Fibonacci is popularly used in trading as a tool for measuring the size of a price move.
Traders use it to identify the levels where they should place the horizontal support and resistance lines on their price charts.
These support and resistance lines become the Fib levels and traders use them to make sound trading decisions.
Such levels help traders to determine the zones on the price chart where the price action is most likely to pause or make a reversal.
Due to this, traders use them to determine the entry points into the market, where to place the profit target as well as the stop loss.
This means that they are very important to traders.
However, there are times when the Fib levels are misused by traders.
Some traders end up placing them on their charts as a pedestal.
A wrong use of the Fib levels can bring more harm than good to the trader.
That’s why you must ensure that you use them correctly when trading.
It will be good for you to know when to use each Fib level.
This will make it easy for you to use the Fib correctly and increase your chances of becoming a successful trader.
In this article, I will be showing you how to use the Fib in trading.
Let’s start…
What is Fibonacci Trading Strategy?
The Fib trading strategy traces the trend of a security.
As the price of a security trends in one direction, most traders expect that a pullback will occur, or a decline in prices.
Traders who trade using this strategy believe that the pullback will occur at Fib retracement levels of 23.6%, 38.2%, 61.8%, or 78.6%.
A pullback may also occur at the 50% Fib level.
For example…
If a forex pair is selling at $20 and then it rises to 21, the pullback will be 23, 38, 50, 61, or 76 cents.
However, the 50% has not been officially approved.
Some day traders tend to see the Fib numbers as a short-sell strategy.
For instance, if a pair drops from $21 to $20.62, some Fib traders will interpret the 38 percent drop as a good opportunity for them to short the pair.
For other traders, the Fib retracement will give them a valid strategy to trade forex.
The Fib trading strategy is all about the Fib retracement levels.
These are just lines that run horizontally on price charts showing the positions where support and resistance lines are most likely to be formed.
These levels are derived from Fib numbers, and each level is associated with a percentage.
Each percentage shows the amount of prior move that the price has retraced.
Remember that we mentioned a number of percentages for Fib retracement levels, including the 50% Fib level which has not been officially approved.
It is a very useful indicator since it can be drawn between any two significant price points, like the high and the low.
The Fib levels are then drawn between these two points.
But the question is…
How are the Fib levels drawn on the price chart of a forex pair?
It’s very simple!
First, a trend line is drawn between two extreme points.
These points can be a swing low and a swing high.
The trend line should run between the two points, showing how the price has behaved between the two points.
A series of horizontal lines are then drawn across the chart to intersect the trend line at various points.
These lines become the Fib retracement levels.
Consider the chart given below…
In the above chart, we have different Fib levels added on the price chart of a forex pair.
The trend line is the dotted line running diagonally across the chart.
A closer look at the trend line reveals that it has been drawn between two extreme points, a swing low and a swing high.
Many horizontal lines have then been drawn to intersect this trend line at different points.
The horizontal lines are the Fib levels.
Each line is associated with a percentage, and you just have to multiple the line value by 100 to get its percentage.
However, you can modify the chart settings on your trading platform to show the values as percentages.
The chart also shows that the 100% Fib level, which is the lowest on the chart, is acting like a support level.
The price was in a bearish move before hitting this level.
The price bounced off the 100% Fib level, making a reversal.
It then changed its trend from bearish to bullish.
This means that the 100% Fib level is acting like a support line.
This confirms the fact that Fib levels can be used to identify areas of support on a price chart.
The 0% Fib level is acting like a resistance line.
The price action was in a bullish move before hitting this level.
It then hit this level and quickly bounces off it.
The bullish trend reversed into a bearish trend.
So, the 0% Fib level is acting like a resistance line.
This confirms the fact that Fib levels can reveal the resistance areas on a price chart.
From the above chart, it’s very clear that the percentage retracements can help traders determine levels of support and resistance on a price chart.
If these percentages are applied to the difference between the high and the low price for a particular period, a trader will create a set of price objectives.
The price of a forex pair will always trend, either upwards or downwards.
The price will always retrace a significant portion of the trend before resuming the move in the original direction.
