Forex Trading Strategy With Fibonacci Retracement

Forex Trading Strategy With Fibonacci Retracement

To a beginner, forex trading could seem to be a simple way to make quick money. All you have to do is to buy a currency at one price and sell it when its value rises. You’ll make a profit as long as your winning trades outnumber the losing ones.

However, anyone with a little experience in the forex market knows that it doesn’t work quite like that. Currency movements are highly unpredictable. A large number of factors determine prices. It’s difficult to outguess the market consistently.

How can you increase your chances of ending a forex trading session profitably? Is there any way to identify the optimum level at which you should enter into a trade?

This is where Fibonacci retracement comes in.

What are Fibonacci retracement levels?

Fibonacci retracements can be used to identify the price at which to:

  • Place orders
  • Take profits
  • Enter into a stop-loss.

How do Fibonacci retracements work? Many forex traders are convinced that future price actions can be predicted by using Fibonacci retracements. Others think that Fibonacci ratios don’t really work that well. They hold the opinion that when prices move as predicted by Fibonacci retracements, it’s only a coincidence.

Which belief is true? In this post, we’ll examine the Fibonacci sequence and how it can be used in forex trading. We’ll also try and determine whether it’s a useful tool for forex traders.

Before we jump into the intricacies of Fibonacci retracement levels and how they work, let’s step back and understand the origin of the term.

Fibonacci numbers and their relevance.

Leonardo Pisano Bigollo was an Italian mathematician who later came to be called Fibonacci. He is credited with having discovered the Fibonacci series. That’s a sequence of numbers in which the value of any number in the series is equal to the sum of the previous two.

Leonardo Pisano Bigollo discovered the Fibonacci series

https://lh4.googleusercontent.com/8eINR4WmIZZMwhGP5QNqoLOklydKzdcMRF8XN6BsRLRf3zPMN6D3-UcgK-ug_zUwwejyRCaoRAJCmf0a4v-5ntfokLyCaBuMVCpGjKXrlfNFinRD3T70Z82Snl0jhHogfQ00ourU

Source: Famous Mathematicians

Here’s the Fibonacci series:

0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55…

You’ll see that if you pick any number in the series, it is the sum of the previous two. So, 5 is the sum of 2 and 3. Similarly, 34 is the sum of 21 and 13, and so on…

Why is this important?

The next step will show you the significance of the Fibonacci series. Divide any number by the previous one. You’ll get approximately 1.618.

55 divided by 34 = 1.618

34 divided by 21 = 1.619

21 divided by 13 = 1.616

1.618 is known as the Golden Ratio. The Golden Ratio repeatedly appears in nature and the cosmos. For example, the proportions of the human body reflect this ratio. A person’s height is about 1.618 times the distance between the ground and that individual’s belly button. The Golden ratio also governs the distribution of planets and asteroids in the solar system.

So, how is all this relevant to forex trading?

Traders think that Fibonacci numbers can be used to identify support and resistance levels. 

When a currency’s price rises sharply in relation to that of another currency, it could fall before retracing its upward direction. Fibonacci retracement levels could be used to pick the price at which the upward trend is resumed.

Similarly, when prices fall, they don’t decrease at a consistent rate. Instead, they often drop to a certain level, rise again, and then resume their downward trend.

Fibonacci retracements are ratios that allow forex traders to identify the point at which prices change direction. Entering into a trade at these levels can result in a profit.

We’ll see how these ratios are determined and how they can be used in forex trading.

Fibonacci retracements are calculated by using the ratios of 23.6%, 38.2%, 50%, and 61.8%.

How the Fibonacci trading ratios are calculated.

In an earlier section of this post, we mentioned that the Golden Ratio is 1.618. The retracement level of 61.8% is based on this ratio. When the market is trending upwards, and it experiences a correction, the price could fall by 61.8% before rising again. The Golden Ratio can help traders determine the point at which the price finds support.

