Forex traders noticed a correlation between the Fibonacci ratio and prices in forex market. The result of this was the development and use of Fibonacci as a technical indicator.
Of the technical indicators in Forex trading, Fibonacci is one of the most important.
Despite it's importance as a technical indicator, it didn't begin life that way. Its origins date back to the early 13th century and an Italian mathematician called Leonardo Fibonacci who loved looking at number patterns. He created a series that looks like this:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144
Where he noticed that every number is the sum of the previous two numbers.
Of more importance to the world of maths and science was that each number had a ratio to the one before or after it that was nearly constant after the initial terms of the sequence. It became known as the Golden Mean. Interestingly he discovered that the ratio was similar to that which creates order in the natural world and perfect proportion in art and architecture; the Golden Ratio.
Fast-forwarding to today, Forex traders noticed a correlation between the Fibonacci ratio and the peaks and throughs of the Forex market and began to investigate further. The result of this was the development and use of Fibonacci as a technical indicator to predict turns in the market.
Analysts have spent years, and continue to do so, analyzing different aspects and combinations of Fibonacci. The two most important tools that have been developed are the Fibonacci Extension and the Fibonacci Retracement.
For each of these, the mathematicians have isolated a set of ratios, based on the Fibonacci ratios that show where a market is likely to peak or bottom out and where it will go to next. They have been defined as follows:
- Fibonacci Retracement Levels: 0.236, 0.382, 0.500, 0.618, 0.764
- Fibonacci Extension Levels: 0, 0.382, 0.618, 1.000, 1.382, 1.618
These levels, which are calculated as ratios to the starting price – a little like stop loss or take profit points, are used by traders as support and resistance levels and whether or not Fibonacci works in theory, it does in practice because so many traders use the levels to buy and sell or to place take profit or stop loss levels that the indicators become self-fulfilling.
Fibonacci Retracements
It's one of the laws of trading that almost always holds true; currencies or other instruments will always pull back a certain amount of their gain/loss before carrying on in the original direction. Linking Fibonacci to this, you'll find that most often these 'retracements' as they are called, happen at the 38.2%, 50%, and 61.8% points. The purists will note that Fibonacci doesn't mention 50%; this is usually added because a lot of retracements begin at 50%.
If it were this easy, everyone would be making money. Instead, it's only probable that one of these points will be the place where the retracement turns but how will you know which?
The trick is to use candlesticks to show you the turn or potential strength of turn and then act on what the combined advice offers.
Fibonacci Extensions
Here, you're looking for the breakout from a pattern but also as to how far you can hold on without the tide turning.
The way to do this is to plot the first swing high or low, then the following low or high, then the most recent swing. Finding these can sometimes be tricky, rewarding a little watching and waiting to clearly identify the swings.
Using charting technology that comes with most platforms, adding Fibonacci will show you the potential extensions and when they may turn.
As with all trading signals and systems, you are likely to come unstuck relying simply on one. So, use our old favorite, the candlesticks, to see whether Fibonacci is telling the truth.
The benefit of using this system is that it tends to maximize profits and can be used in auto-trader too.
Article by Razi Hammouda from fxlords[dot]com
Razi's professional experience was gained over the course of more than a decade working with leading Forex market makers in the Middle East, Asia and Europe where he learned about trading, financial instruments and global markets. Being exposed to the wide range of skills he acquired along the years, he continued to develop his trading strategies and further improving his track record in Forex trading. He used innovative business development strategies to find FXLORDS, helping it to rapidly become a major provider of education and trading tools to the successful trader.
He is an enthusiastic individual, motivated by challenge and renowned for pushing the limits, always looking to gain some more experience and help as much as possible along the way.