The Fibonacci sequence of numbers is named after Leonardo Pisano, an Italian mathematician who was nicknamed Fibonacci. In this sequence, every number is the sum of the two numbers before it. Therefore, the sequence goes like this: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610 and so on to the infinity. It makes every number 1.618 times greater than the preceding number approximately. This value 1.618 is known as the Golden Ratio or Phi. It appears in the natural world as well as biology, architecture and fine art mysteriously.
The use of Fibonacci levels in financial markets
When it comes to trading, the numbers that are used in Fibonacci retracements are not the ones from the Fibonacci sequence. Instead, it is inspired by the mathematical relationship among the numbers. The Fibonacci ratio of 61.8% is derived by dividing a number by the next number in the series. Fibonacci retracement levels are represented by taking low and high points on a chart. The key Fibonacci ratios of 23.6%, 38.2% and 61.8% are marked horizontally for producing a grid. Possible price reversal points are identified by using these horizontal lines. Fibonacci levels are calculated by traders after there is a large move in the market. The key levels of support and resistance are identified by Fibonacci retracements.
The mathematical relationships among Fibonacci numbers you need to know for trading
The base of Fibonacci numbers trading is formed by the interesting relationships among the numbers. You do not know all of them unless you are interested in pursuing high-level mathematics.
However, to learn about the Forex Fibonacci trading strategy, you need to know these important ones:
- If a number is divided by the number before it, then it will be 1.618 approximately. This is the key level that you will need to use in Fibonacci extensions.
- If a number in the sequence is divided by the next highest number, then it will be 0.618 approximately. This number plays an important role in forming the basis of the 61.8% Fibonacci retracement level.
- If a number is divided by another number that is higher by two places, then it will be 0.382 approximately. The 38.2% Fibonacci retracement level is formed by this number.
Fibonacci retracement in trading strategy
Traders use Fibonacci retracements often in trend-trading strategy. When a retracement takes place in a trend, it is observed by traders. Then traders use Fibonacci levels to make low-risk entries towards the initial trend.
Forex strategies using Fibonacci levels
Each trader chooses a unique strategy suitable for him. When you are investing your money in trading, it is important to consider if the strategies fit your angle towards the market.
Forex strategies that use Fibonacci levels include:
- If you place a stop-loss order just below the 50% level, then it is possible to buy near the 38.2% retracement level.
- By placing the stop-loss order just below the 61.8% level, the trader can by near the 50% level.
- You can use the profit-taking targets when you enter a sell position near the top of a large move in the market.
- If you notice the market retracing close to a Fibonacci level and then resuming the prior move, then the higher levels of 161.8% and 261.8% can be used to identify the probable future support and resistance levels when the market moves high or low.
Fibonacci trading strategies
Three simple Fibonacci strategies used in Forex trading are:
In this strategy, the trader needs to identify security within a strong trend. It can be defined as a stock with successive highs and pullbacks lesser than 50%. This setup is ideal for day trading. It can be identified on a 5-minute chart. You need to wait for the market to open and you can identify it about half an hour later. After a strong uptrend is identified, observe the behaviour of the stock around the 38.2% and 50% retracement levels. The right time to enter the trade is when the trading activity slows down or turns. As a target point for exiting the trade, the trader can use a Fibonacci extension level, as well as the most recent high.
Although breakout trades have high chances of failure in trading, you can do a few things so it works out. The first thing you must do is clearing a Fibonacci extension level. It is important to find a stock that clears this extension level with volume. However, buying the breakout only is not enough. You also need to make sure that the stock does not retrace more than 38.2% of the swing before it when it approaches the breakout level. This will increase the chances of the stocks going higher.
Trading with indicators
You can also use Fibonacci levels with the indicator you want. However, it is important to be cautious so you do not have to deal with a spaghetti chart.
These are the ways you can use them:
- Fibonacci retracement with MACD
In this strategy, the traders attempt to match the moments when the Fibonacci levels interact with the price and MACD crosses for identifying an entry point. The stock is needed to be held until a crossover from the MACD from the opposite direction is received.
- Fibonacci retracement with Stochastic Oscillator and Bill Williams Alligator
In this system, traders try to match bounces off the price with overbought or oversold signals of the stochastic. Traders open their positions when they get both signals. If the price is trending in their favour and the lines of the alligator are far from each other, then they stay in the market. On the contrary, when the alligator lines overlap, it is the perfect time to exit the position.
Fibonacci retracement levels indicate reversal points with utmost accuracy most of the times. However, it is best to use these levels as a tool within a broader strategy because only using it in trading can be difficult. Combined with indicators, Fibonacci retracement offers trade entries with a high potential reward at low risks.