Fibonacci is used in Forex trading to determine levels of horizontal support and resistance. But how are these levels calculated and how can you trade them? All that and more in this article…

## Mathematics behind Fibonacci

Fibonacci refers to a sequence, starting with 0 or 1 then followed by 1, where the next number is equal to the sum of the two previous numbers.

0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377…

The interesting fact about this sequence is that the relationships between the numbers form consistent ratios. These ratios are found in all aspects of life, including financial markets.

If you take a number and divide it by the previous number, the answer will be around 1.618. If you take the higher number and divide it by the previous number, the answer will be around 0.618.

If you take a number and divide it by the number two places higher, the answer will be around 0.382.

Why are these ratios important? Because Fibonacci retracements and extensions are calculated based on the above ratios. More on that next…

## Fibonacci Ratios in financial markets

The Fibonacci ratios above are used to measure the size of retracements, or extensions, in relation to the size of the impulse wave (initial move). Ratios are converted into percentages to gauge the size of the move.

Using these percentages, traders find areas (levels) of potential support and resistance where the market could turn.

Before we continue it is important to distinguish between Fibonacci retracements and extensions.

## What are Fibonacci retracements?

Fibonacci retracements are used for entries in the direction of the initial move e.g. if the market moved up, a Fibonacci retracement would give us an indication of where to buy.

3 Fib retracement levels are most used by traders. 38.2% and 61.8% (derived from the 0.382 and 0.618 ratios) as well as the 50% level (even though it is not a Fib number).

For example, if the market moves up 100 pips then we should be looking to buy after a retracement of around 38, 50, or 62 pips. The diagram below should provide some clarity.

The opposite applies to a move down (sell trade).

## What are Fibonacci extensions?

Fibonacci extensions provide possible levels at which a move could end, therefore they are used for exits e.g. after entering a buy at the 61.8% Fib retracement level, the extension levels indicate possible resistance where price could stall.

2 main extension levels are used, the 138.2% and 161.8% levels (derived from the ratios). The diagram below gives a visual representation of extensions.

The opposite applies to a move down (sell trade).

## How to use the Fibonacci tool?

No need to take out your calculator, modern technology allows you to easily use Fib levels in your trading. Most platforms provided by brokers, including our partners Plus 500, include a Fibonacci drawing tool.

All you need to do is connect the two points of the initial move, the high and the low, and the Fib tool draws the levels automatically (using the size of the current move).

When trading an uptrend you would draw from the low and connect the high of the move.

As shown the extensions are above, therefore it is drawn correctly.

When trading a downtrend you would draw from the high and connect the low of the move.

In this case, the extension is below so the Fib is drawn correctly.

## Executing Forex trades using Fibonacci

As mentioned at the beginning of the article, Fibonacci levels are treated the same as conventional support and resistance.

Thus the same principles should be applied – When price tests these levels, wait for confirmation from price action and enter in the direction of the original move.

Entry

1. Price makes a definitive move in either direction.
2. Once there is a clear high and low, use the Fib tool and draw according to the directions mentioned earlier.
3. If price retraces to one of the levels i.e. 38.2, 50, or 61.8 then watch closely.
4. Wait for confirmation via price action and candlesticks.
5. Enter in the relevant direction.

Exit

1. Stop loss above the Fib level being traded as well as any wicks (with some wiggle room).
2. Take profit at the extension levels i.e. 138.2 and/ or 161.8.

Sell example – GBPUSD H4

To wrap up, here are some final points to note about using Fibonacci in Forex trading.

## Important points

• Always wait for confirmation from price action and/ or candlesticks before placing a trade based on Fib levels.
• Look for confluence from other technical analysis tools, to support your bias, such as historical support/ resistance, trendlines, indicators, etc.
• This tool can be used on any timeframe therefore it is suitable for all types of traders (including scalpers, swing traders, and position traders).
• A common mistake that many traders make is drawing the Fib from an overall high or low and connecting it to the current high or low. You should always connect the swing points of the current wave, not the overall move.

Connecting the current high and low – AUDJPY Daily

• Do not use random impulse waves, then connect the high and low. Always use Fib to join the overall trend. Even though the above examples showed only one impulse; we are looking to buy when there is a series of higher highs and higher lows (uptrend) and sell when there is a series of lower lows and lower highs (downtrend).

Using Fib with the trend – EURGBP Daily

Price made a lower low, a lower high, and then a lower low. Thus, it is a confirmed downtrend and we can now use our levels to join the downtrend.

If price made a higher high. higher low and another higher high- An uptrend would be confirmed, and we would look for levels to buy.

Fibonacci is a great tool due to its simple nature, however, remember to combine it with other technical analysis ingredients to find the best recipe for your trading.

May the Fib be with you.

Risk disclosure – Trading CFD’s carries risk, losses can exceed deposits.

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