You might have already heard the term Fibonacci, but do you know what it is and how to use it in your trading?
In brief, Finonacci is a popular technical indicator used by traders to help identify support and resistance levels.
In the following article we will have a look at where Fibonacci came from, how it works and how to apply it to forex trading.
What Is The Fibonacci Sequence?
Leonardo Pisano Bogollo discovered the Fibonacci sequence during the 13th century in Italy.
He was nickamed “Fibonacci” which roughly means “Son of Bonacci”, Bonacci being his fathers family name.
The Fibonacci sequence is a set of numbers that starts with a zero and 1, followed by a one.
0, 1, 1…
The rule for the sequence is that each number (called a Fibonacci number) is equal to the two previous numbers.
For example, starting with 0 and 1:
- The second number comes from adding the two previous numbers, 0+1 = 1
- The third number comes from adding the two previous numbers 1+1 = 2
- The fourth number comes from adding the two previous numbers 1+2 = 3
- The fifth number comes from adding the two previous numbers 2+3 = 5
You will end up with the following sequence:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144,…
So we have gone over what the Fibonacci’s sequence of numbers is, but it is not really the sequence that is important.
It is the mathematical ratios (1.618 and 0.618) between the numbers in the series that is important.
These ratios make up the “Golden Ratio”.
The Golden Ratio
The golden ratio appears everywhere and is the building blocks of nature.
Almost everything adheres to the golden ratio of 1.618 and its reverse 0.618.
In mathematics, you can calculate the ratio by adding the two together and dividing by the largest.
(a + b)/a = a/b = 1.6180339887….
So for example:
If you measured your body from your shoulders to your knees and then your knees to the feet you would have two lengths.
You would then add the two lengths together and divide them by the largest and you should end up with a ratio close to 1.618.
This ratio is also used by forex traders in the form of a technical indicator called called the Fibonacci Retracement.
You might have already heard of the Fibonacci retracement indicator, but do you know how it works?
There are three main retracement levels used which follow the golden ratio.
These levels are expressed in percentages as 23.6%, 38.2% and 61.8%.
So where do these levels come from?
Well lets go back to the Fibonacci sequence 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144.
Each number in the sequence is about 1.618 times greater than the one before it.
When you divide any number in the sequence by the one that follows, it results in a ratio of 61.8 percent.
You can calculate the ratio of 38.2 percent by dividing any number in the sequence by the number two places to its right.
And for ratio of 23.6 percent you can calculate it by dividing any number by the one three places to its right.
When you place these levels on to a chart as horizontal lines they show areas of support and resistance.
Now you know what Fibonnacci is and what to use it for, you now need to understand how to use it correctly.
Using Fibonacci In Forex Trading
The Fibonacci retracement tool is used by many traders and is one of the most widely used indicators.
It helps traders to determine entry levels, target prices or stop losses.
Retracement is used in other indicators such as Elliott Wave theory.
The Fibonacci retracement tool plots horizontal lines to indicate areas of support or resistance.
As mentioned previously the main levels that traders focus on will be the 61.8%, 38.2% and 23.6%.
The general concept of Fibonacci is to confirm support and resistance levels allowing you to see areas of possible corrections, reversals and countertrend bounces.
Drawing Fibonacci On A Chart
When drawing the Fibonacci tool you should make sure you draw it from the left hand side to the right hand side all the time.
No matter whether you’re doing if for an uptrend or downtrend it always has to go from left to right.
First you need to identify where a big move has occurred previously,this can be done on any size wave but the bigger the better.
In the chart above we have plotted where the price movement started and where it bounced back.
You then need to draw the Fibonacci tool from the highest high of where the price movement started to the lowest low.
Remember, this is done from the left side to the right
Using Fibonacci With Support And Resistance
When using the Fibonacci tool on your charts you should be looking for areas for where the price has had difficulty breaking through.
It is these areas that act as support and resistance levels.
In the chart above you will see areas marked in green where the price has tried to break through but was unable to.
The price first tried to break through at the 61.8 level, it then tried again at the 38,2 level and then again at the 23.6 level.
These levels are good indications of support and resistance and should help you in determining possible levels to enter or exit a trade.
The best way to use Fibonacci retracement is to use it in a confluence with other levels.
You could combine Fibonacci with various other indicators and levels such as 00 levels, Pivot points and Moving Averages.
The more levels that overlap with the Fibonacci levels the strong the overall level is.
Fibonacci should not be used without either knowing the fundamentals behind the price movement or the daily sentiment.
When trading with Fibonnaci you need to do the following:
- Determine the daily sentiment
- Apply Fibonnaci retracement
- Locate Support and Resistance levels
- Wait for a pullback to those levels
Placing Your Stop Loss
So if you have placed a trade using the Fibonnaci levels then where will be the best place to put your stop loss?
Lets take a look at the charts again to demonstrate.
If you had entered at the 23.6 level for example then there are possible areas to place your stop loss.
You could place your stop above the 61.8 level or above the 100 level.
Placing your stop at the 100 level prevents you from getting caught out on rebounds but can be risky.
Likewise putting your stop lower at the 61.8 levels puts you at a greater chance of being knocked out early on a rebound.
In general though if you know the fundamentals or daily sentiment of the price movement and you are confident in the trade then putting your stop above the 100 level would be OK.