Fibonacci Trading

We will be utilizing Fibonacci ratios a lot when it comes to trading, so before you decide that it might be something you want to ignore – you might want to get used to it, like your grandmother’s cooking or your significant other snoring.

            Fibonacci is a very popular concept both inside and outside of trading, and there are all sorts of studies revolving around it, but to get started – we will talk about two basic concepts: retracement and extension.

            For the record, Leonardo Fibonacci is not a popular opera singer or a Renaissance painter.  He was actually one of the most famous Italian mathematicians of all time, and his works are still praised and studied to this day.

            One day, he had a breakthrough, where he figured out that a simple series of numbers had a specific ratio that could describe some very interesting natural proportions and phenomena in the universe.  It isn’t every day that someone figures something like this out, which is why this concept is still used centurites later.

            The ratio comes from the following numbers: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144

            You see, the numbers start with 0, and is followed by 1, as you see, clearly. Then, adding 0+1, gets you the third number, which is 2.  Adding the second and third number, gets you 3.  As you can clearly see, after you add 3+2, you get the next number in the sequence, which is 5.

            After the first group of numbers in the sequence, you find an interesting ratio: from the number to the succeeding higher number – the ratio is very specific, and is .618.  For those who are still unclear, take 34 and 55.  34/55 = .618.  See?  Now, if you utilize the alternate number sequence, you actually get .382.  For those who don’t understand, take 34 (skip 55), and 89.  Here, 34 divided by 89 equals…you guessed it: .382!  Hopefully, you get it now.

            These ratios are called the “golden mean”, and though we are not delving head first into all of the mathematics involved, this certainly is enough of an explanation to get you started on trading using these concepts.  Here is what you absolutely have to know:

Fibonacci Retracement Levels:

.236, .382, .5, .618, .764

Fibonacci Extension Levels:

0, .382, .618, 1.00, 1.382, 1.618

Now, before you start to worry, you don’t have to think back to math class, or have to remember all the calculus that you never really understood in high school or college.  Your charting software will help, and luckily, guess what exists?  Fibonacci calculators

Of course, regardless of whatever tools are at your disposal, knowing this stuff never hurts.  Plus, you can impress your next date with your Fibonacci knowledge.

Fibonacci Used For Support/Resistance

            Now, you probably already guessed it: the Fibonacci sequence is used to chart potential support and resistance levels.  The beauty of the Fibonacci sequence is that since so many traders know about it, and watch the same levels, these can often be EXTREMELY effective when it comes to trading, on a psychological level.

            You see, when a certain level is hit, Fibonacci-wise, traders might start taking profit.  As you can imagine, if you are not thinking about the Fibonacci sequence, this might be surprising to you – but not to someone who is keeping this in mind.  In a way, as with other trading techniques, the Fibonacci sequence becomes a bit of a self-fulfilling prophecy.

            It should be noted that almost all charting software has some tool for Fibonacci, because it is such a popular concept.

            Swing High and Swing Low points are essential when it comes to trading using Fibonacci.  A “Swing High” is a candlestick with at least two higher highs, on both the left and right of the candlestick.  Similarly, a “Swing Low” requires two higher lows on the left and right of the Swing Low candlestick, respectively.

Entering a Trade Using Fibonacci Retracement

            At the end of the day, no matter what tool that you are using, it’s important to remember that sometimes it’s best to use the tool for the way the market is trending.  For example, it doesn’t matter what kind of amazing tool that you have for a bullish idea, if you are utilizing it in a bear market – it really could backfire, but it might be able to net you a healthy profit in a bull market, since the bull market is “trending”.  Similarly, you want to go with the market on Fibonacci trades.  Here’s what we mean.

Finding Levels

            To find Fibonacci retracement levels, you have to look for the recent Swing Highs and Swing Lows.  For downtrends, you want to click on the “Swing High”, and drag the cursor down to the closest Swing Low.

            For uptrends – guess what you do?  Yep, the opposite.  Click on the Swing Low and drag the cursor to the latest Swing High.  Simple, right?  Good.  Let’s explore this concept deeper…

Uptrend

This is a daily chart of AUD/USD.

Daily chart of AUD/USD with Fibonacci retracement levels.

Here, we plot the Fibonacci retracement levels.  How?  We find the Swing Low at .6955 on April 20, and then drag the cursor to the Swing High at .8264. 

And guess what?  That’s literally all we have to do!  You have to love technology: the charting software will do all the rest for you.

Here, you can see all of the retracement levels.  The chart clearly spells it out, and labels them at .7955, .7609, .7454, and .7263.  You will also notice that these belong to these Fibonacci percentages respectively: 23.6%, 38.2%, 50%, 61.8%, and 76.4%.

Shall we do the same with Swing High?

Fibonacci Retracement: 38.2% Fib level held as support.

Here, we see that the price pulled back through to the 23.6% support level, and then continued to actually keep going down for the next couple of weeks.  For a long position, this obviously isn’t good or inspiring by any means.

However, we notice that when it comes to the 38.2% level, support was tested, but it was unable to close below this key level.

We even see that later on, the market continued its upward trend and actually broke through and swung upwards!  Wow, this is great news…we see that buying at the key support at the 38.2% Fibonacci level was a great strategy!