Now let’s see how the other retracement levels of 23.6%, 38.2%, and 50% are calculated. Here is the Fibonacci series again:

0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55…

If you divide any of the numbers in the series by the number that is two places to its right, you will get 38.2%. Here are a couple of examples:

13 divided by 34 = 38.2%

21 divided by 55 = 38.2%

Similarly, divide a number in the Fibonacci series by the number that is three places to its right, and you will get 23.6%. You can verify this yourself by having a look at these examples:

8 divided by 34 = 23.5%

13 divided by 55 = 23.6%

You should know that forex traders also consider 50% to be a Fibonacci ratio. However, you can’t arrive at 50% from the Fibonacci series. Then why does it find a place in the list of Fibonacci retracement levels? Traders have seen that prices often resume their original trajectory after a 50% retracement. That’s why this ratio is also considered in the list of Fibonacci retracement levels.

Fibonacci retracement levels – an example:

Let’s see how Fibonacci retracement levels work with a real-life illustration.

EUR/USD Historical Fibonacci Grid

Kapur:Users:nkapur:Desktop:EUR_USD Historical Fibonacci Grid.png

Source: How To Use Fibonacci To Trade Forex

Study the chart reproduced above carefully. It provides details about the price of the EUR/USD pair for the period from 1985 to 2015.

The lowest level was reached in 2001 when the EUR/USD traded at 0.82300 (100% on the chart depicted above). The highest level of 1.60380 was achieved seven years later in 2008 (0%). You can see that these levels have been used to arrive at the reference points of 0% and 100%. Allocating these reference points accurately is a crucial step in the process of calculating Fibonacci retracement levels.

Now, look at the chart closely. You can quickly make the following observations:

  • There were retracements at the 50% level in 2008, 2010, and 2012.
  • In 2014, the retracement level was 61.8%.

Of course, the support levels during the declines aren’t very clear-cut. That’s the way Fibonacci retracements work. They provide only an approximate indication at which you can enter the market.

So, how can you use this method to improve your forex trading strategy?

How you can use Fibonacci retracement levels

When you are using this tool, you need first to identify the topmost and lowest points that you want to consider on your chart. In the immediately preceding section of this post, we described how the reference points of 0% and 100% were fixed. You’ll have to carry out a similar exercise when you are assigning reference points on your chart.

After you allot the reference points, you can divide the vertical distance between 0% and 100% into the Fibonacci ratios. Remember that these are 23.6%, 38.2%, 50%, and 61.8%.

These points can be used to identify support and resistance levels.

Let’s understand the method with a simple example:

How to use Fibonacci retracement in an uptrend

Kapur:Users:nkapur:Desktop:How to use Fibonacci retracement in an uptrend.png

Source: How to use Fibonacci retracement to predict forex market

This illustration demonstrates how Fibonacci retracement can be used when prices are moving up. You can see that the price rises from A to B, and then the decline starts. C, D, and E are different points at which retracement could take place.

In the illustration shown above, C occurs at a level of 38.2% of the price rise from A to B. You can also see that D and E are at the Fibonacci retracement levels of 50% and 61.8%. So, you could take advantage of a rising market by buying at the level of C, D, or E.

Fibonacci retracements work in falling markets too.

How to use Fibonacci retracement in a downtrend

Kapur:Users:nkapur:Desktop:Fibonacci retracement in a downtrend.png

Source: How to use Fibonacci retracement to predict forex market

The chart reproduced above traces prices in a falling market. Prices go down from point A to point B. They then rise before falling again.

The increase in prices starts at B. But there’s resistance at the Fibonacci level. This resistance could take place at C. At this point, which is at 38.2% of AB, retracement starts. Similarly, retracement could begin at D (Fibonacci level of 50%) or E (Fibonacci level of 61.8%).

Why does the price resume its downward trend at E, D, or C? The reason could be that a significant number of traders think that prices cannot rise above those levels. So, they place sell orders when the bounceback reaches one of the Fibonacci levels.

However, don’t think of Fibonacci retracement levels as a magic wand that will boost your trading profits every time that you use them. They work best when the market is trending. It’s also advisable to use a combination of Fibonacci levels with other lines.6 If you do this, you’re more likely to meet with success.