The countertrend moves normally fall within specific parameters, and they form the Fib Retracement levels.
However, it is recommended that you don’t rely on these points alone as it is dangerous to assume that the price will make a pullback after hitting a certain Fib level.
Key Fib Ratios
Consider the following numbering scheme…
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89
Does the numbering scheme mean anything to you?
Not really!
These numbers form the root of the most important techniques for identifying psychological levels in trading and in life.
They were discovered hundreds of years ago by an Italian mathematician who needed to describe the relationship between numbers and nature.
He introduced a number sequence beginning with 0 and 1.
So, we start with 0 and 1…
0, 1
The next number in the sequence is calculated by adding the previous two numbers.
So, this logic gives us the following equation…
0 + 1 = 1
So, our third number in the sequence is 1, and we can now update it to the following…
0, 1, 1
Now, we can add the last two numbers in the sequence to get the next number…
1 + 1 = 2
So, the current sequence after update is as follows…
0, 1, 1, 2
Next…
1 + 2 = 3
Next…
0, 1, 1, 2, 3
Next….
0, 1, 1, 2, 3, 5
Next….
0, 1, 1, 2, 3, 5, 8
Next….
0, 1, 1, 2, 3, 5, 8, 13
And the process continues to infinity.
He also discovered that each number in the sequence is approximately 61.8% of the previous number.
55 / 89 = 0.6179775280898876 = 61.8%
233 / 377 = 0.6180371352785146 = 61.8%
144 / 233 = 0.6180257510729614 = 61.8%
Also, he discovered that each number in the sequence is approximately 38.2% of the number two steps ahead.
(13, 21, 34)
13 / 34 = 0.3823529411764706 = 38.2%
(21, 34, 55)
21 / 55 = 0.3818181818181818 = 38.2%
(55, 89, 144)
55 / 144 = 0.3819444444444444 = 38.2%
(144, 233, 377)
144 / 377 = 0.3819628647214854 = 38.2%
Also, each number in the Fib sequence is approximately 23.6% of the number after the next two numbers in the sequence.
(55, 89, 144, 233)
55 / 233 = 0.2360515021459227 = 23.6%
All these percentages are referred to as Fibonacci ratios.
These numbers are also found throughout nature.
For example…
In the Sea Shell, the volume of every part of the shell matches exactly the Fib number sequence.
Each part of the shell is 61.8% of the next.
This is also the case with the aloe flower.
Consider the following scenario…
Let’s say the price of a forex pair moves from $10 to $15.
These two price points can be used to draw the Fib retracement indicator.
You can calculate the position of the 23.6% level as follows…
$15 – ($5 x 0.236) = $13.82
This means that the 23.6% level should be drawn at the $13.82 price level.
You can calculate the 50% Fib level as shown below…
$15 – ($5 x 0.5) = $12.50
This means that the 50% Fib level should be drawn at the $12.50 price level.
From the above discussion, you can tell that there is nothing to calculate when you’re dealing with Fib retracement levels.
You were just finding the percentages of the price range that you have chosen.
However, the Fib numbers themselves have a very fascinating origin as we have discussed above.
It is easy to trade with the Fib ratios.
You can rely on the Fib levels to place entry orders, determine the stop loss levels, and set profit targets.
For example…
You may see the price of a forex pair moving higher.
The price makes a significant move, then it retraces back to the 61.8% level.
It then begins to make a bullish move again.
Since the price bounced at a Fib level during an uptrend, you buys the forex pair.
You have entered a trade, but you have not protected it.
You need to place a stop loss to protect your trading account in case a price reversal occurs.
So, you can place a stop loss at the 61.8% level.
Remember that if the price action returns below that level, it may be an indication that the bullish move has failed.
There are also other ways through which Fib levels arise in technical analysis.
For example…
They are popularly used in Elliot Wave theory and Gartley patterns.
Once the price has made a significant move upwards or downwards, such types of technical analysis find that reversals mostly occurs close to particular Fib levels.
Fib retracement levels are static prices, hence, they don’t change unlike moving averages.
