The Fibonacci sequence is a series of numbers created by adding the previous two, starting with 0 and 1. Leonardo Fibonacci introduced it to the West in his book “Liber Abaci” (1202). It’s used in mathematics, science, and nature, such as fractals, number theory, and plant/animal growth patterns. Its simplicity and frequent occurrence in nature has drawn interest from mathematicians and non-mathematicians.
Support and Resistance Levels: The sequence can also be used to determine key support and resistance levels, where prices are likely to stall or reverse, providing traders with potential entry and exit points.
Where should I enter and close position? Is it the end of a move or will be there a continuation?
In many cases, trend following investors try to make decisions based on moving averages and oscillators. When the market is oversold, you should go long, and then follow the trend and exit on the signal that the market is overbought.
Sounds pretty easy, doesn’t it? So why are the majority of investors losing money?
The Fibonacci tool, on the other hand, is a tool belonging to leading oscillators. This tool gives you support and resistance levels for the price before it even gets there. You should consider using other tools to take the most probable signal.
Professionals use leading indicators to be the first to enter and exit trades. Soon enough you will be joining this group! Let’s start from the beginning.
Fibonacci numbers. What are they?
Leonardo Pisano Bigollo (born around 1170 in Italy), also known as Leonardo Fibonacci, introduced the Fibonacci sequence to the western world in his book Liber Abaci.
What’s interesting is that this sequence was known to Indian mathematicians back in six century. The Fibonacci sequence is present in many different areas, such as mathematics, nature (spirals of shells or tree branches) and of course we now also use them in trading!
Fibonacci numbers are the sequence of numbers starting as follows: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 337, 610, 987… Each number is a sum of two previous numbers (two to the left).
Look at number 3. It is the sum of number 2 and number 1, because 2 and 1 are to the left of 3. 11 The two numbers to the left of 34 are 21 and 13. So, we add 21 to 13 and the result is 34.
Each Fibonacci number has its own place in the sequence. The sequence is the base to calculating other Fibonacci numbers, such as ratio or extension.
What is the Fibonacci retracement and ratio?
Based on the sequence, we can calculate the ratio. The Fibonacci ratio is counted by dividing a number by the number that follows it in the sequence. Let’s take a look at some examples:
5/8 = 0.625
13/21 = 0.619
89/144 = 0.618
The last ratio listed: 61.8% is the most important ratio and is often called the golden ratio. But there are more ratios, as you have noticed. Where do the other ratios come from?
The answer is simple: it is the result of dividing a number standing two, three and four places to the right.
For instance, two places to the right from 8 there is 21:
8/21 = 0.38
Three places from 8 there is 33:
8/33 = 0.24
Here we have them – the most important ratios: 23.6%, 38.2%, 61.8%.
A ratio is also called a retracement level. It is because there is a chance that a price will stop and reverse at one of those levels. Traders like to use a few levels more, so the list of most popular full retracement levels is as follows: 23.6%, 38.2%, 50%, 61.8%, 78%
The 50% retracement level does not come from the Fibonacci sequence, but it’s an important level. Traders tend to react when a price is near half of the previous swing, so they added it to retracement levels.
The Fibonacci retracement levels
In the previous chapter, you have learned about the most popular retracement levels (23.6%, 38.2%, 50%, 61.8%, 78%). Now it’s time to learn how to draw them and how you can use them in your trading.
How to draw the retracement levels?
It is easy like ABC. So far, we have learned that it is very rare for a price to move in one direction for a longer time. Surely, when there is panic or euphoria on the market because of some big news, prices may skyrocket and it is hard to enter the trade.
In most cases though, the price moves in zigzag shapes. Some traders call it waves, and there is a scientific concept called Elliott wave theory. But for us it is important to know the nature of these moves.
First, we need to identify a swing move that is a move from point A to point B. We know already that after the main swing there should be a correction in the opposite direction to point C.
When we see a move from point A to B, we wait for a move down (correction) to point C. Point C should be located between points A and B.
It is not always so easy to identify points A, B, and C, but it gets easier with time and experience. When we are sure that we have found the ABC move, we can draw a Fibonacci retracement with a tool from our chart software. We start from the low of swing to the high, so from point A to point B.
If you use candle charts, you should draw from the low of the shadow (or peak) of a candle to the high of a candle. Please, notice that you get much more accurate results when you apply the retracement levels to your candle chart. Compare it with the results from the above chart.
How do you know if you have chosen the right top and bottom?
It is a little bit like art and it comes with time. At times, when you have two bottoms near each other, even if you have selected the wrong one, it is not going to change the position of the retracement levels significantly.
Should the price touch the retracement levels?
