8%, 261.8%, and 423.6% (Fibonacci ratios as described above).
These lines act as support and resistance: prices tend to consolidate near these levels before the correction either ends (and the overall trend resumes) or continues (the price breaks one of the retracement levels and moves to the next one, for example, to 50% after the 38.2% level). If the price retraces more than 61.8% of the previous move (on a closing basis), the odds are that it will reach the beginning of the trend. The 50% retracement level is the most widely monitored retracement level and is a common area to buy during a retracement of an uptrend or sell if it’s a retracement of a downtrend.
While plotting Fibo levels, remember that you should use the upper/lower tips of the candlesticks’ wicks to obtain the most accurate results.
You may use Fibonacci on different timeframes. If Fibo levels on different timeframes converge, these levels become more important.
There are 2 ways to trade using Fibo retracement tool:
To trade at every Fibo level. If the market started actively going to the opposite direction, one opens positions against the trend targeting the next Fibo level.
Wait for the prices to recoil from the Fibo level in the direction of the main trend. The price doesn’t always bounce exactly at the Fibo level. In most cases, Fibo points at the area of support/resistance. A confirmation signal at the point C is needed before one opens position.
Beware! Fibos can be treacherous…
Fibo retracements are not 100% accurate. It happens not only because you plotted them incorrectly. Fibo levels are designed to give you a clue about the most profitable entry/exit points, but they don’t guarantee a positive outcome. In order to increase your chances for a successful trade use Fibonacci retracement tool together with other technical indicators to achieve a higher probability of success.
Consider using Fibos with trendlines. Draw a trendline and then plot Fibo retracement. At the point of intersection of these two tools, you might find the most favorable entry point.
If 200-period moving average coinsides with 50% Fibonacci retracement, this level will likely be able to hold the initial attack on the market. This is a good place for taking profit or entering the market in the direction of the main trend.
You can also combine the Fibo retracement tool with candlestick patterns. Imagine that one day you see the price advancing, the bullish candle is formed and closed near a certain Fibo level. You are perplexed. You want to know what will happen next, whether there will be further growth or not. Wait until the formation of the next candlestick near the Fibo level. If it’s a doji – an “exhaustive candle” that tells you that the uptrend is dying out – the odds are that the rally won’t continue. Based on this signal, you can take the necessary actions to protect your gains. Actually, any reversal candlestick pattern next to a Fibonacci level will likely mean that the price action is going to take a new direction.
Other articles in this section
- Chart patterns
- Uncovering Gann indicators
- How to create your own trading strategy?
- Candlestick patterns
- Trend trading
- Carry trade
- Swing trading
- Position trading
- Day trading
- Trading styles and strategies
- Trader's psychology
- Identifying market’s reversal
- Japanese Candlesticks
- Market conditions: trends and ranges