Due to the static nature of the price levels, traders can identify them quickly and with much ease.
They make it easy for traders and investors to anticipate and react wisely once the price levels are tested.
Such levels are inflection points at which a form of price action is expected, either a break or a reversal.
So, the best time to enter the market when trading using Fib levels is when the market is going through a pullback.
The 50% Fib level forms a great entry point for traders.
With Fib trading, you will understand that the price of a forex pair moves in waves and a smaller retracement is an indication of a stronger trend.
To understand the price action better, you must analyze it using the 38.2% and the 61.8% Fib levels.
These two levels will help you know whether a countertrend move will stop or whether the trend will resume.
Many retail and floor traders use Fib levels, hence, even if you don’t intend to use them in your trades, it’s good for you to know that they exist.
Experienced forex traders take it a step further by adding Fib fans and Fib arcs to their trading strategy to search for an edge.
How to Interpret Fibonacci Levels
The key to becoming a successful Fib trader is by knowing how to interpret the Fib levels correctly.
Let me show you how to define the primary trend using the Fib levels…
Strong Uptrend
For you to define the primary trend using Fib levels, you should measure each pullback of the Forex pair.
If the price action shows a series of new highs with retracements of 50% or even less, this is a signal that the market is in an uptrend.
Consider the chart given below…
The above chart shows the price of a forex pair in a strong uptrend.
From the chart, you can tell that there is no retracement greater than 50%.
So, successive new highs with minor pullbacks are a sign that the market is in a strong uptrend.
During the uptrend shown in the above chart, the price action only made one weak pullback.
This has been shown by the small, red horizontal line on the chart.
The price action formed a series of strong, successive bullish candles during the uptrend.
This is a signal that the bulls are very strong and that they are currently controlling the market.
Choppy Market
Consider the chart given below…
The above chart shows how a choppy pattern looks like.
Each pullback is greater than 78.6%.
If such level of retracement occurs repeatedly, it produces a choppy market.
Therefore, you don’t need to have lofty profit targets on your trade while the forex pair is in a tight trading range.
The 78.6% is not a hard-fast rule.
A retracement of 61.8% or 100% is a signal that the forex pair is most likely in a basing phase before the next move occurs.
That’s how you can use the Fib levels to define the strength of the move in the market.
Always remember that the market can be either trending or flat.
A general rule of thumb is that the market will trend 20% of the time and spends the remaining 80% of the time in a range.
Fibonacci Trading Strategies
Here are three strategies that you can use to trade using the Fib ratios…
#1: Pullback Trades
When using this trading strategy, you should first identify a forex pair that is in a strong trend.
A strong trend can be defined as a forex pair with successive highs with pullbacks of less than 50%.
If you are a trader, it will be good for you to identify this trend on a 5-minute chart within the first 20 to 30 minutes after the market opens.
Once you have identified a strong trend, observe how the forex pair behaves around the 38.2% and 50% Fib retracement levels from the morning highs.
The moment you see the trading activity turning or beginning to slow down, enter the trade.
You can then use the most recent high or a Fib extension level to set the target that will help you to exit the trade.
Consider the chart given below…
In the above chart, the price stays around the 78.6% Fib level before making a higher high.
The price is seen making a sideways movement around the 78.6% Fib level.
But, where can things go wrong?
The fact is that you will mostly have a hit rate of 40%-70% depending on your ability to manage emotions and honor your trading rules.
So, you have to prepare yourself so that you can be ready in case things go wrong.
When running a pullback trade, the main issue will be that the price of the forex pair may fail to stop where you expected it to stop.
It may make a pullback to a full 100% retracement, or it can even go negative on the date.
You may find yourself in a situation where the price makes a 15% or greater swing from the morning highs.
Here is how you can protect yourself from such a scenario…
Trade Low Volatility Forex Pairs
Forex trade looks great when a trader is talking of a 30% gain in one hour.
However, it will be brutal if you are on the other side of the trade.
Trade forex pairs with a high volume and some volatility since you need to earn a living through trading.
Max Time Loss
Look back over your winning trades to know how long it takes you to make a profit with 85% confidence.
