In the uncertain world of forex trading, many investors rely on a wide variety of prediction techniques to help guide their decisions; these include everything from monitoring current events, reviewing past market movements and assessing the overall sentiment among their trading peers.
One popular way of examining the market is through Fibonacci retracements, a subset of technical analysis which incorporates mathematical ratios in an attempt to gauge where the price of their chosen instrument is likely to go next.
As a forex newcomer, adding elaborate equations into the mix may sound daunting at first, but underlying principles are actually fairly simple — so let’s start from the beginning:
What is a Fibonacci Sequence?
Named after the 13th Century Italian mathematician who popularised the ancient concept in the Western world, Leonardo Fibonacci, the Fibonacci sequence is a list of numbers whereby each number is the sum of the two preceding numbers, from zero right up to infinity:
While this is interesting in itself, what’s really significant is that by diving each number in the sequence by the following number — once you move past the early, single-digit entries in the list — you always end up with approximately 0.618. For example:
What’s more, dividing a number in the sequence by the number two spots ahead always results in around 0.382:
Moreover, dividing by the number three places ahead results in roughly 0.236:
These mathematical constants are known as ‘Fibonacci ratios’, and when divided by each other will give you another Fibonacci ratio — either 0.618 or 0.382:
Finally — and perhaps most importantly — dividing a number in the sequence by the previous number will always typically give you approximately 1.618:
This crucial figure, 1.618, is termed the ‘golden ratio’ and is also known as ‘the golden mean’ or the Greek symbol φ (‘phi’).
The golden ratio isn’t simply a mathematical curiosity for academics and science enthusiasts, however; the principle is routinely applied in architecture and works of art as a geometric form. Remarkably, it’s such an integral precept that it also frequently appears in nature — one such example is in the biological field of phyllotaxis, which measures the number and arrangement of petals, branches and seeds on flowering plants!
How Do Fibonacci Retracement and Extension Levels Work?
Fibonacci numbers can be used to highlight potential pivot points on forex charts — i.e. price levels at which the direction of travel will change.
As a general rule, these Fibonacci ratios can be split into two camps, known as ‘retracement’ and ‘extension’ levels:
· Retracement is most often associated with 0.236, 0.382, 0.618 and 0.764
· Extension is most often associated with 0, 0.382, 0.618, 1.000, 1.382, 1.618
The former idea operates under the premise that once the price shifts dramatically in one direction, it will usually hit some form of resistance and partially self-correct (swinging back towards its earlier price) — the ‘retracement’ phase — before pressing on with the general trend.
Thus, traders use Fibonacci retracement levels as a tool to try and predict support and resistance boundaries, while at the same time using the same indication process with the ‘extension’ levels to place their take profit points and decide when would be best to exit the market.
In fact, these guides are used so often that both have a tendency to become self-fulfilling prophecies. This is because investors are all working with the same data and come to similar conclusions so they are likely to buy or sell at the same critical points, thereby causing abrupt shifts in supply and demand across the markets.
Further reading: https://vantagepointtrading.com/use-fibonacci-extension-tool-find-targets-reversal-points/
How Do You Set Fibonacci Retracement Levels Effectively?
Most modern forex software packages include simple Fibonacci plug-ins to help you through the complex part, which allow you to simply click and drag over the candlestick chart to find your key ratio points (and, hopefully, your support and resistance levels).
Nevertheless, to make the most of the Fibonacci tool, you’ll first need to identify what’s known as your ‘swing high’ and ‘swing low’ points — the beginning and end points of the current directional trend.
This will allow you to place the Fibonacci calculator overlay at the most effective place on the chart for optimum accuracy:
· Swing high points are your upper boundary candlestick for this particular analysis, identifiable by at least two lower highs placed either side of it (i.e. peaking on the third of a five-candlestick movement).
· Swing low points are lower boundary and are effectively the exact opposite, identifiable by at least two higher lowers to both the left and right of it (i.e. being the lowest point being the third in a five-candlestick movement, the bottom of a ‘V’ shape).
Fibonacci ratios can serve as a valuable guide or rule of thumb when planning your swing trading movements — though it goes without saying that these are only rough suggestions and speculators should by no means base their decisions on them! If it were that easy, everyone would be a successful forex trader.
Nevertheless, Fibonacci principles play a valuable part of any discerning investor’s arsenal and, when used in conjunction with other types of analysis, can be a helpful predictive tool when the market’s direction looks otherwise unclear.
Further reading: https://www.investopedia.com/articles/active-trading/091615/how-set-fibonacci-retracement-levels.asp
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