When price moves in a financial market from Point A to Point B, it rarely moves in a straight line. Generally, price will move in waves. One of the primary aims of technical traders is to identify how far these waves will retrace, and one of the most popular tools to do this is the Fibonnaci Sequence. In this article, we are going to discuss the basic mathematical notion behind Fibonacci theory, and we are going to discuss a basic Fib Strategy that works.
The Fibonacci sequence is a naturally occurring sequence in nature that can be observed in various physical phenomena, and in financial markets, price tends to retrace according to these ratios. For example, if price moves from Point A to Point B, then it will generally retrace to Point C between Point A and Point B.
The picture above depicts a move from Point A to Point B. Now, as price begins to retrace back against Point A, it will most likely move to a Fibonacci Ratio. The most common retracements are the 38%, 50%, 62%, and 79%. The truth is that massive amounts of forex account traders use Fibonacci Sequence when applying technical analysis to price charts, and that is one of the primary reasons that Fib levels tend to offer strong support and resistance on a consistent basis. Let’s look at some real examples.
In the picture above, you can see that after price moved from the LO to the HI, price retraced to the 38% at Circle 1, then to the 50% retracement at Circle 2, and to the 62% retracement at Circle 4. At each of these Circles, price moved favorably back to the upside and offered a profitable trade.
Most traders use Fibs in confluence with other technical tools. For example, traders will perhaps use a few key moving averages, candlestick analysis, stochastics, etc, and then use Fibs as an overall tool to identify high probability market reversal areas.
One of the most basic ways to use Fibonacci is to first use a trend identification indicator. Here are the steps to follow in this strategy:
- Identify a currency pair that has a clear trend.
- Wait until price begins to move against the trend.
- Then, draw Fibs from the last swing HI swing LO.
- As price retraces against the overall trend and comes into a Fib level, see if there are any other technical tools that confirm an entry.
- If a Fib level lines up with some other technical indicators, then enter the trade in the direction of the overall trend, in expectation that the overall trend bias will pick back up.
This is a very basic Fib Strategy that when used with other technical tools will offer strong probabilities of winning trades.
Interestingly enough, certain Fib Ratios tend to work better with specific currency pairs in the forex market. The GBP/USD tends to respect the 50%. The EUR/USD tends to respect the 38%. A more advanced method of using Fibs is to consider the backside of them. For example, when price retraces to the 38% Fib level, price should find support. However, if it breaks below the 38% retracement and continues to retrace deeper, then the 38% retracement will now become overhead resistance when price begins to move back up.
Fibs are an incredible tool for identify high probability market reversals, but always keep in mind that this, and any other, trading theory is purely hypothetical. Past performance can never guarantee future results and extensive training and knowledge should always be obtained before trying it out.