Fibonacci Retracement Forex Strategy: Many Forex traders have learned to use Fibonacci retracements and projections when trading. Nevertheless, not all of them realize that they are using an element of Elliott Wave Theory in the process of doing so.
In the 1940’s, R. N. Elliott enhanced his initial Wave Theory tenets to include Fibonacci numbers. He did so because he noted that the mass psychology underlying the markets’ movements displayed a tendency to repeat over time.
Basically, Elliott related this repetition to an important sequence of numbers that the mathematician Bigollo, also known as Fibonacci, tied to the reproductive increase of a theoretical population of rabbits.
The History of the Fibonacci sequence and How to Generate It
The well-known Fibonacci Sequence was originally derived from a hypothetical question involving rabbit reproduction that was posed by Leonardo Pisano Bigollo, an Italian who was also known as Fibonacci. He did so in the book entitled Liber Abaci which he published in the early 1,200s.
Basically, to generate the Fibonacci sequence, you can follow these steps:
- Start with a pair of immature rabbits, one male and one female.
- Then you wait one month before breeding them.
- Then you wait one month for them to have a pair of babies – one girl and one boy.
- Then you wait one month when the original pair have babies, but their babies do not.
- Then you wait one month when the original pair have babies, and so do their first set of babies, but not their second set.
- Repeat the process over and over and over again until you get tired.
- Assume that no rabbits die.
- Count how many pairs of rabbits there are at the end of each month.
- Steps (1) and (2) will generate the first two numbers in the Fibonacci sequence, which are 1 and 1.
- Step (3) will generate the next number, which is 2 (one original pair and one pair of baby rabbits of the opposite sex).
- Step (4) will generate the next number, which is 3 (one original pair, their first pair of babies, and a second pair of babies from the original pair).
- Step (5) will generate the next number, which is 5 (one original pair, their first pair of babies, their second pair of babies, and a new pair of babies from the original pair and the first pair of babies.)
And so on…
Eventually you might note an important short cut, which is that you can simply compute the current number of rabbit pairs by adding together the previous two numbers. This generates the infinite Fibonacci sequence as follows:
1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144…
How to Use Fibonacci Retracement to Enter a Forex Trade
The first thing you should know about the Fibonacci tool is that it works best when the forex market is trending.
The idea is to go long (or buy) on a retracement at a Fibonacci support level when the market is trending up, and to go short (or sell) on a retracement at a Fibonacci resistance level when the market is trending down.
Finding Fibonacci Retracement Levels
In order to find these Fibonacci retracement levels, you have to find the recent significant Swing Highs and Swings Lows. Then, for downtrends, click on the Swing High and drag the cursor to the most recent Swing Low.
For uptrends, do the opposite. Click on the Swing Low and drag the cursor to the most recent Swing High.
Got that? Now, let’s take a look at some examples on how to apply Fibonacci retracements levels to the currency markets.
This is a daily chart of AUD/USD.
Here we plotted the Fibonacci retracement levels by clicking on the Swing Low at .6955 on April 20 and dragging the cursor to the Swing High at .8264 on June 3. Tada! The software magically shows you the retracement levels.
As you can see from the chart, the Fibonacci retracement levels were .7955 (23.6%), .7764 (38.2%), .7609 (50.0%), .7454 (61.8%), and .7263 (76.4%).
Now, the expectation is that if AUD/USD retraces from the recent high, it will find support at one of those Fibonacci retracement levels because traders will be placing buy orders at these levels as price pulls back.
Now, let’s look at what happened after the Swing High occurred.
Price pulled back right through the 23.6% level and continued to shoot down over the next couple of weeks. It even tested the 38.2% level but was unable to close below it.
Later on, around July 14, the market resumed its upward move and eventually broke through the swing high. Clearly, buying at the 38.2% Fibonacci level would have been a profitable long term trade!
Now, let’s see how we would use the Fibonacci retracement tool during a downtrend. Below is a 4-hour chart of EUR/USD.
As you can see, we found our Swing High at 1.4195 on January 25 and our Swing Low at 1.3854 a few days later on February 1. The retracement levels are 1.3933 (23.6%), 1.3983 (38.2%), 1.4023 (50.0%), 1.4064 (61.8%) and 1.4114 (76.4%).
The expectation for a downtrend is that if price retraces from this low, it could possibly encounter resistance at one of the Fibonacci levels because traders who want to play the downtrend at better prices may be ready with sell orders there.
Let’s take a look at what happened next.
Yowza, isn’t that a thing of beauty?!
The market did try to rally, stalled below the 38.2% level for a bit before testing the 50.0% level. If you had some orders either at the 38.2% or 50.0% levels, you would’ve made some mad pips on that trade.
In these two examples, we see that price found some temporary forex support or resistance at Fibonacci retracement levels. Because of all the people who use the Fibonacci tool, those levels become self-fulfilling support and resistance levels.
The bottom Line: Fibonacci Retracement Forex Strategy
One thing you should take note of is that price won’t always bounce from these levels. They should be looked at as areas of interest, or as Cyclopip likes to call them, “KILL ZONES!” We’ll teach you more about that later on.
For now, there’s something you should always remember about using the Fibonacci tool and it’s that they are not always simple to use! If they were that simple, traders would always place their orders at Fibonacci retracement levels and the markets would trend forever.
Please note that: Successful Technical Analysis largely depends on the functionalities of the MT4 Platform provided by your broker. If you are new in forex trading, you might consider reading the article on what is the best trading platform, Introduction to MT4 Platform and MT4 Platform functions. We have used a fully functional MT4 platform provided by HYCM Broker. Read why their MT4 platform has better trading conditions from the HYCM Broker review.
Technical Analysis in Forex Trading
|Lesson 1||Types of Technical Analysis Indicators|
|Lesson 2||Forex Trading Trendline Analysis|
|Lesson 3||Forex trading Chart Patterns|
|Lesson 3.2||Double Tops and Double Bottoms|
|Lesson 3.3||Head and Shoulders Pattern|
|Lesson 3.4||Rectangle Chart Patterns|
|Lesson 3.5||Triangle Chart Patterns|
|Lesson 4||Japanese candlestick Trading Strategy|
|Lesson 4.2||Japanese candlestick Trading Strategy Part 2|
|Lesson 5||Support and Resistance Levels|
|Lesson 6||Types of Technical Analysis Indicators|
|Lesson 6.2||moving averages Technical Analysis|
|Lesson 6.3||MACD Indicator Technical Analysis|
|Lesson 6.4||RSI Indicator Technical Analysis|
|Lesson 6.5||Stochastics Indicator Technical Analysis|
|Lesson 6.6||Technical Analysis with Bollinger bands Indicator|
|Lesson 7||Fibonacci Retracement Forex Strategy|
|Lesson 8||Forex Trading Pivot Strategies|