Fibonacci trading strategy

Apr 13, 2020

Introduction

As trading becomes more and more complicated with many variables and uncertainties, various tools and software aimed at easing trading such as Fibonacci have found great usefulness. An Italian mathematician named Leonardo Fibonacci (who lived in the thirteenth century) discovered that specific ratios of a number series could be regarded in describing the natural proportions of things in the universe, including price data.

The Fibonacci sequence has found a great application in various areas such as Mathematics, nature (spirals of shells or tree branches, fruitlets in a pineapple, sunflower florets, arrangement of Pine Cone, etc.) and, of course in trading.


Traders can choose from a large number of strategies when it comes to trading with Fibonacci forex retracement. However, some are more suitable than others.

Some of these strategies include:

  • The Fibonacci number sequence;
  • The Golden ratio;
  • Fibonacci levels;
  • The 50% retracement level;
  • Fibonacci retracement levels as a crucial part of a trading strategy;
  • The application of Fibonacci extensions.

The Fibonacci number sequence

In Fibonacci number sequence, it is obtained such that if we start from 0 and then move unto the next whole integer number 1, by adding the two previous numbers, i.e., 0 +1, we get the following number which is 1, adding the previous two figures again, i.e ., 1+1 we arrived at two if we go on to add 2 to the former number, i.e., 2+1 we obtain 3 continuing this till infinity, we get this sequence: 0, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987, 1597, 2584, 4181, 6765, 10946 till infinity. This number series is referred to as a Fibonacci sequence.

The Golden Ratio in Forex

The Fibonacci ratio is a ratio that is obtained by dividing any number in the series by the next number higher in the series example 1/1 is 1.0, ½ is 0.5, 2/3 is 0.667, 3/5 is o.6, 5/8 is 0.625, 13/21 is 0.618 or 61.8%, 34/55 is 0.618 or 61.8% 21/55 is 0.382 or 32.8% and so on. If we keep doing this division up till infinity, the ratio gradually approaches the number 1.618 (it comes to a point where if we take any number and divide it by the number before it, we get 1.618), the inverse of 1.618 is 0.618 this is referred to as the Golden Ratio or Golden Mean, represented in Greek by the letter phi. The other ratio to note is the 0.382 ratio; it is derived from dividing a number in the Fibonacci series by a number two places to the right, e.g., 144/377 = 0.382.

These ratios have found significant applications in the financial market over the past ten decades as the likes of W.D Gann, and Ralph Nelson Elliot significantly used these ratios. Up until the late 90s, applying and tracking of these numbers were done manually. With the advent of the proliferation of real-time charting and data, software that could automatically calculate and display these levels in real-time, this brought Fibonacci into the financial mainstream.

A Fibonacci ratio is a vital tool in technical analysis. In Forex trading, the key ratios to look out for are 0.382 (38.2%), 0.50 (50%), 0.618 (61.8%), 0.786 (78.6%), 1.27 (127%), 1.618 (161.8%), 2.618 (261.8%). However, the 50% level is not a Fibonacci ratio, and this is also used because there is a possibility for an asset to continue in a particular pattern upon completing a 50% retracement level. 76.4% is used on meta trader charts 38.2 × 2 = 76.4% and 1 - 34/144 = 0.764. Price often bounces off an exact 76.4 % retracement level, and 76.4 has been considered by various forex brokers.

Fibonacci is one among the numerous strategies or technique in forex trading, Fibonacci is a tool that is not mystical nor is it magic when it is appropriately applied in conjunction with a couple of other means, it will present an enormous profitable high rewarding low-risk trading opportunities that traders can take advantage of on a daily basis.

Fibonacci is a wonderfully powerful tool that can give insight into what the market is doing and what it intends to do.

This article will make lucid the use of the Fibonacci trading strategy in forex trading and further insight and understanding into what Fibonacci trading strategy is all about and how best to use the Fibonacci tool.

Fibonacci Retracement level

Another name of the ratio is a retracement level. This is because there is a likelihood that a price will stop and reverse at one of those levels. When putting Fibonacci levels on the charts, it is essential to look back on each time frame for significant highs and lows, and this usually involves looking back days or even weeks. Fibonacci lines drawn over a weekly or monthly chart will affect the market. The convergence of different Fibonacci levels may occur from levels placed on the different time frame chart; the levels becomes highly significant where convergence occurs. It is, therefore, crucial to look out for convergence with support and resistance and trendlines.

Retracement trading offers a safer trading risk than breakout trading. The important levels to watch out for are: 38.2%, 50%, 61.8% and 78.6% (or 76.4). typically, the market will retrace after a strong move before it continues. The market may not always hit these levels exactly. Price can reverse midway between 50% and 61.8%, and it is also possible for the price to overshoot or undershoot a Fibonacci level.

