Introduction
As a beginner, you may wonder how a 12th-century Italian mathematician is relevant in trading currency pairs. Well, even today, Fibonacci has a legion of devoted enthusiasts and analysts.
Fib is present in many components in the natural world, like snail shells, bee hives, tree branches, hurricanes, flower petals, DNA molecules, and even the human face.
Fib is a concept you can only grasp after tons of screen time. However, this guide will ease you into this complex yet practical trading approach with useful tips.
Traders use Fibonacci in Forex for various purposes like support and resistance, harmonics, Elliott waves, stop loss/take profit orders, trailing stops and forecasting the depth of retracements.
What is fibonacci forex trading?
Leonardo Bonacci, a highly-regarded Italian math wizard of the Middle Ages, inspired the Fibonacci sequence in forex. Leonardo had a manuscript called ‘Liber Abaci’ (meaning The Book of Calculation) released in 1202.
It was here that the Italian introduced the Fibonacci series. In this book, he referred to himself as ‘filius Bonacci,’ which, in Latin, means ‘the son of Bonaccio.’ It eventually got combined and shortened to Fibonacci.
The Fibonacci sequence includes a series of numbers where each is the total of the previous two: e.g., 1,1,2,3,5,8,13,21,34, 55, 89 …
The magic happens between these numbers with the ‘divine proportion’ or ‘golden ratio,’ the foundation of any Fibonacci forex trading strategy. The golden ratio states that each figure in the sequence is roughly 1.618 higher than the preceding number.
For example, dividing 55 by 89 gives you about 1.618; dividing 21 by 24 returns a close-by value, and so on.
As mentioned, this relationship is present with proportions in numerous natural objects, including the human body.
Here’s a little experiment. Measuring the length between your feet and head, and dividing it by the distance from your navel to your feet gives you an answer close to 1.618.
The golden or 61.8% ratio isn’t the only notable pattern in Fibonacci Forex trading. For instance, the 23.6% ratio results from dividing one number in the sequence by another three places to the right.
So, 13 divided by 55 equals approximately 0.23. Another popular ratio is the 38.2%, found by dividing a figure by one two places to the right. So, for example, five divided by 13 gives you about 0.384.
We can witness these intricate proportions in the financial markets, most commonly with the Fibonacci retracement tool. Yet, other Fib-related devices express similar patterns for different purposes, which we’ll also cover.
Depending on your trading software, you may only have access to part of the suite of Fibonacci tools.
Most popular types of Fibonacci forex trading tools
Let’s now cover all the main indicators by explaining how they work using candlestick pictures.
Retracement
As already mentioned, the retracement tool is the most well-known in any Fibonacci Forex strategy due to its simplicity and practicality. It helps first to define what retracements are. As we know, trends do not move in a straight line but rather various peaks and troughs.
However, you can reasonably tell the general direction of an FX pair. A retracement is a temporary movement opposite the predominant trend.
The Fibonacci retracement strategy helps with observing the depth of pullbacks on any time reference using specific ratios in the sequence, namely:
- 0.236 (or 23.6%)
- 0.382 (or 38.2%)
- 0.5 (or 50%)
- 0.618 (or 61.8%)
- 0.786 (or 78.6%)
- 1 (or 100%)
When you plot the tool on your chart, you draw it from two anchor swing highs/lows. Firstly, determine the leg of a movement where you’d like to see retracements. Let’s look at the image below:
Here, on the daily chart of AUD/CHF, we decided to draw the tool from the swing low at 0.64188 to the swing high at 0.70946. The price was clearly in an uptrend. Still, a trader using a typical Fibonacci retracement strategy will be curious to know where the price will likely stall.
A pullback signals a pause or break in the prevailing momentum. The idea is to enter once this period is over in anticipation of the trend continuing in its predominant direction. Fib retracements are one technique used in these scenarios.
There is no consensus over which ratios the market retraces. The 50% tends to be a sweet spot for most movements. Generally, the strength of the first trend leg determines roughly where the market corrects itself.
