In the world of foreign exchange, forex traders, analysts, and brokers use various tools and techniques to keep abreast of the current market situation and finding price levels that are suitable for them to enter and exit the market.
While all of these tools are used for different purposes, each of them helping you anticipate the next move of the market, one of the most useful techniques that you need to learn about are the basics of Fibonacci Trading.
In this article we’re going to run down the technique, starting from its history, application, processes, and results!
Fibonacci trading is basically based upon Fibonacci number and ratios that were first developed and introduced to this world by Leonardo Fibonacci himself. He was a famous Italian mathematician who wrote a book in the 13th century in order to contribute towards Western Mathematics.
His Fibonacci analysis is based on a series of numbers that are divided with each other to create ratios. These ratios are used in describing various situations, circumstances, and proportions of this universe in a way that is beneficial for a number of purposes, especially predicting financial market trends.
Fibonacci Trading: Numbers and Ratios
The numbers in the Fibonacci series are not the same as our regular numbers and the formation of a series is based upon a simple calculation.
The number series is as follows: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89…
This series of numbers starts with 0 followed by 1. These two are then followed by 1 again which is derived as a result of adding 0 and 1 whose result is 1.
This 1 is the added to the previous number which is 1 which gives us the next number 2 for the series.
Now adding 2 with the previous number gives us 3 which is the next number in the Fibonacci numbers.
Following this simple calculation of adding the current result with the previous number gives you the number next in series. Knowing the easy formulate will help you in calculating all numbers in the series.
These numbers are then divided with each other to derive the Fibonacci Ratios. These ratios are calculated by dividing any number to its succeeding higher number.
These ratios are called the ‘Golden Mean’ that are considered to be the basics of Fibonacci trading. Most traders use these ratios to identify the market support and resistance levels and profit taking levels known as retracement and extension levels respectively.
We are here to make your lives easier by providing you these levels that are going to help you a long way in trading and devising strategy and techniques for yourself.
Fibonacci Retracement Levels
0.236, 0.382, 0.500, 0.618, 0.764
Fibonacci Extension Levels
0, 0.382, 0.618, 1.000, 1.382, 1.618
Application of Fibonacci Levels
Fibonacci levels are applied to the charts that you are analyzing to take a position in the market. To apply this you first need to identify two points which are as follows:
This is usually determined using a candlestick chart. Such a candlestick has at least two lower highs on both its sides, left and right.
This is also determined on a candlestick chart. Candlestick has at least two higher lows on both the sides, left and right.
Fibonacci Trading Techniques
Fibonacci Trading techniques are basically used by traders to identify the support and resistance levels of the market and in order to gauge the buying and selling behavior.
This is why it is said that the Fibonacci tool works best when the market is trending. If it is trending upwards then the idea is to go long on a retracement at a Fibonacci support level. And if it is trending downwards, then go short on a retracement at a Fibonacci resistance level.
It helps you, as a forex trader, to understand when you should enter or exit the market according to your own specific analysis.
To come up with these retracement levels, you need to go back to your basics of Fibonacci Trading and then apply the two points required to attain the Fibonacci levels i.e. swing high and swing low.
This can be done by selecting a swing low and dragging it to connect to swing high for an uptrend. This will show you the retracement levels on your chart whose calculations are built-in in trading platforms these days.
The opposite needs to be done for a downtrend, joining swing high to swing low.
The above chart is an example of an uptrend where a swing low is connected to a swing high. This chosen market swing shows the range in blue. The black dotted lines show the Fibonacci ratios which can be used as support levels by traders.
Here, the price found some initial support at 0.236 but broke the level further breaking 0.382 and finally having 0.618 as the Golden ratio level after which the market bounced back thus stopping the retracement.
Fibonacci fans are derived from the Fibonacci retracements. These fans are a series of trend lines that are drawn starting from the same point. To make these fans you first need to draw a vertical line down from the swing high as shown in the chart above. This vertical line intersects with three Fibonacci ratios at each level.
With swing low as the starting point, now draw three lines each passing one of the three intersection points of the Fibonacci ratio levels.
These trend lines help you clearly identify support and resistance levels which are circled in black in the chart.
Forex traders consider Fibonacci extension levels to show them the relevant profit taking levels. These are somewhat similar to Fibonacci retracements but instead of projecting retracements within the range of the market swing, it is able to project extensions beyond the market swing and is useful for planning price targets.
