13. What is Fibonacci Trading in Forex
Italian mathematician, Leonardo Fibonacci discovered Fibonacci sequence of numbers. This sequence starts with 0 and the second number is 1. The third number in the sequence is the sum of previous two numbers, so 0+1 = 1. The fourth number being 1+1 = 2. Thus, the sequence goes like this:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34…
Now you are thinking how this is relevant to Forex. In the Forex world we are concerned more about the Fibonacci ratios, i.e. ratios derived from this sequence by applying mathematical calculations. The important Fibonacci ratios are:
0%, 23.6%, 38.2%, 50%, 61.8% and 100%
Before we get into more details we are going to introduce another new term here “Fibonacci Retracement”. Prices often retrace a particular amount of the previous before reversing or continuing with the trend. Fibonacci retracement is a method of technical analysis. From the name it is pretty clear that this method is based on the Fibonacci sequence and ratios.
The key Fibonacci ratio of 0.618 or 61.8% is referred to as the “golden ratio”. If you carefully look at the sequence you will see that each number in the sequence is approximately 0.618 time greater than the preceding number.
For example, 5/8= 0.625 and 8/13 = 0.615. Similarly other ratios are calculated by dividing one number by other numbers in the sequence in sequential order. These ratios play very important role in technical analysis to identify support and resistance levels in Forex trading.
Most charting software used by technical analysts include Fibonacci retracement levels. So you don’t have to worry much about the technicalities involved. Let’s understand how Fibonacci retracement levels are applied in your chart.
What we try to do is applying the Fibonacci levels to the major highs and lows of the most recent trend. Fibonacci retracements are indicated by horizontal lines on the chart the key Fibonacci levels.
How do you arrive at these levels? It’s a simple calculation. Find out the two extreme points, calculate their difference and then divide by the Fibonacci ratios. Most of the charts used for technical analysis come with this inbuilt calculations. We just mentioned it here in case you were very curious to know about the calculation of these levels.
So, how do identify the swing highs and swing lows. A swing high is a recent high with two lower highs on the left and right of the high. This is also known as the head and shoulders pattern. And similarly a recent low with two higher lows on either side of the low indicates a swing low.
Thus, you can locate Fibonacci retracement levels in the chart and adjust your trading strategy accordingly. If the price is below a retracement level and it is an uptrend you can think that the next Fibonacci level as the future resistance level.
Similarly in the case of a downtrend, each Fibonacci retracement level identifies the support level.
Again, as we always mention you should always keep in mind that, we are just identifying potential support and resistance levels, price may not always reverse from these levels. But definitely they should be considered and you can formulate your strategy based on them.
Now getting into risk control. How do you control your risk? Obviously as a new trader you can place stop losses. Fibonacci retracement levels are also used by traders for placing stop loss orders. When it is an uptrend, and you are buying or going long, it would be a good strategy to place the stop loss below the latest swing low. Because this low rate can become the support level. Similarly when it is a downtrend and you hold a short position an ideal strategy would be to place the stop loss above the swing high as this could represent a resistance level. If by any chance you were incorrect in identifying the support and resistance levels, setting the stop losses below and above the support and resistance respectively, can prevent further losses.
There are various strategies traders use based on the Fibonacci ratios, but at this point of time as a beginner you need to have your basics right as we always say. So, don’t worry about the complicated stuffs for now. Keep things simple.
Knowledge of Fibonacci levels brings you one step closer to making money with Forex market. A simple trading system and knowledge is all it takes to be profitable. Oh no that is not all. You need to have lots of patience and willingness to learn to make the process a bit easier. Keep Learning!