This is always a problem for new investors. They think that the retracement to point C is only valid when the price touches down to this level, they are wrong.
Fibonacci retracements are a great tool, but there is no 100% accuracy. Sometimes the price closes near the retracement level and it can still be a valid move.
In a downtrend, there was a correction up. The price looked as if it would move up to the 50% retracement level, but that did not happen.
The result was that both candles closed below the 38% level. Still, it is a valid correction to point C, and then the price moved back to a downtrend.
Try to pay attention to this.
On numerous occasions the price will almost touch your retracement level, which is great. However, be aware that sometimes the price only draws near that level, and still trading is worth continuing.
What retracement levels should I use?
It is very confusing at the beginning, because there are many Fibonacci retracement levels and some people use only specific ones, while others like to draw all the retracements.
My advice is to try to use the standard levels. Over time, when you gain more experience, you will decide which are the most important ones and which ones you prefer to use.
So, which levels should you start with?
Why use the 50%?
It is not a Fibonacci retracement, but still an important level (half way up or down), so traders like to keep this retracement level together with other proper levels. Stick to these levels and it should be enough to trade well when it comes to price correction.
I have my retracement lines, when should I open a trade?
Now you know how to draw the retracement lines. Thanks to them you can now enter a trade with confidence, which is always a good thing. After drawing the retracement levels, you should decide when you want to open your position.
We have confirmed that the main trend is strong and is up. After a swing move from A to B, there was a strong correction, so we have drawn the retracement levels. We are waiting to take a long position, because the main trend is up.
If you are new to the foreign exchange market consider checking out this article to help you get started.
Now we have three options of doing this.
You are willing to take bigger risk in turn for a possible bigger return. When the price (almost) reaches the 61.8% retracement, you go long at this level or a little bit above it. This level is very popular among traders, so, very often, at least for a moment, the price stops here and bounces back.
You can take the same action at 50% or 38.2% if you think that the correction ends and there is your point C. Remember, this may not be a bounce to new highs.
You do not have the knowledge about it at the time of trading. Having seen the right side of the chart and you know that in that case the correction ended on the 61.8% level.
In real life, when you choose this option, you never know if the correction really ended at point C or it was just a false move. But if you are right, your possible profit can be very big.
The second option is when you wait and watch how the price reacts towards the retracement levels. If you see that 61.8% is probably the retracement which a bounce back may occur from, you are ready to take a long position.
But unlike the first case, you wait for another confirmation. It could be many things, such as a confirmation from an oscillator or moving averages – simply something that is written in your trading plan.
When there is a confirmation signal, you go long. Of course, confirmation signals are not always 100% correct, but in that case you have lower chance of failure. This, in my opinion, is a better way to enter trades.
The ratio between risk and possible profit is very good. In this example, the trader decided that the signal will be a close of price above resistance.
As I have mentioned, you have to decide and test yourself what signal works best for you.
In the third case you wait until the price breaks above the recent high (the one you have used to draw your retracement levels – point B). There is a good chance that the move will continue. This way of trading is the safest one, but your possible profit is the smallest.
Personally, I trade according to the third scenario very often. The reason for this is simple – there may be a big mess near retracement level and I cannot get a confirmation signal. I simply wait for the break above point B and go long at this point.
Which way is the best for you? It is your decision. It depends greatly on your trading skills and mental strength. How much risk are you willing to take?
Do you have good and working confirmation signals? You should try all the three ways and decide which one you like the most and can make most money with.
You do not buy blindly at the top anymore. Now you have the knowledge and you wait for the correction to buy for a better (lower) price. Of course, your aim is not to catch the bottom, because it is very hard to do, but if you buy after the correction ends, you are ahead of many others investors.
The Fibonacci retracements are great when it comes to placing stop losses. Let’s assume that you have a long position opened after a correction to point C. Where should you place the stop loss order?
I like to put it below point A, that is, below the place where the swing move started. If the price moves back down below point A, there is probably something wrong with the trend strength.
Below, I marked 3 possible places where you can place your stop loss order in such a case:
It all depends on how aggressive you want to trade. Sometimes I place stop loss just below the 78% retracement line. If you want to place a tide stop loss, you place it below the retracement that you think is your point C.
The good thing is that, over time, you will understand the behavior of the price better and you will be able to place the stop losses in better places.
Here you can find other profitable strategies to trade the currency and indices markets. Find one that best suits you and you can even use them together with this fibonacci sequence strategy for coonfluence.
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Written By: Allen Matshalaga
Allen is a professional forex trader, blogger, and online enthusiast who spends most of his time testing and reviewing legit ways of making money online and is determined to help others succeed.