Fibonacci Retracement in Forex Trading

Discover the art of the Fibonacci Retracement Method in Forex. Learn and discover trading techniques using a simple trading guide designed for beginners.

The Fibonacci retracement tool originates from a famed mathematical pattern. It came from the Fibonacci sequence. 

The Fibonacci sequence is significant in different fields of study. The pattern naturally appears around us, from atoms to flowers to galaxies and stars. It also magically finds its way into architecture.

Let’s find out if this “magic sequence or pattern” is the key to unlocking the secrets of the foreign exchange trade. 

What is the Fibonacci sequence?

Before we learn to trade with the Fib retracement method, let’s have a brief look at history.

The Fibonacci sequence was introduced in 1202. It appeared in “Liber Abaci” (Book of Calculations) penned by Leonardo Fibonacci. 

It was a revolutionary book. It laid out the basis for modern algebra, arithmetic, and other fields of math.

The Liber Abaci also played a role in advancing commerce and banking. 

The Fibonacci sequence appeared in the book as a solution to a problem involving rabbits. 

The Fibonacci sequence starts from 0 and 1. Each of the succeeding numbers is a sum of the two that precedes them. 

To better understand, look at this illustration. 

Get the sum of 0 and 1.

0 + 1 = 1

Put 1 in the sequence.

0 1 1

Then, you add 1 and 1.

1 + 1 = 2

Put 2 in the sequence.

0 1 1 2

Do this again and again. It will give you a patter on numbers that will look like this.

0 1 1 2 3 5 13 21 34 55 89 144 233…

The pattern can stretch to infinity.

What are Fibonacci ratios?

Traders find this pattern notable. It is because of the relationships of the numbers to each other. 

These are known as the Fibonacci ratios. These ratios appear frequently and consistently in the pattern.

When you get any number from the pattern and divide it by the number that succeeds it, you will get 0.618. In percentage, it is 61.8%.

3455 = 0.161818181 or 0.1618

The second ratio appears when you divide any number in the pattern with the number two places ahead. You will get 0.382 or 38.2%.

3489 = 0.38202247 or 0.382

The second ratio appears when you divide any number in the pattern with the number 3places ahead. You will get 0.236 or 23.6%.

34144 = 0.236111111 or 0.236

Another interesting fact. If you divide these ratios with each other, the answers are either of the three ratios. 

0.2360.382 = 0.6178010 or 0.617

Armed with this knowledge, let’s apply it to the foreign exchange trade.

What is a Fibonacci retracement level?

In foreign exchange, the Fibonacci ratios are converted in percentages. These percentages act as retracement levels. 

The Fibonacci levels appear as a set of straight horizontal lines in the chart. Fibonacci lines show where the price will likely meet resistance or support.

The resistance is an area where the price regularly stops rising. While the support is an area where the currency exchange rate keeps bouncing back up. 

Commonly used Fibonacci percentages:

  • 23.6%
  • 38.2%
  • 50%
  • 61.8%

If you noticed, the set includes a non-Fibonacci ratio. 

The 50% is a product of Dow’s Theory. It postulates that averages are likely to go back to half of the price. Then it will continue in the initial direction of the trend. 

Other non-Fibonacci ratios that can be used in retracement are:

  • 78.6%
  • 161.8%
  • 261.8% 

Using the Fibonacci retracement Method

How do you get the Fibonacci retracement levels?

The retracement levels are not computed. 

There is no formula. The levels are simply the percentages of the selected price movement.

For example, there is an increase in the price. Let’s say the currency exchange rose from $20 to $30.

The 50% retracement level will fall on $25.

[$30 – (10 x 0.5)] = $25

The 61.8% retracement level will fall on $23.82.

[$30 – (10 x 0.618)] = $23.82

How do you use Fibonacci retracement in forex?

The basic idea of Fibonacci trading is:

· If the market is on a trend, it will almost always revert to an earlier price before continuing on its course. It’s retracing a previous price. Hence the word, retrace. 

The Fibonacci retracement method tells you when to sell or buy based on past movements of the price. 

If the market is in an uptrend, the ideal action is to buy when the price hits a support level. 

It is when the price pulls back and sits at a lower price. 

But, during a downtrend, the ideal action is to sell when the price hits a resistance level. 

It is when the price hits a peak before dipping back down. 

How do you use Fibonacci retracement in a chart?

Fibonacci forex tool is available in most chart settings. If you click on it, and it shows you the retracement levels. 

When a trader uses the retracement methods, he uses the levels as indicators. 

The horizontal lines can help predict if the price is going to down or bounce back up. These are the ideal positions where the trader can enter or exit a trade. 

If there is a decrease in the price after a large and consistent upward thrust, the hope is it will retrace. 

The pullback happens after hitting resistance. 

For downtrends, the retracement level indicates an opportunity to go short or sell. 

Game plans employing Fibonacci Retracement Method

When it comes to foreign exchange, there is no perfect math or solution. Otherwise, all forex traders will have made millions.

Each trader has strategies that are honed by practice and experience. 

If this is your first time, here are actions you might want to try using the Fibonacci retracement method. 