If it’s 5 minutes or 1 hour, this should become your time stop.
If you only have a 15% chance, you will walk away a winner.
Simply exit your trades with a predetermined allowable loss percentage or right at the market.
Max Stop Loss
Of course, you will have blowup trades.
You may be a good and experienced trader, but the market will have to bite you at some point.
So, you must have a max stop loss in your mind.
I prefer using 10%, but since I use only a small portion of my account size, it normally keeps me under a total portfolio loss of 2%.
So, always ensure that you are prepared for the inevitable, which is making a loss.
#2: Breakout Trades
Breakout trades record high failure rates in trading.
However, there are a number of things that you can do to increase your chances of winning.
You must first identify a Fib extension breakout trade.
Determine where to place your entry and profit targets.
Know how to day trade that forex pair over multiple days.
That’s how Fib extensions are once the price clears the 100% retracement and presses on.
You should find a forex pair that clears this extension level with volume.
So, it’s not enough for you to just buy the breakout.
You need to be sure that as the forex pair approaches the breakout level, it hasn’t retraced more than 38.2% of the prior swing.
This will lead to an increase in the odds that the forex pair is set to go higher.
But, where can things fail to work?
This is similar to what we had in pullback trades.
The major difference is that you are exposed to more risk since forex pair could have a deeper retracement because you are selling at the low or buying at the peak.
So, if you need to mitigate this risk, use the same mitigation tactics that we mentioned for pullback trades.
#3: Trading with Indicators
You can combine the Fib levels with other trading indicators.
However, just be keen so that you don’t end up with a cluttered chart, which may hinder the visibility of the price action.
Let’s discuss the different ways to do this…
Fib Retracement + MACD
You can get a great trading strategy by combining the Fib retracement levels with the MACD indicator.
The MACD indicator is made up of two lines that can help you know when the market is in an uptrend as well as when it’s in a downtrend.
Let’s try to match the times when the price interacts with the most important Fib levels together with MACD crosses to identify the entry point.
You should hold the forex pair until the MACD makes a crossover in the opposite direction.
Consider the chart given below…
The above chart shows the price action of a forex pair interacting with the Fib levels.
The MACD indicator has also been added to the bottom part of the chart.
The black circle shown on the chart shows the times when the price interacts with the price breaks through the 78.6% Fib level.
Note that the breakout occurs in a bullish direction and there are very strong bullish candles in the market at that time.
The black circle on the MACD indicator section shows a bullish crossover between the MACD lines.
These two events in the market are an indication that it’s a great time for you to enter a long position.
That’s why we have a black arrow marked as Long.
You can enter a long position at this time by buying the forex pair.
If you look at what happened with the price action after this, it maintained a bullish move for some time.
This means that if you had entered a long position at the marked position, you would have made a profit from this bullish move.
You could also have entered the market if the market had made a price bounce on a Fib level coupled with a bullish crossover between the MACD lines.
The red circles on the chart and on the MACD indicator section show the times at which you should exit or close your trade.
A closer look at the MACD indicator at this time reveals that it makes a bearish crossover.
This sends a clear signal that a bearish move is about to begin in the market, hence, it’s time to enter the market.
This means that it’s the right time for you to exit your long position before you can make a loss.
Fibonacci Retracement + Stochastic Oscillator + Bill Williams Alligator
In this Fib trading system, your goal should be to match bounces of the price with the overbought/oversold signals generated by the stochastic.
After getting the two signals, you can open positions.
If the price begins to trend in our favor, you should stay in the market if the alligator is “eating” and its lines are far from each other.
Once the alligator lines overlap, the alligator will fall asleep and you can exit the trade.
Consider the following chart…
The above chart shows how to use the Fib levels, the Alligator, and the stochastic indicator to determine the best time to enter the market.
The entry point has been pointed to by a black arrow marked as Long.
This is the best time for you to enter a long position in the market.
During this time, the price moves to the 100% Fib level in a bearish direction.
After hitting this Fib level, it bounced off it and reversed, beginning a new bullish move.
