Among the technical analysis tools used in forex trading, Fibonacci is perhaps the most popular and widely used one. The system serves forex traders and analysts in several ways, such as providing a framework for various trading strategies, identifying prices at which changes in price direction should occur, and many more.
We will review how Fibonacci levels can be effectively used in Forex trading strategies.
How does Fibonacci work in trading?
First, it is essential to understand the Fibonacci sequence and its unique mathematical properties before considering the mechanics of Fibonacci trading and how it pertains to Forex Fibonacci trading strategies.
Fibonacci sequences are sequences of numbers in which, after 0 and 1, every number is equal to the sum of the two previous numbers. Infinity follows this pattern.
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987, 1597, 2584, 4181, 6765….
The Fibonacci numbers form the basis of trading based on fascinating relationships. There are many different Fibonacci relationships, and we cannot cover all of them here, but these are the most important ones for our later discussion of Fibonacci Forex strategies:
- A number can be divided by 1.618 by multiplying it by the previous number. The Fibonacci extensions use this critical level, as you’ll learn later in this article.
- A number can be approximated as 0.618 when divided by the next highest number. Fibonacci retracement level 61.8% is calculated based on this number.
- By dividing a number by another two places higher, it approximates 0.382. Fibonacci’s retracement level of 38.2% is based on this number.
- The Golden Ratio, Golden Mean, and Phi are 1.618. Nature, biology, and the cosmos are dominated by the inverse of this number, 0.618. William Hoffner of the Smithsonian Magazine wrote in December 1975: “Although the proportion .618034 to 1 is not found in nature, it is the basis for many things, including the Parthenon, sunflowers, snail shells, Greek vases, and spiral galaxies in outer space. The Greeks used this proportion heavily throughout their art and architecture.”
Fibonacci levels used in the financial markets
In the context of trading, Fibonacci’s sequence is not used in Fibonacci retracements; instead, the numbers used are derived from the mathematical relationships between the numbers. A number in the Fibonacci series is divided by the number following to develop the “golden” Fibonacci ratio of 61.8%.
A ratio of 89/144 is 0.6180, for example. Fibonacci series numbers are divided by two places to the right to calculate the 38.2% ratio. For instance, 89/233 equals 0.3819. A number in the Fibonacci series is divided by three places to the right to determine the 23.6% ratio. For instance: 89/377 = 0.2366.
A chart illustrates Fibonacci retracement levels by marking the high and low points with horizontally, 23.6%, 38.2%, and 61.8% Fibonacci ratios. Horizontal lines are drawn to determine possible price reversals.
Chart software usually can draw Fibonacci levels on a grid that includes the 50% retracement level. There is no Fibonacci number based on the 50% retracement level, but it is widely recognized as a significant reversal level, both in Dow Theory and the work of W.D. Gann
A Fibonacci retracement level often signals reversal points with uncanny accuracy. In retrospect, it seems complicated to trade them. As a tool within a larger strategy, these levels are most effective. A confluence of several indicators is ideal for identifying potential reversal areas offering low-risk, high-profit trade entry opportunities.
However, Fibonacci trading tools often suffer the same pitfalls as other universal trading strategies such as the Elliott Wave theory. Despite this, many traders find success placing investments within long-term price trends using Fibonacci ratios and retracements.
P.s. Technical information have been taken from: https://www.investopedia.com/ask/answers/122414/how-do-i-use-fibonacci-retracements-create-forex-trading-strategy.asp , https://www.fxcc.com/fibonacci-forex-strategy