Downtrend

Okay, so how do we use the Fibonacci sequence to our advantage during a downtrend?  Remember that when it comes to forex, you can make money both ways – long and short.  Let’s take a look at the 4-hour EUR/USD chart.

4-hour chart of EUR/USD with Fibonacci retracement levels.

Here, we see that the Swing High was at 1.4195 on January 25, with our swing low being placed at 1.3854 about a week after, on February 1. 

The retracement levels here can be found at 1.3933 (23.6%), 1.3983 (38.2%), 1.4023 (50.0%), 1.4064 (61.8%) and 1.4114 (76.4%).


Now, we know that a downtrend means that we should expect that the price retraces from this low, and might see resistance at key Fibonacci levels, because traders might be ready with sell orders at these key areas.

Okay, so what happened?  Let’s find out.

Fibonacci retracement: 50% Fib level was resistance.

So we see that the market clearly tried to rally, and stalled around the 38.2% level of resistance, but ultimately tested the 50% level!

If you had kept orders at these levels – meaning, either the 38.2% or 50% levels, you clearly could have profited a certain amount of pips on this trade.  Not bad!

Basically, in these two examples – the price found both support and resistance at key Fibonacci levels.  This isn’t surprising, because like we said before, many traders use these levels.

Now, remember that these rules are never set in stone!  They are zones of interest, but the market DOES WHAT IT WANTS!  We know that anything can happen when it comes to the forex market, and even Fibonacci levels can be wrong.

Of course, if everything was that simple, everybody would buy at the same levels, and sell at the same levels, and then there wouldn’t really be the liquidity needed for a market!

Let’s see how Fibonacci sequences aren’t exactly perfect.

When Fibonacci Fails

You should know that support and resistance breaks, from time to time.  This certainly applies to Fibonacci levels, as well!  Let’s look at some examples to help you see this visually.

Here is a 4-hour chart of GBP/USD.

Here, the currency pair is in a very obvious downtrend.  You might think, okay, well, I can look at a key Fibonacci retracement level to enter for a great trade, and make some money!  Right?  So, you use the Swing High here at 1.5383, with a swing low right there at 1.4799. 

You also take a look, and notice that there is heavy resistance over here at the 50% level. 

You know exactly what to do!  Since it’ s having trouble at the 50% level – it’s time to short this baby!  Yes!  You are feeling great about how smart you are.  What could go wrong, right?

Man, this is the move, right here.  This is too easy!  You start daydreaming about how you are going to Vegas with all of your friends based off how genius of a trader you are, and consider your next foreign car, and how that new car will attract a whole new level of women in your life.  You can’t wait!  You can finally get married and get your mom off your back! 

You look back at the market.  The resistance at 50% is holding, and all is well in the world.

Okay, so let’s say you put in an order at the level, and you decide to celebrate by eating a nice steak at the house.  You might as well get used to the taste, right?  Instead of microwave dinners, you’ll be doing a lot more steak and lobster very, very soon.  You take a nice nap, happy and full.

Imagine if you had actually put in an order at this level, and this had all happned as described.  Well, Mr. Genius, you would have certainly been in for a surprise when you woke up.

Let’s see what exactly happened.

Yep, your worst nightmare: The Fibonacci retracement levels definitely failed, and the price broke the other way, on to new highs!

The market actually determined that the Swing Low was the bottom of the downtrend, and not the time to short.  In fact, the market brought it past the Swing High!  Ouch!

Now, what did we learn, besides the fact that you should be more realistic about the market?

Fibonacci retracement levels are a great tool – but like any technical tool, they don’t work all the time.  In fact, imagine if there was a technical tool that worked 100% of the time.  Everyone would use it, and everyone would be on a yacht.  Reality check: is everyone on a yacht?

No.

The market does what it wants.  Yes, sometimes you might find the perfect trade that follows these levels, and boy, are they great.  You will feel great, too!  You should always recognize, however, that these levels can be BROKEN, just like support and resistance can be broken.  It might hit the 50%...It might hit the 61.8% level…but nothing is for sure.

You might not be using the right Swing Low and Swing High, and the market might not resume its trend.  Yes, this means that the uptrend might not continue after facing resistance, and the downtrend might not continue after testing support. 

Ultimately, these tools can HELP, but they are not 100% correct,  and this is important to keep in mind.

Now, this doesn’t mean that you can’t HONE your skills to be as strong as possible!  Let’s keep doing that, shall we?

Using Fibonacci Retracement With Support/Resistance

As mentioned, Fibonacci levels and its use can be very subjective, but there are ways that you can make your trade more informed, believe it or not.

It goes back to the idea that you should use all of the tools at your disposal, to make the most informed decision possible.

You know how there is a star athlete who helps lead a team to a championship?  No matter how incredible that player is, what his statistics or legacy is; winning that championship still requires an entire team, correct?  Similarly, you can’t just use the Fibonacci retracement level – but you have to use all of the tools that you can to make the best possible trade.

Fibonacci Retracement / Support and Resistance

Now, this is a simple way to make your Fibonacci retracement trade even better.  Remember how we established clear support and resistance zones?  Why not use that additional knowledge to make a better trade, shall we?   Keep in mind that so many traders are watching these levels, so this is definitely worth considering.

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