  • Setting your profit-taking targets using the retracement levels.
  • Put your stop-loss orders just before the retracement levels. For instance, if you enter at 38.2%, your stop-loss order should be at a price below 50%. 
  • During a breakthrough, you can still use the Fibonacci numbers. Use the Fibonacci extensions 161.8% and 261.8%. 

Which timeframe is best for Fibonacci retracement?

Before we move on, let us first look at some of the different types of traders and trading styles.

Four types of Forex Traders

There are four different types of traders according to their preferred trading timeframe.

Scalpers

Scalpers try to scrape small percentages from tiny fluctuations in the currency exchange. They trade within the shortest timeframe. Scalpers open and closes a deal from a few seconds to a few minutes. 

Day traders

Day traders open and close their deals in a day. They maintain their positions for a couple of hours but closes them before the end of the day. 

Swing Traders

Swing trading takes a little bit longer. The traders can hold their positions for more than a day to a couple of days. Although, they will most likely close their trades before the weekend. 

Position Traders

Position traders trade the longest. They can hold their positions from several weeks to several months. 

How to use Fibonacci retracement for long-term trades

The retracement method is ideal for any timeframe. But it is proven most effective for longer or broader trading plans.

In a broader spectrum, technical tools like retracement give more probable signs.

The longer the time, the more pattern is formed. More patterns mean a higher probability.

What are the advantages of using Fibonacci retracement in long-term charts?

  • Long-term charts show you a holistic view of the market prices.
  • Traders can find key levels that have a statistical significance. It is due to the wide range and longer timeframe. 
  • Long-term key levels are applicable for short-term trades.

Why is using Fibonacci retracement in short-term trades less effective?

Like we have discussed, the levels are ideal entry and exit points for a trade. 

Short-term traders will see fewer ups and downs in the currency rates. 

It is due to the very short period. The peaks and through created by very tiny changes may not be reliable indicators. 

Take a weekly chart and a ten-minute chart. 

You will see more significant retracements in the weekly than in the ten minutes chart. 

Unless you are trading volatile assets, this method may not work as well in short trades as it does in long trades.

But if you insist, you can safely trade short-term with these tips. 

How to safely trade short-term using Fibonacci retracement?

Always be on alert for and check the earning calendar as these may instantly impact the market. 

  • Pick within 30 to 60-minute candlesticks.
  • Choose a chart showing changes in prices within 30-60 minutes. 
  • Click on the latest highest point and draw a line to the lowest point. If it is an uptrend, draw the line from the lowest to the highest point. 
  • The Fibonacci tool will show you levels of interest.
  • If the price nears or hits a Fibonacci level, it does not mean that you immediately buy or sell. 
  • Watch for a pattern to form that will show possible reversals. 

What is the Fibonacci retracement tool?

Fibonacci retracement tool is used to plot the ratios or percentages in a chosen Fibonacci chart. It starts by drawing a line along with the trend from two extreme points (the peak and the trough or vice versa). 

Between those points, the ratios signifying levels are drawn as horizontal lines. These lines form the basis for monitoring resistance and support levels. 

Here is a brief guide in using the Fibonacci retracement tool. 

Using Fibonacci retracement tool in an uptrend

  • Find the lowest and highest points in a trend.
  • Click on the lowest point (trough) and drag the line to the highest point of the trend (peak).
  • Identify and track potential support levels.
  • Look for a confluence of signals and act according to your strategy.

Using Fibonacci retracement tool in a downtrend

  • Find the highest and lowest points in a trend.
  • Click on the highest point and drag the line to the lowest point of the trend.
  • Identify and track potential resistance levels.
  • Look for a confluence of signals and act according to your Fibonacci trading strategy.

What are the common mistakes when using the Fibonacci retracement tool?

1. Picking inconsistent reference points.

  • The diagonal reference line should be drawn from candle body to candle body or wick to wick.
  • Inconsistent reference points lead to incorrect key levels which results in improbable signs. 

2. Unable to recognize long-term trends.

  • Most beginners have trouble recognizing long-term trends and short-term trends. 

3. Oversight in considering long-term trends.

  • Long-term trends are indicators of possible future pullbacks and reversals. It creates patterns and establishes key levels.

4. Utilizing the method for short-term strategies. 

  • Using the retracement method over a very short timeframe gives less likely indicators. 

Is Fibonacci retracement reliable in forex?

Fibonacci retracements are commonly used by traders. 

To a degree, it can provide reliable indicators. But it is not foolproof. The ratios are not magic numbers.

It is a bad trading habit to rely solely on retracement levels. 

The levels are not signals to act. 

They are areas of interest where possible signals may form. These signals can show either the duration or direction of a trend. 

There is no exact math or formula in trading. 

A good trader knows to combine different techniques. It increases the probability of a successful trade. 

Parting words

The Fibonacci retracement strategy is a commonly used analysis trading tool. 

But when it comes to the foreign exchange trade, you need to have an eclectic strategy. 

This strategy should: 

  • Define how and when you are going to enter or exit a trade;
  • How are you going to manage your trades;
  • How are you going to take profits;
  • How much you are willing to risk;
  • What are your targets and how are you going to determine them;
  • What other risk management strategies are you going to use. 

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