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Guide to Fibonacci Retracements

Fibonacci – The Nature of Numbers and Ratios

The study of Fibonacci numbers, retracements and extensions will feel strangely “out there” for most Forex traders – as if trading profits can be found in Fibonacci like the future can be found in palm readings.  This is until one realizes that Fibonacci analysis actually works!

Fibonacci numbers, sequences and ratios are the result of work done by a famous Italian mathematician named Leonardo Pisano (his nickname was “Fibonacci”).  Basically, his work showed that there is a mathematical “order” that is found again and again in nature, describing everything from ocean waves to spider webs to snail shells.  As these mathematical relationships were observed too often to be considered random, it was determined there was some significance in them.

Fibonacci and Forex

So what does the mathematical relationship of a snail shell have to do with making money in the Forex market?  This is a fair question that is asked by all Fibonacci skeptics.  Here are the only two facts a Forex trader needs to consider when evaluating the importance of Fibonacci analysis:

  1. Fibonacci determined there were certain ratios found everywhere in nature – and that these ratios were “significant”
  2. MANY Forex traders know and consider Fibonacci ratios

It can be argued that Fibonacci ratios only appear to be significant in the Forex market because everyone pays attention to them – as if the collective attention given to the ratios becomes a self-fulfilling prophecy.  Does everyone look at Fibonacci ratios because they’re significant?  Or, are Fibonacci ratios significant because everyone looks at them?  The philosopher will try to answer this question – the Forex trader says, “who cares!?” and figures out how to use them to make money!

Fibonacci Ratios to Watch

Fibonacci analysis suggests there are ratios, or percentages, that are more significant than all other ratios, these being: 38.2%, 50%, 61.8% and 75%.  Considering these significant ratios, in conjunction with other trading methodologies, gives a trader more insight into profitable entry and exit points.

Buying on a Dip

Fibonacci analysis can provide a Forex trader with profitable entry points.  Assume a trader has discovered a strong upward trend in the EUR/USD, but doesn’t want to buy at the highest point on the trend.  Fibonacci analysis suggests the price could retrace a portion of the upward move – either by 38.2%, 50% or 61.8% - before resuming the uptrend.  The trend trader looking to join the trend, but at a good price, could buy the EUR/USD when it pulls back to any of the Fibonacci retracement levels – 38.2, 50, or 61.8%.  For this method of trading, Fibonacci analysis suggests that if the uptrend retraces by 75%, the probability of the uptrend continuing is very low.  Therefore, when buying into the trend at the 38.2, 50, and 61.8 levels, a logical level to place a Stop Loss order is just below the 75% retracement price.

Taking Profits

Fibonacci retracements help a Forex trader pick the best prices to exit a profitable trade.  Suppose a trader has determined a recent uptrend in the GBP/USD is ending and initiates a short position.  The trader expects the GBP/USD to go lower – but how much lower?  Using Fibonacci analysis one could expect prices to fall to levels equal to 38.2, 50, or 61.8% retracements of the exhausted uptrend.  Sure, prices could fall even lower, but Fibonacci analysis and probability suggests it’s more likely prices fall to one of these levels and then go turn around and go up!  Taking profits on 1/3 of the total short position at each of these levels – 38.2, 50, and 61.8% - can be a very profitable strategy.

Recent Example

On April 5th, 2009 the EUR/USD was at a high price of 1.3582.  Over the next four days it fell almost 500 points to 1.3087.  There was still evidence to suggest the downtrend could continue lower over the long-term; however, initiating a short position after a drop of 500 points in four days would not be considered a favorable entry point.  Instead, a trader with a bearish view of the EUR/USD would want to wait for a retracement of the significant down move.

This retracement actually happened and on April 13th the EUR/USD topped out at 1.3390 – exactly 3 points shy of the 61.8% retracement of the recent downtrend (top green line = 61.8% level).  This was our opportunity to initiate a short trade and join the downtrend!  Over the next seven days, the EUR/USD not only fell back down to its recent low of 1.3087, but kept moving lower to 1.2887 on April 20th.

Fibonacci retracement chart

By placing a short trade at the 61.8% retracement and taking profits a week later, we earned a total of 503 points!

Why We Made Money

There’s no debating that the EUR/USD resumed its strong downtrend after retracing to exactly the 61.8% Fibonacci level – it’s clearly seen on the chart.  What can be debated is why it did this – was it:

  1. The Fibonacci Retracement level of 61.8% is just a “magical” number?
  2. Thousands of traders, just like me, were waiting for the price to retrace to this level before initiating a short position?  And when it did retrace, we all sold short and pressured the downtrend to resume…

Again, the philosophy student will attempt to answer this question.  The Forex trader just recognizes the value of Fibonacci analysis and uses it to make money!