If it’s long with little to no pullbacks, the price will likely retrace between the 23.6/78.6% and 38.2/61.8% ratios. Similarly, a pair may pull back deeper than the 23.6/78.6%, closer to 1 or 100% in range-bound conditions.
However, these are not hard-and-fast rules; the market can retrace at any level it wants. The key is to specialize in looking for opportunities at particular ratios rather than all of them.
Extension
The Fib extension tool is, well, an ‘extension’ of the retracements. We use the latter to determine a probable pullback zone. On the other hand, we utilize extensions to work out future support/resistance levels and profit targets. This is the difference between the two.
The typical ratios for extensions are multiples of the 61.8% and 100% levels, i.e., 161.8%, 200%, 261.8%, 300%, etc. Drawing these levels is simple. You first plot the normal retracement tool and add the extensions manually. Let’s look at an example of using this tool.
On the 4HR chart of CAD/JPY, we can see the market has been trending. Let’s assume you were looking to short this pair at the 107.558 swing high. You can draw your Fib from this point to the support/swing low at 104.570.
Notice that we have extra levels beyond this area, which are the extensions. Assuming the market did continue its downtrend, these areas could represent potential profit targets depending on your time horizon of holding positions.
Time zones
Time zones are different from the two price-based Fibonacci projections we spoke of. These are the least popular when it comes to Forex Fibonacci tools and one of the more complex. So how do they work?
When you plot this tool on a price chart, it shows vertical lines focused on periods equal to the Fibonacci sequence in Forex: 1,1, 2,3,5,8,13,21,34,55,89,144,233, etc. You draw this tool from a swing high/low, and the zones will project themselves to the right-hand side of the chart.
Many analysts advise ignoring the first five zones (1,1,2,3,5) given their tight cluster. This is a list of the nearest zones and their respective periods:
- 6th zone: 13 days
- 8th zone: 21 days
- 9th zone: 34 days
- 10th zone: 55 days
- 11th zone: 8 days
Here’s a look at the time zones on a chart:
The theory is that a pivot point will likely occur around these Fibonacci periods. So, for instance, if you were looking at the ‘13’ band, the market may produce a swing high/low after 13 days around this point.
Fib time zones are highly subjective and best suited to experienced analysts. Experts in this field use them for confirmation with another Fibonacci Forex trading tool instead of independently.
Arcs
Like time zones, arcs are seldomly used Forex Fibonacci projections. They consist of half circles intersecting at typical Fib ratios and represent potential support/resistance zones. When plotted, they span outward from a diagonal line connected to a swing high and swing low.
As the distance between these two points increases, so do the arcs. This quality means that arcs factor in price and time, hence why devoted Fib analysts consider them more versatile.
Let’s look at arcs on a real chart to understand their function.
We have drawn the arcs on the 1HR chart of NZD/CHF from the low to the highest price. Note that the price (0.62520) is at the 0.5 arc. The market will trace along this circle if this level proves to be a resistance zone.
The retracement tool only provides pullback points. However, arcs offer an idea of the price trajectory, which will vary the wider or narrower the half circles become.
Fans
These are similar to arcs because they account for price and time. After you have picked the relevant swing high and swing low, the tool will plot various trendline zones based on the Fib ratios.
Like arcs, fans aim to trace the potential pivot points at different ratio zones. Fans are simply an advanced version of the standard trendline.
Channel
This Fibonacci tool is a cross between the standard channel and Andrew’s Pitchfork. Similar to Fib fans. Fib channels show pivot pivots diagonally instead of horizontally.
The main difference is that fans show the zones in a cone-like shape, while channels show the zones in a rectangular fashion.
Advantages of Fibonacci Forex Trading
Let’s look at the reasons why many traders use Fib.
Versatility in different strategies
Whether you are into mean reversion or reversals, the Fibonacci sequence in Forex will have relevance. When trading with the trend, you first look for an established move.
