Fibonacci Retracements - a Technical Analysis Tool Developed From the Fibonacci Number Series.
Most foreign exchange and stock traders have used at some point in their careers a technical analysis tool which is called Fibonacci Retracements. The name of the tool comes from the name of the inventor of the Fibonacci number series Leonardo Fibonacci. He was an Italian mathematician who developed the number series which traders now use to help them identify and act upon asset prices support and price resistance points. Price support points are the price levels at which an asset will have difficulty in crossing when there is a bearish trend even though the price is moving down. On the other hand price resistance points are the opposite and come into play when prices are moving up.
The Magic Numbers of Fibonacci
The Fibonacci Numbers
The first two numbers in the Fibonacci series are 0 and 1. The series then proceeds with the next number being the sum of the previous two numbers. The Fibonacci series is 0,1,1,2,3,5,8,13,21,34,55,89,144 and so on onto infinity. What is so interesting about this series of numbers is the relationship between them. It is exactly 1.618. So if we take the number 21 and multiply it by 1.618 the answer is 34 which is the next number in the series. If we now take the number 34 and divide it by the next number down in the series which is 21, the answer is 0.618 or 61.8%. If we take 34 and divide it by the second number down in the series which is 13 we get 0.382 or 38.2%. If we divide 34 by the third number down in the series we get 0.236 or 23.6%.
So now we have a series which looks like this; 0.236, 0,382, 0.500, 0.618, 0.764, and 1.000. At these levels a currency will most likely retrace before it continues on its trending course, whether the asset is in a bear trend or a bull trend.
EUR/USD Daily Chart with Fibonacci Retracement
A Simple Fibonacci Trading Strategy
If we look at the EUR/USD chart below we see that the Euro has an overall bearish trend and the price is falling from around the 1.4700 price level. The price hits the 38.2% price level and then retraces to the 50% price level before continuing its fall to the 23.6% price level. The price then retraces again back to just above the 61.8% level before falling for a second time down to the 38.2% price level. It then retraces to the 50% level before falling back to the 23.6% price level. Again the price retraces back to the 38.2% price level before it plunges down until it hits the 0% level, before correcting back up to the 38.2% level.
So how could a trader use Fibonacci as a trading strategy? Once the price of the Euro starts to drop below the 100% level the trader would take a short position and stay short even when the retracements happen. At each retracement however, as each retracement is roughly 150 pips or more in length, the trader could open a new long position, whilst keeping his original short position intact, with the certainty that the EUR/USD currency pair would probably retrace to the next price level at least before resuming its downward movement again. The trader would need to close out his long position once the retracement ends. If the trader had gone short at say the 1.4600 price level he would make 2000 pips on the short position. The six retracements would glean say 150 pips each, which is another 900 pips profit. Therefore a trader who had invested $1 million using this particular Fibonacci strategy would make an approximate profit of $290,000 which equates to a return on the investment of 20% in five months.
Trading a Fibonacci High Probability Trade
Even traders with limited experience can swiftly comprehend that it is not conceivable to be able take advantage of each market move. However, traders are nearly always watching for ways to increase the odds of manufacturing a decent trade. A permutation of Fibonacci techniques and trends can increase the probability that trades will be successful and give a strong entry and exit signal.
The awareness that there is an effective logic in using trend lines to indicate an entry to a trade and that there is likewise a effective logic to Fibonacci retracement numbers used as entry signals points to the fact that a permutation of the two affords us with a high probability trade.
How to Trade a Fibonacci High Probability Trade:
On the EUR/USD weekly chart I have drawn two trend lines (thick yellow lines) which join the highest prices or swings in an upward trend and the lowest prices or swings in the same trend.
Have you ever traded foreign currencies?
Since January 2013 the EUR/USD price has been moving up in a series of waves consisting of higher swing highs and higher swing lows. Over this period there were quite a few opportunities to enter the market and make some trades. The ideal scenario is to go long on the swing up and take our profit on the swing down. However, we never want to simply guess when we will have a swing high we want to be much more certain. So although we have swing highs on an upward trending line we still need to improve our chances of success. In all probability there are support levels near the level of the trend line and if these support levels coincide with Fibonacci retracement levels we have an excellent chance of a successful trade.
Now we need to draw Fibonacci levels on our EUR/USD weekly chart. We draw the Fibonacci levels from the lowest price to the highest price level and then look to see where Fibonacci levels cluster. This clustering shows us that at these clustered levels there are very strong support or resistance levels. The yellow horizontal line indicates the strong resistance levels along the higher highs and strong resistance levels at the higher lows.
This resistance level is very strong at the 1.3900 price level and we can see that it was very difficult for the market to move above that price. The market hits the 1.3900 price four times and is resisted. Similarly, there are strong support levels at 1.2760, 1.3000 (the 23.6% level), 1.3200 (the 38.2% level), 1.3330 (the 50% level), 1.3500 (the 61.8% level). Strong resistance levels have occurred at the 1.3000, 1.3330, 1.3500, 1.3800 and 1.3900 price levels. Most traders use weekly and daily charts to find strong support and resistance levels through the use of trend lines and Fibonacci levels as we have just seen. Therefore we need to study the chart to pinpoint exactly where our entry levels should be. We use the same EUR/USD weekly chart and as you can I have drawn red arrows to indicate where the strong entry level prices are. We go long at each entry level indicated and always make sure that we have place a stop loss for our previous long trade where the new upswing begins, except where I have placed the white arrow. Here the price has retraced all the way back to the price we went long at, therefore in order not to lose our profits we had to close out the trade. Notice how our yellow trend line acts as a support level for a few months.
If we exit all 6 trades after an upward swing of 1200 pips at the price of 1.3927, we would be making a nice profit because the second trade (2nd red arrow) makes all the 1200 pips and the subsequent trades make between 400 and 600 pips each. The observable breaking of the upward trend would definitely be our trigger to exit.