How to draw the Fibonacci retracement levels

It is very uncommon for a price to move steadily in one direction over a long time. Indeed, when some unexpected news is causing euphoria or fear among investors, prices may skyrocket, on the chart, this may look promising but trading this becomes very it is crucial at this point to take your position early, otherwise, later entry point will be precarious. Price can trend upward, downward, or even sideways. Of course, the trick is to search for investment opportunities in an up and downtrend. Doing otherwise implies no explicit sense of direction.

To draw Fibonacci retracement levels, we must be able to identify the current trend and to identify the turning points, i.e., been able to know the higher highs and higher lows or lower highs and lower lows. Usually, price moves in waves (zigzag shapes), it is vital to understand the nature of these moves, we need to identify a swing move that is a move from point A to point B. It is also a known fact that after the primary step, there would be an accompanying correction in the other direction to point C. When the move from point A to B becomes evident, we wait for a downward movement (correction) to point C. Point C should be located between points A and B.

On a chart, illustrating an uptrend may look like this:

Once you find the ABC move, draw a Fibonacci retracement with a tool from your chart software.

Start from the low of swing to the high, so from point A to point B, as shown below:

Fibonacci retracement

For candle charts, you should draw from the low of the shadow (or peak) of a candle to the high of a candle.

Fibonacci retracement

The common question that has been asked by newbies investors is if the price should touch the retracement levels. The answer is no, as there isn't any 100% accuracy. The price could close near the retracement level, and it can still be a very logical move.

An example is shown below:

Fibonacci retracement

In the diagram above, it shows a downtrend, and there was a correction up. The price looked as if it would move up to a 50% retracement level, but it did not happen. The result was that both candles closed just below the 38% level.

Choosing the right retracement level

There are several Fibonacci retracements levels, and it may be difficult to choose which one to use. Some traders exclusively employ the use of certain retracement levels, while others would prefer to draw all the retracements. It is advised to use standard levels. Over time with more experience, one can then decide which are the most important ones to use. 23.6%, 38.2%, 61.8%, 50%, 78%. 50% is not a Fibonacci retracement. However, still a great level (halfway upward swing or downward swing), so forex traders need to keep this retracement level together with other proper levels. Sticking to these levels should be enough to trade well when it comes to a price correction.

The figure below gives us an example of GBPUSD making a bottom and swinging back. Note also the multiple entry points from the same Fibonacci retracement levels. We notice here that there are high potential entry points at 38.2%, 50%, and 61.8%. All of these could have been entry points with high-profit potentials. However, you will see that after the initial breakout above 100%, other opportunities to gain entry into the trade were available. Ultimately, the price jumped to the 138% point before backtracking. This shows the importance of identifying potential levels above and beyond the initial 100% retracement.

Choosing the right retracement level

Fibonacci forex trading

Forex traders have, to no small extent, utilized Fibonacci forex retracements to determine where to position either order for entry into the market or for taking profits or for placing stop-loss orders. Fibonacci retracements indicate the levels of support and resistance. Usually, these levels are derived after the forex market has made a significant major swing either upward or downward and has flattened at a particular price level.

Forex traders organize the significant Fibonacci levels of 38.2%, 50%, and 61.8%. This they do by drawing a Fibonacci retracement line to point out where the market may likely retrace to or before resuming the general trend made by the initial big price swing. The retracement becomes significant when the market approaches or surpasses great price support or resistance level.

Technically, the 50% level is not part of the Fibonacci number sequence. Still, it is widely used in forex trading of a market retracing approximately half a significant move before resuming and consequently continuing an initial trend.

Some of the forex strategies used when working with Fibonacci levels are:

  • Purchasing near the 38.2% retracement level, with a stop-loss order position a little lower than 50% retracement level;
  • Purchasing close to the 50% level, with a stop-loss order placed slightly below the 61.8% retracement level;
  • Joining the sell position at the top of the big swing, traders often utilizes Fibonacci levels in forex to determine take-profit targets, and this is should the market retraces close to any of the Fibonacci levels and afterward resumes its initial trend, this is particularly useful with the aid of higher Fibonacci levels of 161.8% and 261.8% to forecast possible future support as well as resistance levels.

Forex Fibonacci levels applied within Fibonacci Forex retracements in trading are not based on numbers in the sequence. They are instead obtained from the mathematical relationships between numbers in the sequence. The main basis of the golden Fibonacci ratio (which is 61.8%) comes from dividing the number in the Fibonacci series by a certain number that succeeds it. For instance, 89/144 = 0.6180.

Also, a 38.2 ratio is acquired from dividing a specific number in the Fibonacci series by a number two spots to the right (e.g., 89/233 = 0.3819). The 23.6 ratios are derived from dividing a number in the Fibonacci sequence by the number three spots to the right, for example, 89/377 = 0.2360. Fibonacci levels are illustrated by taking high and low points on a particular chart, and then marking the main Fibonacci ratios of 23.6%, 38.2%, and 61.8% horizontally, to generate a grid. In turn, those horizontal lines are used to determine possible price reversal points.