Trend traders then wait for a period when the market pulls back to an ‘area of value’ rather than entering when the price is at its peak. Who doesn’t like a bargain? You must be patient to wait for the price to return to a more optimal zone to achieve a better risk to reward ratio.
There are a few to define an area of value, such as using moving averages and support/resistance. However, a Fib ratio can offer a point of interest on where the price may retrace before continuing with its trend.
Of course, Fib can work with reversals as well if you know the best ratios to forecast a potential turning point. Fibonacci is also an excellent confluence factor where you can combine things like price action, chart patterns, moving averages, and trend lines.
Complex trading analysis
Many traders implementing Fibonacci in Forex use sophisticated strategies like the Elliott Wave theory and harmonics.
Elliott Waves are based on The Wave Principle, created and published by Ralph Elliott in 1938. This theory is a system of identifying market psychology through a five-wave impulse and three-wave pullback.
Each wave has its own identification criteria based on Fibonacci retracements and extensions. Let’s look at the chart below.
In the Wave Principle, Elliott suggested that wave 2 should form between the 50% and 78.6% retracement of wave 1. We can see that the price did indeed correct itself around these levels before the next wave. This is an example of using Fibonacci in Forex to project potential Elliott waves.
Traders also need Fib with harmonics, a way of trading the markets using precise geometric shapes. Similar to Elliott waves, harmonic trading has been around since the 1930s with the introduction of the Gartley pattern.
Harmonics aim to depict pinpoint-accurate turning points guided by Fibonacci. Also, these patterns have meticulous stop loss and profit targets. Prevalent harmonics include the Gartley, butterfly, bat, 5.0, 3-drive, and shark patterns.
Let’s look at an example of a bullish Gartley with the chart below.
These are the Fib ratios for this pattern (notice how the price moved nicely from D):
- XA can start from anywhere
- AB is 61.8% of XA
- BC is between 38.2% to 88.6% of AB
- CD is either 127.2% or 161.8% of BC
- AD is 78.6% of XA.
Determining support/resistance and take profit levels
All Fibonacci ratios are merely prospective turning points, which are just support and resistance areas. We also saw that Fib extensions project take-profit levels. Many beginners need help determining the best places to take profits since they often use uninformed methods.
So, Fibonacci offers a more detailed guide on where you might decide to exit a position. Also, this tool can help with stop losses. For instance, if you generally enter the market on the 50% point, you may place your stop at the nearest ratio as your invalidation mark.
Disadvantages of Fibonacci Forex trading
Fibonacci is definitely not free from flaws.
Lack of predictive power
Like many other tools, the overarching drawback with Fib is that it doesn’t always work. Trader discretion is advised. There is no factual evidence stating markets will retrace around Fib levels.
This behaviour is more self-fulfilling as a result of the herd mentality. In simpler terms, the more people use a Fibonacci trading strategy, the more everyone agrees with it. Yet, the momentum will only sometimes align with the ratios.
So, if you expect a pullback at the 50% level, the market can disrespect it completely, retrace at another point, or invalidate all the ratios.
Subjectivity
There is still debate on how to draw certain Fibonacci Forex trading tools. The way you plot Fib on your charts will produce different results compared to somebody else. For instance, some traders prefer to project the ratios from left to right (past to current price), while others do it the other way around.
Therefore, the interpretation is subjective rather than objective. As a trader, it is always best to analyse the markets impartially so that you don’t second-guess yourself.
Complexity
This point is related to the previous one. Any Fibonacci trading strategy, especially harmonics and Elliott Waves, takes a lot of work to master. Also, the more you study Fib, the more time it consumes due to how long it takes to plot the tools.
On the bright side, as a beginner, you will do fine learning only about retracements and extensions because these are the simplest to grasp.
Conclusion
As with any trading approach, you should never treat Fibonacci in Forex as a magic solution for your analysis. The aim is to apply a mathematical approach to things with little room for uncertainty. So, Fibonacci Forex trading shouldn’t be regarded as a sole strategy but rather a means to an end.