With an upward trend and a trade in which you are in a long position, the idea is to take profits at the Fibonacci Price Extension Level.
In the example of the chart given above, more price action has been added to the right side of the chart to deeply understand the concept of extensions. The black dotted lines with the Fibonacci ratios are taken as possible resistance levels. The 0.236 proved to be resistance for a short while but then the trend started moving further upwards.
Sometimes the extension levels initially taken as possible resistance levels start acting as support which indicated the changing of these levels from resistance to support.
Fibonacci Trading Techniques – Advanced
Apart from the basic Fibonacci Retracement and extension, there are other advanced techniques related to Fibonacci trading that are used by forex traders to have a holistic view of the market and its behavior. These advanced techniques are mentioned as follows.
Fibonacci Circles and Arcs
The addition of circles to the Fibonacci trading techniques basically adds the element of time to these charts. These curves demonstrate the concept of accelerating prices that suggest the parabolic chart patterns.
When tracing an uptrend, the swing high serves as the center of the circle. Draw a circle around the swing which serves as a diameter until you get a 100% circle level. Now, with the help of Fibonacci ratios calculate diameters for other circles inside the 100% circle level.
The importance of circle trading as compared to the arc trading is that it uses the entire circle as the potential support and resistance levels. In arc trading, the lower or bottom half of the circle which is indicated below the red line in the chart above, are used to indicate potential support and resistance levels.
Fibonacci Time Extensions
As evident by its name, Fibonacci time extensions indicate when you can expect the market to turn in the direction opposite to what it is currently trending at. The extension lines, as used in Fibonacci extensions, needs to be marked on the horizontal time axis to get Fibonacci time extensions.
It is recommended to use this trading technique on charts that have a time base as these are time extensions. In the chart above, it clearly shows at 138.2% and at 200% the extensions caught the turning points.
A Fibonacci time zone is another Fibonacci trading technique that uses the time element. Fibonacci numbers are used instead of Fibonacci ratios to project time extensions.
Points to Keep in Mind with Fibonacci Trading
There are two important points that traders using Fibonacci trading techniques need to keep in mind which are discussed below:
- The market swing needs to be selected with extreme focus as it would provide the basis for all our future upcoming projections upon which you are going to trade and enter into positions in the market. This swing needs to be adjusted according to the changes in price that takes place in that time. A rule of thumb for selecting market swing is to select the one that is most clear and takes up a majority portion of the chart.
- You must decide if the projections based on your selected market swing serve as effective support and resistance levels. As discussed above in Fibonacci trading techniques there are instances when a possible resistance level starts acting as a support level which demonstrates the changing of resistance level to support level.
Methods to Place Stop Order in the Fibonacci Trading
It is necessary to understand how and when to place a stop order on the trades in which you enter on the basis of Fibonacci trading techniques. As much as you want to make profits and benefit using these techniques you also want to limit your exposure in the market so that on days when the market is against you, you do not have to lose a lot of money.
There are two simple methods that are used to set stop and limit your losses.
Method # 1: Stop Placed Just past Next Fib
Fib is your Fibonacci level, and this means that your stop on a particular trade must be placed just past the next Fibonacci level as indicated on the charts above. For example, if you plan to enter the market at 50.0% then you should place your stop past the 61.8% level.
The reason behind placing a stop at this level is that you firmly believe that the market would hold at 50.0% level as a resistance. But if it did not and the prices rose beyond this point then your ideas and beliefs are invalidated.
One drawback of this method is that it shows that you firmly believe that the resistance level you have predicted would hold and that the timing at which you took a position in the market was perfect.
This is absolutely not the case and the market might go in any direction that it wants as per the behaviors of its participants, hence determining the overall market sentiment.
Method # 2: Stop Placed past Recent Swing High/ Low
This is a safer option as compared to placing it past the next fib as it offers you more cushion and a better chance that the market might move in the direction that is favorable to you. But if the prices surpass the swing low or swing high then it indicates a reversal of pattern is in place.
Result and Use of Fibonacci Trading Techniques
These various Fibonacci trading techniques help you achieve your desired results if applied in the correct manner and are extremely helpful for traders who are fond of using leading indicators to enter a position rather than lagging indicators.
This is the very reason why these basic of Fibonacci trading are considered to be of predictive nature and are used for:
– Anticipating price action but not reacting to it
– Attempting to find support and resistance areas to enter and exit the market
– Calculating market swings; swing high and swing low