The 50% Retracement Level

Technically, the 50% retracement level is not part of the Fibonacci number sequence. However, it is commonly included in the Fibonacci levels' grid that can be drawn applying charting software. Since the 50%, retracement level is a market retracing approximately half a significant move before resuming and continuing the initial trend.

Why does market retrace?

Point A:This is essentially the first leg of the trend, it's the start of initial advance, the price begins to rise as buyers enter the market, gains encourage new buyers, thereby pushing prices higher. Point B: Pullback or correction begins, at this stage, supply meets Demand, the price becomes too expensive, it has gone up relatively significantly and is no longer attractive to bring in new buyers. The market then turns sensitive to counter-trend events because the traders who have belonged would have made some profits and would necessarily want to protect their earnings. This makes them want to collect their earnings and get out, and this creates a correction down.

Point C: At this point when the moves get lower, those traders that wanted to belong but didn't because the price had already essentially becomes too expensive, all of a sudden the market starts to look more attractive because now the prices are lower and are much more interesting to get back in, and those same people who had taken profits earlier see this correction running out of steam and gets back in. And that's what propels the trend higher and creates newer highs and newer highs.

What Fibonacci analysis would primarily address is where the turning point is, that is where necessarily a trader can say this correction is over, I want to get back into the market. So basically, a Fibonacci number sequence can be used to help forecast the likely depth of a counter-trend retracement, hinting where a correction may end and the dominant trend resume.

Using Fibonacci extension levels

Fibonacci extension levels help in the prediction of price level of support and resistance, and they are used in the calculation of how far price will travel after a retracement is completed. If Fibonacci is used to entering a trend, then Fibonacci will give the right prediction of the end of the pattern. The Fibonacci extension is based on the swing move (A to B). point C is not used in the calculation (the extension levels are calculated based on the distance between points A and Point B)

The Golden ratio (1.618) is a significant number in the Fibonacci sequence, and it acts as the most used Fibonacci extension level (the 161.8% level).

Uptrend

uptrend

Exit at C (C = 161.8%)

downtrend

Exit at C (C = 161.8%)

From the diagram of the uptrend above, traders would usually attempt to enter the 'bounce' at point B and measure the last retracement from point A to B to find out how far the trend may move before reaching point C (161.8%) level.

In the downtrend, traders will attempt to enter the market at the 'Correction' at point B and measure the last retracement from point A to B to find out how far the trend may move before reaching point C (161.8%) level.

Reversal traders may as well attempt to use the 161.8% level to enter into counter-trend trades, but this is, however, suitable for more advanced traders.

Also, a target point D (Profit Objective) and retracement point C can be calculated by.

Profit Objective

A to Point B and multiplying by the factors as shown in the table below:

Fibonacci trading strategy

Fibonacci convergence

A Fibonacci convergence is a point where there is a coincidence of two or more Fibonacci price relationships with a relatively tight range. If we take a Fibonacci retracement and projections from several different lows or highs to find a level where two or more retracements and forecasts are the same levels, this will give a level with a strong possibility of a turning point.

A good example is a Fibonacci convergence where a 38.2% off one high and 50% off another and 61.8% off another, converging on the same area of the chart. A Fibonacci extension can converge with a Fibonacci retracement creating a bounce.

Fibonacci software

In much charting software, you would find a Fibonacci retracement tool. Using Fibonacci could be a powerful tool in conjunction with overbought and oversold conditions and also looking at structures for entry and exit in a trending market.

If you like this strategy, you might also be interested in this Pivot point trading strategy

Conclusion

Market don't move in straight lines, and even though they may trend in a given direction, they don't necessarily trend in that direction all the time. There is a period within an uptrend where prices correct lower, and the trick is obviously to find that spot, to see where that correction is over, and when the overall trend begins. And looking at the downtrend, we find the same thing we have an overall trajectory lower, but with periods of correction and the trick is to locate where that turning point might be to jump back into the trend.

The use of Fibonacci cannot be overemphasized in the maximization of profits in forex trading. Fibonacci levels help to determine reversal points with an excellent degree of accuracy. It is no doubt that Fibonacci retracement can be of immense importance in forex trading. Knowing how to draw and apply them is of utmost importance. Fibonacci is a great deal in enhancing your technical analysis skills and forex trading strategy. Fibonacci retracement strategy is, however, not as simple as it looks. It is, however, very excellent when it is appropriately applied in conjunction with a couple of other tools. It presents an enormous profitable high rewarding low-risk trading opportunity that can be leveraged every day.

author

NSBroker Analytics Team

Expert Traders From NSBroker specialize in forex trading and have been successfully helping people profit from the markets for the past 9 years. Our traders consistently blog about the state in which the markets are at. Learn how to profit via forex trading with NsBroker.