At the same time, the stochastic indicator is below the 20 threshold.
This is an indication that the forex pair has been oversold.
This is a good time for you to enter the market and purchase the forex pair.
A closer look at the chart reveals that the bullish move continued for some time.
If you had bought the forex pair at the recommended position, you will make profit from this bullish move.
During the bullish move, the alligator is “eating”.
The alligator lines are widely spaced from each other, meaning that there is a trend in the market.
The alligator should determine how long you stay in the market, meaning that it’s the tool to help you determine when to exit the market.
You should stay in your long position until the alligator stops eating.
This is the time when the alligator lines overlap and fall asleep.
So, when this time comes, exit your long position and probably enter a short position.
The reason is that it will be a signal of a possible trend reversal.
Continuing to stay in your long position at such a time will increase your chances of incurring a loss.
Fib and Volume
Combining the Fib levels with the volume indicator is a great trading strategy for most forex traders.
Even the fundamentalists are aware of this combination.
Consider the chart given below…
The above chart shows how you can combine the Fib levels with the volume indicator to analyze the price behavior of a forex pair.
The chart shows the price moving bearishly until it bounces off the 100% Fib level.
The market reversed and begun to make a bullish move.
At the same time, there is a decreasing volume in the market.
This has been shown by the black arrow marked as Decreasing Volume.
This is a sign that the selling pressure has reduced and buyers are rallying up to push the price of the forex pair higher.
This is a nice opportunity for you to enter a long position.
Other than bouncing off at the Fib levels, the price may stabilize around one of the Fib levels.
After hitting the Fib level, the price may begin to move around the Fib level, creating a form of a range.
This will also be coupled by a reduction in the volume of the forex pair.
This will also be an indication that the selling pressure has reduced, and that buyers are about to enter the market to push the price lower.
It will also be a good time for you to enter a long position by buying the forex pair.
Advanced Fibonacci Trading Topics
Let’s explore some of the advanced topics in Fib trading.
Fibonacci Speed Resistance Arcs
Traders use Fib arcs to analyze the strength and speed of market reversals or corrective movements.
If you need to install arcs on your price chart, you should measure the top and the bottom of the trend using the arcs tool.
The arcs will look like half circles under your price trend, and these are the levels of the arc’s distance from the top of the trend with 23.6%, 38.2%, 50.0%, and 61.8% respectively.
Each Fib arc is a psychological level showing areas where the price action may find support or resistance.
Consider the figure given below…
The above figure shows the Fib arcs indicator added on the price chart of a forex pair.
As you can see, there are arcs under the price that look like half circles.
The black arrow added on the figure shows the price action finding support at the 78.6% Fib arc.
The price was initially in a bearish move before hitting this level.
After hitting this level, the price action made a reversal and begun to move upwards.
This shows that the 78.6% Fib arc is acting like a support level.
This is also a good time for you to enter a long position by buying the forex pair.
However, after entering the trade, you need to ensure that you’re protected.
The reason is that the market may make a reversal and begin to move downwards.
This can wipe out your trading account.
A stop loss is the best way to protect your trading account.
It will help you exit the trade immediately the market begins to move against you.
But, where should you set your stop loss?
Just place the stop loss some pips below the arc.
This is shown in the figure given below…
The small, red, horizontal line shows the ideal place where you should place your stop loss.
This is the position just below the 78.6% arc which offers support to the price action.
If the price makes a reversal ad begins to move bearishly, this stop loss will be triggered and you will automatically exit the market, preventing you from making a loss.
The stop loss has also been placed some distant from the Fib arc.
This will prevent it from being triggered unnecessarily in case a consolidation occurs in the market.
If the stop loss is triggered unnecessarily, you may exit the trade prematurely or when it’s too early.
This may make you watch the market as it moves in a direction that favors you while you are out of trade.
This means that you will miss out on making profits.
Fibonacci Time Zones
The Fib time zones work based on the time that a move should take so as to complete, before a trend can change.
The indicator requires you to choose a swing high or low as the starting point.
The indicator then plots the additional points based on the Fib series.
