What is Fibonacci?
Fibonacci was an Italian mathematician who curated a number sequences made popular by its use in the creation of the Mona Lisa. Besides its use in arts, this has been now been integrated into modern financial trading.
Modern trading platforms like MT4, have taken previously difficult mathematical models and consolidated them in technical indicators. Traders no longer need to be math wizards like Fibonacci to calculate and use these formulas. They simply now open a chart, apply the indicator with a few clicks, and try to interpret where the opportunities may be.
Fibonacci Retracement Lines
The Fibonacci retracement lines are essentially an in depth and automated version of the support and resistance lines. Unlike the support and resistance the Fibonacci retracement lines provides the number sequence associated with Fibonacci, in which traders believe the chances of history repeating itself to be greater.
There are 4 main levels of the retracement lines. Each level highlights the percentage of price retracement from high to low or low to high of a given chart. The percentages excluding 0 and 100% include 23.6%, 38.2%, 50% and 61.8%. As you can see on the chart above, the percentages (highlighted in the red circle) are listed in hierarchical order however there individual popularity isn’t ranked the same. Below is how they are currently ranked in terms of popularity with traders.
- 50% – 61.8%
How can you use Fibonacci patterns to buy/sell?
There are many ways a trader can use Fibonacci patterns to not only enter but also exit a trade. As detailed above the retracement lines act as support and resistance levels with the percentages telling a trader where opportunities could be, lets detail this further.
Essentially the Fibonacci patterns are a self-fulfilling prophecy. With any prophecy, there are tiers of believers. The strongest to the weakest. The tiers in Fibonacci as already defined above are led by 38.2%, followed in joint second place 50%/61.8% and lastly 23.6%. So how are they used?
There are 2 ways to use the patterns. On an upwards trend and a downwards trend.
In applying the patterns of an upward trend, you will have to draw the indicator from the swing high (high of the chart) to the swing low (low of the chart). So in this example the Fibonacci lines are acting as levels where the buyers look to enter. Below is an example using the most popular level.
As you can see on this upwards trend, 38.2% is clearly the level where the buyers really started to buy and raise the value. So if and when the market drops back down, a lot of traders will be already waiting to buy.
In applying the patterns of a downwards trend, you will have to draw the indicator from the swing low (low of the chart) to the swing high (high of the chart). So in this example the Fibonacci lines are acting as levels where the sellers look to enter. Below is an example using the most popular level.
As you can see on this downwards trend, 38.2% is clearly the level where the sellers really started to sell and lower the value. So if and when the market rises , a lot of traders will be already waiting to sell at the 38.2% level.
Problems with using fibonacci retracements
The largest cause of confusion when using fibonacci retracement levels are that they’re discretionary. That basically means that for the same market, over the same period, you and I might draw our fibonacci at different points, therefore meaning that we will get differing support or resistance levels.
Now, whilst this is an issue, the same can be said for normal support and resistance levels that we draw, one person might consider it a level whilst another doesn’t. This is fundamentally where new traders begin to get lost, they try to be the perfect trader but actually the way to be successful is to find a way that you understand and that makes sense and then to stick to it.
If, after 100 trades, drawing your fibonacci level one way results in a positive overall result, then stick with it. Trading is all about finding a strategy that works and sticking to it like glue. Deviations will always hurt your PnL and it ultimately comes down to you risk management.
Examples of different fibonacci drawing
If in the chart below, we thought the market is going to go up, we are looking for buy signals on the support levels of a fibonacci retracement.
Possible options to draw your fibonacci:
You can see that by drawing two different fibonacci’s, we are getting different retracement zones and therefore support zone.
So where do I draw my fibonacci?
As mentioned earlier, you draw it where you think makes the most sense. I am always of the opinion that markets move in waves and therefore if there is any short sudden rallies or sell-offs, then you should draw from the top to the bottom (or vice versa) of that move.
Because the Forex market is so liquid, it does tend to follow the tenets of dow and trend nicely, therefore you can often draw from a moves high and low point.