Fibonacci strategy in forex trading is an attempt to profit by trading from the key price levels by using the Fibonacci sequence. This sequence creates support and resistance levels between two extreme points (swing high and swing low).
Pattern recognition is one of the fundamental developments in the history of humankind. Recognizing the patterns allowed us to adapt and optimize our behavior for the world around us. While we can attribute our scientific progress to the discovery of constants like c(speed of light), pi(circle's circumference to its diameter), or gravity (G), the Fibonacci sequence is one of the few concepts that found its way to the financial markets.
Origin of Fibonacci
Popularized by Leonardo “Fibonacci” Bonacci, a 12th-century Italian mathematician, the Fibonacci sequence made an appearance in his work “Liber Abaci” (Book of Calculation). This book was one of the first Western books to review the Hindu-Arabic system as a more practical mathematical system than Roman numerals. However, the sequence appears in Indian mathematics as early as 200 BC in the works of Archarya Pingala.
The concept is a sequence of numbers where each number is the sum of the two preceding ones. Starting from 0 and 1, the following values in sequence would look like:
0, 1, 1, 2, 3, 5, 8, 13, 21...
What is Fibonacci Retracement?
Fibonacci retracement is a method of technical analysis that uses the ratio of Fibonacci numbers to project the levels between the extreme points on financial charts.
The idea behind the method is that these levels represent the points where the market might stop while retracing before moving in the trending direction.
While the extreme points represent 0 and 100%, the levels in between are 23.6%, 38.2%, 50%, 61.8% and 78.6%. Interestingly, 50% is not in the Fibonacci sequence but it was adopted as a bias between the bullish and bearish movement, and eventually, it became the part.
The Fibonacci retracement drawing tool is now widely available, allowing you to draw the precise retracement within seconds.
What is the golden ratio?
The golden ratio is a mathematical ratio of two quantities, whose sum has the same ratio to the larger quantities as they are to each other.
This ratio, represented by the Greek letter phi, is an irrational number that equals 1.618033988...
It is also present in the Fibonacci retracement sequence as one of the levels - 61.8%. Known as the most famous number in the universe, this ratio appears seemingly everywhere – from a human body, through nature, and even in the observable universe.
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Applying Fibonacci to Forex Trading
We need to emphasize that Fibonacci is not best suited as a standalone system that gives signals or similar, it is best suitable for those who already have systems but need a clear opinion on the directional bias.
By drawing the Fibonacci retracement between the two extreme points you will get the projected levels.
GBP / USD , daily chart; Source: TradingView
This GBP/USD daily chart shows the retracement between the extreme points. Remember, while it looks like the price perfectly respects some levels in hindsight, we can't know that in advance until we have the extreme points (highs and lows) to draw between.
However, once we know them, we can observe how the price struggles at 50% level, breaks down, and then struggles again at 38.2%. Thus, we can go forward with a bearish bias at GBP/USD, prioritizing the setups that favor the US dollar over the British pound.
Furthermore, if we look at the same pair’s lower time frame (15 min) chart, we can see the temporary resurgence of the pound, as it is keeping above the 50% level.
GBP/USD 15-min chart, Source: TradingView
Thus, a short-term trader might wait until the price dips below 50% and retests it from the underside. Then, an idea might be to enter a short position, place a stop loss just above the 38.2% level and look at how the price reacts from the 61.8% level below, while 78.6% level can be an idea for the take profit level.
How to Use Fibonacci to find important levels on the higher timeframe?
Even if you are not planning to use the Fibonacci sequence on a lower time frame for day trading or swing trading, this doesn't mean it can't provide value.
Regardless of your strategy, you will always look for good take profit or stop loss levels, revolving around strong support and resistance levels.
However, support and resistance levels are nothing else but price levels where there are significant pending orders that absorb a large volume of buying or selling. Imagine if a bank or other financial institution wanted to accumulate or unload a large position at a limit price or better – this is one of the scenarios where support or resistance can develop.
How to spot these levels? In forex markets, the essential advice is to always look to the left. Look for the spots where the price paused or pivoted while trending on the higher timeframe.
Consider the following EUR/USD example:
EUR/USD daily chart, Source: TradingView
After breaking the support and falling for 6 consecutive sessions, EUR/USD pulls back creating a bullish candle, before continuing to fall.
If you draw a Fibonacci retracement from the high to the low of this candle and take the middle of it (50%), this will be your new level to work with. Observing forward you see that this level is highly respected, price bounces from it several times before finally breaking it. It is highly possible this will be a relevant point if the price approaches it again, sometime in the near future.
While daily levels will be stronger than hourly levels, weekly levels will be stronger than daily levels. It is the higher timeframe that gets the priority.
While it might sound like one in the line of mathematical concepts that made its way to the financial markets, the Fibonacci sequence is legendary. It appears everywhere and anywhere from our bodies to the universe.
It has multiple applications to financial markets, but it is best suited for giving direction bias and as a risk management tool. Projecting important support & resistance levels can be priceless when already in a trade.
Yet, although successful, this doesn't mean it is an end-all method, but simply one of the tools in the vigilant trader's toolbox.
Frequently Asked Questions
How accurate are Fibonacci retracements?
Fibonacci retracement is more accurate on the higher timeframe. Remember – small time frames are often noisy, and applying the method on a very short timeframe will likely be ineffective.
Furthermore, we need to consider proper reference points – drawing candle to candle or wick-to-wick.
Why is 1.618 so important?
Phi or the Golden Ratio is the relationship between the two numbers in the Fibonacci sequence. In addition to the 0.618 Fibonacci level, 1.618 is often referenced as the next possible important level – beyond the existing points of reference. Thus, 1.618 is one way of using the retracement in an attempt to predict the future – often as a possible take profit level for trades that are deep in the money.