Doing The Fibonacci

Hello and welcome to another edition of the bulls vs the bears.  Today we are going to be  do the Fibonacci.  Please if you’re thinking we’re going to learn the latest hip hop dance  you’re at the wrong address. We’re going to learn how to use a very famous  forex indicator called the Fibonacci.

Remember when I mentioned the Fibonacci tool in   my post “How To Calculate Risk Reward Ratio Without Blowing Your Forex Trading Account?” Well  we are going to do an in depth study on this indicator. Now I’m not a huge fan of indicators. They’re  really not part of my trading menu.  But I will make an exception  because it’s quite popular among But the Fibonacci comes highly recommended among traders because of its usefulness in analysis such us support / resistance, risk/ratio, stop losses,  retracement, e.t.c

So here is what we are going to do. I’ll give you the definition, give you the background to Fibonacci and then show you two instances by which you can use the fibonacci rule.

What exactly  is the Fibonacci Indicator?

Well Fibonacci the Fibonacci indicator  uses retracement  to define areas of support and resistance on the charts. You basically use the Fibonacci to draw static horizontal lines to determine where possible support and resistance levels will occur. Now the fibonacci tool was name after a famous Italian Mathematician called Leonardo Fibonacci. He basically had a flash bulb moment when he stumbled on a series of numbers describing the natural arrangement of things in our universe.

Now how did he derive these numbers? He started with 0 followed by 1 and then he added 0+1 to get the third number 1. Fibonacci added the third number(1+1) to get 2 and then the third number and so on. So   you have ratios  in the following sequence:0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144….  Don’t scratch your head about manually calculating these numbers. Your  MT4 software does all the leg work. The most important thing is understanding  the workings behind the the Fibonacci tool.

Speaking of which, the only ratios you need to know for the Fibonnaci are as follows:

Fibonacci Retracement Levels

0.236, 0.382, 0.500, 0.618, 0.764

Fibonacci Extension Levels

0, 0.382, 0.618, 1.000, 1.382, 1.618.

There is one little catch though. In order to apply the Fibonacci  indicator  you need to know how to  identify swing high and swing low points.  In case you’ve forgotten, a swing high is a candlestick with two lower highs on its left and right. While a swing low is a candlestick with two higher lows on its left and right.  For more information on swing points look up Do A Little Swing Trading.

I guess the burning question  on everybody’s mind is:

How Do We Use Fibonacci Retracement To Enter A Trade?

Before you consider kicking the the Fibonacci tool into  action, there is one thing you need to understand about the Fibonacci. And that is, the Fibonacci only works when there is a strong trend in the works. If the bulls are in action you go long(or buy) at the retracement level at a Fibonacci support level. But when the bears take over, you do the complete opposite. You go short(or sell) on a retracement at a Fibonacci resistance level.

Fibonacci retracement levels are quite useful to the trader. Their job is to attempt to predict where price will hit in the future. You could say they play a prophetic role. Some of you are probably wondering”What’s the theory behind the workings of the retracement levels?”  Well, the secret is whenever either the bulls or the bears start a new trend  price will retrace or pull pack to a previous level before continuing on their journey.

I guess the next question  we have to answer is

How Do we Find The Fibonacci Retracement Levels?

Like I alluded to earlier, you need to locate the latest swing highs and swing lows. If you see the bears in action click on the Swing High in your MT4 chart and drag your cursor to the most recent Swing Low. But if you happen to spot the bulls  click on the Swing Low and drag the cursor to the most recent Swing High. Let’s take a look a look at how to make those retracement levels work on the forex markets, starting with the uptrend

Daily chart of AUD/USD with Fibonacci retracement levels

Ladies and gentlemen, This is a daily chart for the AUD?USD pair in the uptrend. The horizontal and diagonal lines  represent  retracements levels of the Fibonacci indicator.  Look out for .6695 close to the .7000 line. As you can  see you plot Fibonacci retracement levels  by clicking on the Swing Low at .6995 on April 20  and then drag the cursor to the Swing High at .8264 on June 3. This creates a diagonal  line right across the chart.

Voila! your software then calculates  the retracement levels like clockwork.  You don’t need to pull your hair out doing any weird calculations. Oh! by the way the faded numbers next to the shaded areas on the shaded areas in the far right corner are the retracement levels.

Let me break this further down in simple English. IF the AUD/USD pair pulls back from a new high  one of the retracements levels will provide support as the pair look for a landing spot. Why? because  traders will be placing their buy orders at the retracement levels as price does its pullback.

Now let’s see what happens with the Swing High

Fibonacci Retracement: 38.2% Fib level held as support

Well we see that price retraced to the 23.6 level and continued with its slalom run  for the next few weeks.  See how it tried to breach the 38.2 level but failed to close the deal. See how price resumed its bullish run on July 14th and eventually breached the Swing High. It’s pretty obvious that putting in a buy at the 38.2 level would have been profitable long term.

Now let’s look at retracement levels in the downtrend using the 4 hr chart of the EUR/ USD pair.

4-hour chart of EUR/USD with Fibonacci retracement levels

Look at the Swing High at 1.4195 and the Swing Low at 1.3854.  The shaded areas in the far right corner are the retracement levels. What’s the expectation here? That  if price retraces from this Swing Low, it could run into resistance at one one of the resistance levels. This is because traders wanting to trade the downtrend may want to put their sell orders  at that level.

So what happens next?

Fibonacci Retracement: 50.0% Fib level held as resistance

Something interesting is happening here. First price mounts a daring rally, and then gets stopped  in its tracks below the 38.2 level, before trying to breach the 50% level. If you place your sell orders at the 38.2 or 50% level you stand the chance of making some ridiculous profits.

Now what did  we learn about price from these two examples? Price run into into brief support or resistance at Fibonnaci retracement levels. Now if most traders believe a retrace will occur at a Fibonacci level and are anticipating price to touch that level, then all those pending orders will have a major influence on price.

 

That’s a wrap for ” Doing The Fibonacci ”. Next week we’ll find out  what happens when retracement levels do a 360 on you.

Till next time take care.

Opening Of Live  Forex Trading Account

If you’re looking to open a live trading account sign up with EasyMarkets.

Advertisements