This post explains what Fibonacci retracements are and how they are forex traders use them. If you are interested in trading using Fibonacci levels, check out the next article, How to Calculate and use Fibonacci Extensions in Forex Trading.
The first section shows what Fibonacci ratios are and how to calculate them. The second section explains why traders use Fibonacci retracements and provides some examples using the EUR/USD pair. The third section is a video walkthrough showing how Fibonacci levels could have been used to help trade the GBP/AUD pair in 2012-13.
Fibonacci Numbers and Ratios
Fibonacci retracements are a method of predicting when the price may stop and reverse. They use the Fibonacci sequence which is each number is the sum of the two preceding numbers: 0,1,1,2,3,5,8,13,21,34,55,89
Fibonacci retracements use ratios based on the number sequence.
21/89 = 23.6%
34/89 = 38.2%
55/89 = 61.8%
Most trading software also includes 50% as a retracement level. This is not strictly a Fibonacci ratio but it is useful because prices have a strong tendency to retrace about half.
Some traders also use 78.6% (the square root of 61.8%). I find 78.6% a useful level because it can act as support and resistance and also because if the price gets beyond this level it will often retrace the entire move.
Why Do Traders use Fibonacci Retracements?
Traders use Fibonacci retracements to help make sense of price action. They often become support and resistance and provide opportunities to enter trades. They also provide levels for taking profits and stop-losses. Fibonacci levels can help traders quantify how significant a retracement is and help distinguish between a retracement and a new trend.
Fibonacci can be used in all markets and on all timeframes. Everyone from day traders to long-term position traders use Fibonacci levels.
Fibonacci levels work the same way as other types of support and resistance. It is important to remember that they are guidelines and the price does not always respect them. Despite the fact that prices do not always respect them, they are still useful. Often a price will crash straight through a strong support or resistance level but will subsequently go back to this area to retest it.
The below weekly chart shows a strong uptrend that was halted and saw a gradual retracement back to the 50% level. In this case, the price penetrated the 50% level on a number of occasions but was unable to close below on a weekly basis. The market was stuck for four weeks at this level before moving higher and making new highs.
The chart below shows a 38.2% retracement on the daily chart. The price is clearly in a downtrend, however, within the trend, there is a minor upward retracement to the 38.2% line before the price continues to go down. 38.2% is a relatively weak retracement and suggests that the original trend is strong. The example below would have been a good opportunity to enter short on either the failure of the price at 38.2% or as a break below 0%.
The chart below shows a 61.8% retracement on the 1-hour chart. Smaller timeframes have more noise than longer timeframes. However, they still can be successfully traded using Fibonacci retracements.
Video: Using Fibonacci Retracement Levels in Forex Trading
This video shows how Fibonacci retracements are used in forex trading. How you should place them on the chart and examples of how they have acted as support and resistance levels.