Fibonacci is an extremely interesting concept, not just in trading but in the natural world.
There are specific numbers that we see in nature all the time. Together we call them the Fibonacci sequence and they look like this:
As you may have noticed, the sequence is very simple. The previous two numbers in the sequence add up to equal the next one.
1 + 1 = 2
1 + 2 = 3
2 + 3 = 5, and so on.
Now here is the interesting part. When we divide almost any of the Fibonacci numbers by the one that comes before it in the sequence (excluding the first few entries to the sequence), you get the same number every time – 1.618.
For example, 144/89=1.618, or 55/34=1.618
This number is now commonly referred to as the golden ratio and it can be found everywhere across the natural world.
We can see it in how pine cones are arranged, the angle at which flower petals are places with one another, seashells, hurricane formations, human faces, DNA molecules, and even the way our galaxies are formed. Pretty amazing right?
Okay, so what does all this have to do with forex trading I hear you say? Well, it turns out that these numbers also give us significant price levels when it comes to trading.
Using charting software, we can plot a Fibonacci tool onto our graph which will display Fibonacci retracement and Fibonacci extension levels that we can use to enter our long/short position. These give us great entry and exit points, so it is definitely worth taking the time to master these tools.
Let’s start with the most common tool, the Fibonacci retracement.
When we divide a number by the next one along in the sequence, we get a number that is pretty close to 0.618. When we divide number by the number two along in the sequence we get 0.382; three along, we get 0.236.
Also, when we divide one by two which is located right at the start of the Fibonacci sequence we get 0.5.
Okay, now we have these key Fibonacci numbers, we can turn them into percentages.
So how can we apply this to our trading? Take your Fibonacci tool in your chart software and draw a line from the bottom of the price move you are looking at to the top. This is called the swing low and the swing high.
After you have done that, you can pull down a graphic that will display the key Fibonacci levels that the price may retrace to.
These levels are said to act as hidden support and resistance levels in the market and we can place our entry, exit and stop losses around these points.
We can draw Fibonacci extensions in the opposite way. Take your Fibonacci tool and draw a line from the swing high to the swing low and then extend the graphic to see the key Fibonacci extension levels.
Similar to the retracement levels, the key Fibonacci extension levels are: 38.2%, 50.0%, 61.8%, as well as the 100%, 138.2% and 161.8% extensions.
These levels will initially act as resistance levels for the price to break back through again. Once the price has broken through, they will act as support.
Note: Fibonacci levels should be used as a tool to accompany your other trading strategies and should not be used alone. If you see that Fibonacci support or resistance coincides with another indicator, such as a moving average or RSI divergence, then this may suggest a good position to open a trade.