Consider the chart given below…
In the above chart, the price of the forex pair is making moves based on the Fib numbers.
The time zones are the shadows running vertically on the price chart.
So, other than human psychology, Fib ratios also imply time.
Disadvantages of Trading with Fibonacci
Although fib ratios are good trading tools, there are a number of problems associated with them.
Let’s discuss them…
Increased Expectations
When trading using the Fib ratios, you will be expecting some things to happen.
For example, you may see an extension as the price target and become so locked in that figure such that you can’t close the trade waiting for bigger profits.
If you are trading pullbacks, you can decide to wait for things to bounce only for the forex pair to go much lower without looking back.
Therefore, when trading with Fib at the core of your system, you must admit and prepare for failures since it will not work 40% of the time.
So, when trading using this technique, ensure that you put proper money management techniques into place to ensure that your capital is well protected.
Failure to do this may make you incur a loss or even wipe out your entire trading account.
Closing Too Soon
You may also find yourself in this scenario…
You set your profit at the next Fib level up.
However, the forex pair explodes right through this resistance.
So, you will watch the trade moving in a direction that favors you, but you will be out of trade.
Consider the chart given below…
In the above chart, the trader entered the market when the price bounced off the 100% Fib level and begun to make a bullish move.
The trader entered a long position at this point and set the profit target at the 23.6% Fib level.
The price managed to hit that level, meaning that the trader will exit his long position at that level.
A consolidation period followed this, which may be caused by the profit taking activities of the buyers in the market.
However, the price action resumed its bullish move immediately.
This happens at a time when you are outside the trade.
This means that you will miss out on making profit from the subsequent bullish move.
What’s the Solution?
So, Fib trading will not solve all your trading problems.
When using this in your trading strategy, expect to be right 60% to 70% of the time.
Many are the times when you will find yourself having entered bad trades.
You will also find yourself in scenarios where you have exited the trade when it’s too early.
So, what should you do?
The answer is to keep placing trades and keep collecting data for each trade.
You will have accepted the fact that you will not win every trade.
Lunch Time Trading
If you talk to any day trader, they will tell you that lunch time trading is the most difficult thing to master.
The reason is that forex pairs tend to float about with no reason or rhyme during this time.
You will see forex pairs with 2 to 3 percent range bars with only a minimal trading.
So, how can you trade effectively during such a time?
The answer is to use Fib levels.
This is the time when you should expect to see a pullback to a key fib support level, for example, the 78.6% Fib level.
The reason you should expect such a deep retracement is that if you are wrong, the forex pair will not have as far to fall.
During this time of the day, the forex pair may form a base around a particular fib level, say 50% Fib level.
You should then expect two things to happen…
The volume may make a huge drop to low levels, and the price may stabilize at the Fib level.
A combination of these two factors is a guarantee that the volatility will hit lower levels.
Your goal is to see the volatility drop, so that in case you’re wrong, the forex pair will not go against you too much.
So, how can you manage your trade in such a setup?
First, you should observe the forex pair base for at least one hour.
Then, higher lows should be formed within a tight range.
So, when trading at the middle of the day, you have to do it with extreme caution.
The reason is that these setups tend to fail a lot.
Ensure that you have placed tight stops in your trades and have realistic expectations.
Conclusion:
This is what you’ve learned in this article…
- The Fib sequence begins with 0, 1, and each number thereafter is the sum of its previous two numbers.
- Each number in the Fib sequence is 61.8% of its next number.
- Each number in the Fib sequence is 38.2% of the number after the next in the sequence.
- Each number in the Fib sequence is 23.6% of the number after the next two numbers in the sequence.
- A deeper retracement on a pullback is a signal that the forex pair is less likely to break out to new highs.
- Fib levels are very critical in trading because they show the behavior of traders and their psychological reaction to price changes.
- The Fib retracement is the most common Fib trading instrument, and it’s a very crucial part of technical analysis.
- Fib time zones and Fib speed resistance arcs are also popular Fib trading tools among forex traders.
- Always ensure that you have a trading plan in place regardless of whether you trade breakouts, pullbacks, or indicators.