Leonardo Pisano Borgollo was an Italian mathematician that presented the Fibonacci sequence to the west in the thirteenth century. This series of numbers has unique properties that can be found in nature, architecture, and biology, especially famous in rabbit population growth.
The properties of the Fibonacci sequence are also found in the financial world. For example, traders often use the Fibonacci sequence to find probable turning points.
The Fibonacci series is a numerical series in which each number is the sum of the two previous numbers of the sequence. The most beautiful and important thing about Fibonacci's sequence is the Golden ratio. If we divide any number by the previous number through the whole series, the result will be 1.618. The magic in that is the wide range of fields in which this number appears, especially in nature. The Fibonacci series goes like 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610… to infinity.
What does the Fibonacci series represent in trading?
In trading, the Fibonacci sequence is used to define retracement levels. These are called Fibonacci retracements. This is a tool that technical traders use to predict how big the retracement of the pip level will be before it continues its previous trend.
Although, it is not the entire nature of the Fibonacci sequence that is used. What is really used are the proportions between any given number and those close to it. Traders have found that they can set levels to which they expect the price to bounce using these proportions.
The ratios between the numbers of the Fibonacci sequence applied in trading are represented by percentages. The most common ones are 23.6%, 38.2%, 50%, and 61.8%.
The 23.6% ratio is derived from the division of a series and another number three position after it. For example,
144 ÷ 610 = 0.23605
The proportion of 38.2% is given by dividing the Fibonacci sequence by a number two positions after the first number. For example,
233 ÷ 610=0.3819
The percentage of 61.8 comes directly from the golden ratio. It is the proportional difference between two consecutive numbers. For example,
377 ÷ 610= 0.618
The 50% and 100% are not really found on the Fibonacci sequence except at the beginning of the series. Still, most traders include those 2 values that have proved to appear repeatedly on retracement behaviour.
How to use Fibonacci retracement in trading?
After a strong trend, it doesn't matter if it is an uptrend or a downtrend. Traders expect the price to retrace until they reach one of the common proportions. They measure the size of the trend and then set horizontal levels at 23.6%, 38.2%, 50%, 61.8%, and 100%. So the theory says that when a trend presents a retracement, the price will reverse to any of those levels to find a turning point and continue the initial trend.
If the initial trend was an uptrend that is now reversing, Fibonacci retracement theory dictates that traders should expect a reversal downwards of 23.6%, 38.2%, 50%, 61.8%, or 100% the size of the initial trend before the price goes up again.
If the initial trend is a downtrend, then traders should expect a retracement until the price finds another turning point at any of the levels at the given ratios.
In the image above, you can see how the EUR/USD price was on a downtrend by the end of June. At the beginning of July, a reversal of the trend lasted a few days until the retracement reached levels close to 23,6% and then returned to its previous downtrend.
So, when using a Fibonacci retracement, what the trader does is a bet on one of the Fibonacci retracement levels, and if the retracement continues, then bet to the next one.
Fibonacci retracement allows us to open low-risk positions. But as with any other technique, the probability of success increases when others indicators also confirm the trend. Also, time plays an important role in the validity of movements based on the Fibonacci retracement. Therefore, the longer the time frame, the stronger the forecast will be.
Fibonacci Extensions
Fibonacci sequences are more known for predicting retracement levels, but it also has other useful applications, one of them is Fibonacci Extensions. This indicator is also based on the proportion between numbers of the series, and we can think of it as a continuation of the Fibonacci retracement theory. This indicator predicts how far the price will go after the retracement is over. Fibonacci Extensions are used to predict when a trend will end.
As with Fibonacci retracement, this indicator has its own ratios. The most commonly used is 161.8% which shouldn't be a surprise because it's the golden ratio. There are also other percentages used by traders to establish a take profit level. Some of them are 61.8%, 100%, 138.2%, 150%, and 200%.
In Summary
Trading tools based on the Fibonacci series have been proved over many years. The right way of using Fibonacci retracement and expansions is betting that once the price has passed one of the levels of the Fibonacci sequences, the turning point will be at one of the next levels and not between them. So, you want to enter a position once you identify the pattern and exit as close as you can at the next level. For example, suppose a retracement had reached the level of 38,2% and continues the same way. In that case, a proper strategy may enter a position at that point and exit the position at the 50% level or, depending on other factors like the magnitude of the initial trend, maybe take a higher risk and go for the exit at the exit 61,8% level.
Like in any other technique, this one by itself can't always predict the behaviour of the prices, and it won't work all the time. Many factors can influence pip levels and create turning points in places we didn't expect them. The smarter thing to do is use Fibonaccis techniques combined with other indicators and in a proper time frame.
Let's get you started
Receive the BSF Trade Manager To Help You Practise Better RIsk Management.
