Forex Trading with Fibonacci Retracement Lines

FX City > Theories > Forex Trading with Fibonacci Retracement Lines

 

A history and explanation of Fib Numbers

First off let’s start with a brief explanation of what these numbers are and why they might be significant to our trading.

A quote from Gaucan (2011, p.24) states “… Fib numbers’ (as they are often referred to) also appear in many aspects of nature such as the arrangement of leaves on a stem and the branching of trees. Some day traders, swing traders and investors therefore say that the nature of the financial markets also manifest themselves in the structure of Fibonacci numbers”.

In this journal Gaucan goes on to state that the mathematics behind this theory where devised by an Italian mathematician by the name of Fibonacci who lived from 1175-1240. You do not need to worry about the mathematics behind this, the question is, do these retracement numbers have an effect on the price movement in financial markets?

She suggests that the answer to this question is that they are significant indeed if for no other reason that they have become a self-fulfilling prophesy because they are used by so many Foreign Exchange, stock and futures traders. This idea of a self-fulfilling prophesy can apply to many other aspects of technical analysis such as trading using trend lines.

They suggest that the method is assumed to have an ontological power behind the chaos of the market place. This power can be the mass psychology of speculators buying or selling at key points. As explained previously, if all of a sudden a price hits a point and everyone demands to buy at this point, price will be driven up.

What are the Key Retracement points to look out for?

The key Fibonacci ratios used in the financial markets are; 0%, 23.6%, 38.2%, 50%, 61.8% and 100%. The most commonly used ratio recognised and respected by traders is the 61.8% retracement point, also known as ‘the golden ratio’.

How to draw a Fibonacci retracement line?

Most charting packages will come complete with a function to draw Fibonacci retracement lines. Meta Trader 5 does, and so does the back testing software Forex Tester 3 (in case you want to back test this method).

The Fibonacci lines are typically used in a trending market when price has been trending in one direction or the other. We would simply start the line at the bottom of the rally in price and end it where the rally ends and begins to retrace. In the example below the straight red line indicates where the rally starts and where it also ended. From this our charting software will create the Fib lines.

 

how to draw fibonacci lines

We can then see below how price panned out after the rally in price. As you can see price found support at two of these significant levels.

Fibonacci retracement set up

But how do I use Fibonacci lines in my trading?

So the question arises, how can we use the significance of these levels in our day to day trading?

If we have an idea that there is likely to be a bounce from one of these levels, we can choose to use them as an entry signals on a larger trading strategy. One strategy I liked to use would be to wait for moving average to cross over, price below above/below the fast moving average and wait for a retracement back to a fib number. Once I saw the price stalling I would use this as my entry in to the trade. See example below for a high probability trading set up.

Fibonacci trend following strategy

Remember the pro’s use Fib numbers so it would be foolish to dismiss them all together. One of the key numbers pro’s like to use is the 61.8% retracement as in theory it has the highest probability of a bounce in price. See below example. In this case Fib numbers are being used to enter a short trade.

Fibonacci 61.8% retracement

 

If your considering forex trading with fibonacci retracement levels. I would advise against simply creating a strategy which buys or sells whenever one of these levels is hit as there would be too many signals and too many whip saws in my opinion. But combine it other entry signals and you can devise some high probability trading set ups which gives the trader the edge they need on the market.

Read this post for a full high probability trend following system

Reference

Gaucan, V. (2011) Journal of Knowledge Management, Economics and Information Technology, How to use Fibonacci retracement to predict the forex market, 1(2), p.24. Retrieved 14/10/2013 from http://www.scientificpapers.org/

 

 

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