In the next section, we’ll look at ways to ensure that you get the greatest possible benefit from using Fibonacci retracement levels.

Do Fibonacci retracement levels provide a failsafe method for trading in the forex market?

Unfortunately, they don’t. Remember that Fibonacci levels should be used when the market begins trending in a new direction. The price increase (or decrease) will not take place at a constant rate. Instead, in a rising market, prices will retrace their path to a lower level before restarting their upward journey.

Similarly, in a falling market, prices will rise temporarily before recommencing their downward trend. Fibonacci retracement levels work best when they are used as a predictive technical indicator.

At what price should you place an order? When should you exit? Fibonacci retracements can tell you. However, there are several caveats that you should keep in mind.

They don’t tell you the exact turning point: The retracement could take place at 23.6%, 38.2%, or one of the other retracement levels. There’s no way to be sure. Additionally, prices could change direction at a little above or below these levels.

You could also face a situation where the price retraces 100% of the last price wave. If that happens, the Fibonacci trading strategy that you’re using won’t work at all.

Fibonacci retracement levels may not work well over short intervals: Placing your reference points over a short timeframe can be a mistake. If you consider too short a period, the inherent price volatility could result in misidentification of retracement levels. Consequently, you could take profit too early or miss out on an opportunity to sell.

So, remember that longer timeframes generally work better with Fibonacci levels.

Don’t use Fibonacci retracements in isolation: New traders sometimes use Fibonacci levels blindly. They assume that if the price touches one of the Fibonacci ratios, a reversal is imminent. However, that may not always be true.

It’s preferable to follow a slightly different approach. When you’re using Fibonacci retracements, combine them with another tool. MACD — moving average convergence/divergence — is a popular trading indicator. Use it to reconfirm if you are on the right track.

The bottom line

Are Fibonacci retracements a useful tool that can help you craft a profitable forex trading strategy? Or is it too far-fetched to think that currency prices are influenced by a series of numbers discovered by an Italian mathematician many centuries ago?

Whatever the truth, the fact is that many traders use Fibonacci retracements regularly. As a result, this tool can create a self-fulfilling prophecy.

Traders can use Fibonacci ratios to determine entry and exit points for their forex trades. However, it’s advisable to apply this tool in combination with other technical indicators. Doing this will increase your chances of boosting your trading profits.

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Fat Finger

Fat Finger

Hello everyone!

My name is Phat Fin Ge, but most people just call me Fat Finger or Mr. Finger.

Many years ago, I was a trader on the Hong Kong Stock Exchange. I became so successful that my company moved me to their offices on Wall Street. The bull market was strong, but my trading gains always outperformed market averages, until that fateful day.

On October 28th, 1929, I tried to take some profits after Charles Whitney had propped up the prices of US Steel. I was trying to sell 10,000 shares, but my fat finger pressed an extra key twice. My sell order ended up being for 1,290,000 shares. Before I could tell anyone it was an error, everyone panicked and the whole market starting heading down. The next day was the biggest stock market crash ever. In early 1930, I was banned from trading for 85 years.

I went back to Hong Kong to work at my family's goldfish store. Please come and visit us at Phat Goldfish in Kowloon, only a 3 minute walk from the C2 MTR entrance.

I thought everyone would forget about me and planned to quietly return to trading in 2015. To my horror, any error in quantity or price which cause a problem kept getting blamed on Fat Finger, even when it was a mix up and not an extra key being pressed. For example, an error by a seller on the Tokyo Stock Exchange was to sell 610,000 shares at ¥6 instead of 6 shares at ¥610,000. That had nothing to do with me or with how fat the trader's finger was, but everyone kept yelling, "Fat Finger! Fat Finger!" In 2016, people blamed a fat finger for a 6% drop in the GBP. It really was a combination of many things, none to do with me or anyone else who had a wider than average finger.

Now that I can trade again, I'm finding forex more interesting than stocks. I've been doing some research on trading forex and other instruments and I'll be sharing it here.

If you see any typing errors, you can blame those on my fat finmgert. If you see any strange changes in price, it's not my fault.

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