One of the first tools taught everywhere to unsuspecting traders as they begin their journeys.
But what is it?
And just how useful is it, really?
Let’s find out.
Leonardo Fibonacci was an Italian mathematician who lived, did his thing, and died in medieval times.
One of his coolest contributions was the Fibonacci sequence.
In this sequence, each number is the sum of the previous two numbers (with the exception of the first two numbers: 0, and 1).
Fibonacci sequence: 0, 1, 1, 2, 3, 5, 8, 13, 21, ….
Notice the second 1 is 0 + 1, while 2 = 1 + 1, and 3 = 2 + 1, and so on…
Why is this sequence important?
Turns out this sequence explains many phenomena in nature.
an example, according to historians, this sequence of numbers determines how a population
of rabbits grows.
Even though the sequence packs a bunch of interesting properties, such as that of the golden ratio (we’ll probably touch on that in another page), we will focus on the property used for the Fibonacci retracement.
As you will, if you divide any number in the sequence by the next bigger one, you will get approximately 0.618 or 61.8%.
If you divide any number in the sequence by the second next bigger one, you get approximately 0.382 or 38.2%.
For the third next bigger number in the sequence, the division gets you 0.236 or 23.6%.
Ok, so what?
Well, some freak decided to use this cool-ass ratios in finance.
Does this look familiar?
Fibonacci ratios have many applications.
When you expect a move to retrace -in other words, for a trend in price action to reverse- you can use these ratios ahead of time to get a better idea of where you can expect price to fall (or climb back) to.
You’ll get a clearer picture down below, so read on.
With time, the use of Fibonacci ratios in trading became ubiquitous, which means a good proportion of traders out there started using this tool.
Why is that important?
Because when a good chunk of traders pay attention to the price zones given by the Fibonacci retracement, then those price zones suddenly become much more likely to affect price action -because many orders are placed in those zones.
I still don’t get it…
Ok, have you heard of a self-realizing prophecy?
As in, everyone tells you you’re good at something you didn’t know before.
You start acting like you are good at it, and engage in that activity more often.
Eventually you do become good at it…
It’s the same here.
Since many people placed orders to buy on a support zone signaled by a Fibonacci retracement, then price is much more likely to stall or rebound from that level if it falls to it.
All because a majority (or a good portion) of the market is paying attention to these levels, and acting on them.
Great. But how do we use them?
Can I just jump into a chart and draw a random retracement?
The Fibonacci retracement connects two points in your chart (two candlesticks) and calculates the retracement levels based on the vertical distance between those two points.
In order to do this, you have to choose those two points wisely.
Since you’re expecting to see a retracement, you should pick the lowest low as one extreme, and the highest high for the other extreme.
These are called swing low and swing high respectively.
This is important!
Later we will describe what swing trading is, and you will need to know how to identify swing lows and swing highs.
Either way, to use the Fibonacci retracement tool well, you will need to identify the recent swing low and swing high, and use them to get the Fibonacci levels.
Let’s head into an example in the following section.
So we now know what a Fibonacci retracement is: a forex technical analysis tool which allows us to see potential support or resistance zones for a retracement of price action.
Phew…. What a mouthful.
And you know you have to use swing lows and swing highs.
Well, a swing low is a bearish candlestick for which the previous two candles are higher, and the following two candles are also higher.
It is pretty easy to spot once you’re looking at a chart, so don’t sweat it.
For a swing high… well… it is the reverse!
The highest point in recent price action (a bullish candle where the previous two candlesticks, and the following two candlesticks are lower).
A picture says more than a thousand words:
There was a higher high later in the chart, but let’s assume you wanted to long GBP/USD before that point appeared, and you were waiting for a retracement.
A good moment to enter could have been on the 61.8% retracement zone you can see on the chart (second yellow line from bottom to top).
Ok, so now that we have them what do we do?
Let’s remember that any technical tool, Fibonacci retracement included, should be used within the context of your overall strategy.
And this overall strategy must absolutely be dictated by fundamentals.
Even if you’re scalping, you need to know what’s happening (or not happening) fundamentally with the currency pair you plan to trade before you start doing your thing.
With that out of the way, let’s assume your fundamental analysis tells you the Euro will gain against the American Dollar.
But you want to enter the trade at a good price, and you believe price will retrace in the short-term due to a momentary break for the USD.
If so, you need to check the latest swing high and swing low.
Start at the swing low and take the tool towards the swing high (I use MT4, this might be slightly different in another platform, but the concept is the same).
You got your levels.
If price retraces, good levels to buy EUR/USD might be close to the 38.2%, 50%, or even the 61.8% level (quite a deep retracement, make sure the fundamentals for the long trade have not changed).
Also, to make this more potent, make sure those retracement levels are close to support/resistance zones price action has printed.
If those levels match, congratulations, you likely have some solid levels to buy off-of.
This depends on your strategy.
As I mentioned, using the Fibonacci retracement tool as part of a well-thought out strategy (which takes fundamentals very seriously) is incredibly useful.
And a great example of an application would be swing trading.
But you can use them in many other ways such as scalping, or even day trading the market sentiment.
This was a long piece.
However, I think it was very useful.
Wishing you the best,
The Forex Economist
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