Fibonacci Trading &8211; How To Use Fibonacci in Forex Trading
Fibonacci trading is becoming more popular, because traders have learned that Forex and stock markets react to the Fibonacci numbers.
Fibonacci is the sequence of numbers discovered by Leonardo Fibonacci, an Italian mathematician: 0, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987, 1597, 2584, 4181, 6765, 10946, 17711, 28657, 46368, 75025, 121393 &8230;&8230;.
Fibonacci numbers start from zero, and then 1 after that. The third number is calculated through adding 0+1 that are the first and the second numbers. The fourth number (3) is the second plus the third numbers (1+2). And so on&8230;
Looks easy, right?
Now if you calculate the ratio of each number to the next one, you will have the Fibonacci Ratios that are the same numbers (levels) we use in our Forex or stock market technical analysis: 0.236, 0.382, 0.500, 0.618, 0.764 &8230;&8230;.
To use these numbers in technical analysis you don&8217;t have to make any calculations and you don&8217;t even have to memorize them, because all trading platforms allow you to draw the Fibonacci levels and they have everything ready to use.
The only thing you should know is how to use the Fibonacci levels to analyze the price chart and find the next price destination.
Fibonacci trading means to know when and where market reverses or keeps on following the same direction. The most important thing in Fibonacci trading is that the Fibonacci levels act as support and resistance levels. When the price goes up, they act as resistance levels and visa versa. Also like regular support and resistance lines, when a Fibonacci level is broken as a resistance, it can act as a support and be retested. It is the same as when a Fibonacci level becomes broken as a support. It will act as a resistance then.
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Why the Price Reacts to the Fibonacci Levels on Different Markets?
The answer is &8220;we don&8217;t know&8221;. The only thing we know is that Fibonacci numbers work in everything from the microscopic materials like DNA molecule to the distance between our eyes, ears, hands, even the distance of the planets in the solar system and the way they move in the space, even the distance and pathway of the stars in the universe, and finally in currencies&8217; prices and the way they move up and down. Fibonacci numbers can be found in everything in the world. Nobody knows why Fibonacci numbers have such a feature.
I think you have already seen the below painting by Leonardo Da Vinci (he is another Italian scientist and physician). If you draw Fibonacci levels on it (like what I did), you will see how Fibonacci numbers, specially the 0.618, work. They say 0.618 ratio can be seen in everything in our body in internal and external organs.
How to Use the Fibonacci Numbers in Forex Trading?
Fibonacci trading is not complicated. By using the Fibonacci numbers on the charts, you can find more supports and resistances. It will be a big help to choose the right direction and avoid taking the wrong positions. They are also so helpful in setting the stop loss and target orders.
To use the Fibonacci numbers on the charts, you have to find the top and the bottom of the previous trend. When the previous trend is a downtrend, you draw the Fibonacci levels from top to bottom and extend the lines in the way that they cover the next completing and ongoing trend. When the previous trend is an uptrend, you draw the Fibonacci levels from bottom to top and extend the lines in the way that they cover the next completing trend.
You have to wait for the trend to become matured. You can not plot the Fibonacci levels while the trend is not matured. When you can not find a completed trend in a time frame, you have to look for one in a smaller or bigger time frame in the same currency pair or stock.
For example, on the below chart I plotted the Fibonacci levels from the beginning of an uptrend that was started on 16 Aug 2007 to the end of it that was on 23 Nov 2007. I plotted the levels from bottom to top.
Now let&8217;s see how Fibonacci levels worked as support and resistance levels in the next trend. Please follow the red numbers on the below chart:
1. The price that started going down on 23 Nov 2007, touched the 23.60% level on 5 Dec 2007. This level worked as a support, and so the price went up as soon as it touched the level, but then went down to retest the 23.60% level.
As you know, usually when the price cannot break a support or resistance, it tries again and again and sometimes it can succeed to break out of the level.
2. So the price went up, but tried to test the 23.60% level eight days later on 14 Dec 2007 and succeeded to break below the 23.60% level this time, and then it went down.
3. The price tested the 38.20% level on 17 Dec 2007 and tried to break below it for five days, but failed and so started going up on 23 Dec 2007. It touched the 23.60% level when it was going up and it could break above it on 27 Dec 2007.
4. On 31 Dec 2007 it went down to retest the 23.60% as a support. On 2 Jan 2008 it failed and went up.
5. Currently (17 Jan 2008) it is retesting the 23.60% level once again as a support, and if this time it breaks the 23.60% level, it will go down. If not, it will go up, or sideways.
Let&8217;s look at another example. Please follow the red numbers on the below chart:
A big downtrend on the GBP/JPY daily chart started on 22 July 2007 and ended on 17 Aug 2007. So I plotted the Fibonacci levels from the top to the bottom (from 22 July 2007 to 17 Aug 2007).
1. While going up, the price tested the 23.60% level on 20 Aug 2007 and broke above it easily, but on the next day it went down to retest the 23.60% level as a support. It could not break below, and so the price went up.
2. The price didn&8217;t show any reaction to the 38.20% level as a resistance and went up, but was stopped by the 50% level on 26 Aug 2007. From 26 Aug to 1 Oct 2007, price went up and down between the 23.60% and 50% levels. During this period of time, the 38.20% level worked as support and resistance several times and it seems that the price was rotating around the 38.20% level. It made a consolidation around the 38.20% level.
3. The 50% level was broken finally on 1 Oct 2007 and the price went up.
4. It had a hard time in breaking the 61.80% level. It tried for ten days from 5 to 16 Oct 2007 to break the 61.80% level, but failed and bounced down.
5. While going down, it passed through the 50% level without any problems, but it was stopped by the 38.20% level that acted as support on 22 Oct 2007. It went up on 23 Oct, tested the 50% level, went down on 24 Oct and then tested the 50% on 29 Oct and broke above it.
6. On 31 Oct 2007, it reached the 61.80% once again and tried for several days but failed again, went down and made a double top. The price went much lower after it failed to break above the 61.80% level.
7. On 9 Nov 2007 it broke below the 38.20% level and made a consolidation around the 23.60% level. Like the 61.80% level, the 23.60% level acted as support and resistance several times and a consolidation was formed around it.
As you know, consolidations including, triangles, wedges, pennants and channels are continuation patterns. It means the price usually follows the same direction that it was following before the consolidation forms.
8. Finally it went down and broke below the 0.00% level on 2 Jan 2008.
As you saw above, the price really reacts to the Fibonacci levels.
Why do Fibonacci levels have such a strong impact on the markets. Why does the price become stopped sometimes for several days below or above the Fibonacci levels?
Of course if you use the Fibonacci levels in the bigger time frames like weekly and monthly charts, you will see that sometimes the price becomes stopped by one of the Fibonacci levels for several weeks or months.
The answer of the above questions has no impact on our trading. I mean whether you know the reason or not, you can use Fibonacci levels in your trades. I know most of you don&8217;t care about the answer, but some of you are eager to know.
Fibonacci numbers are used in the formation of humans body, from the genes (DNA molecule) to the internal and external organs. So they should be effective in their behaviors too.
Prices go up and down because of the behavior of traders: Buying and Selling >>> Bulls and Bears
Therefore, it is not surprising to see that markets react to Fibonacci levels.
What Time Frame Is Better for Using the Fibonacci Levels?
It depends on your trading system. You can use Fibonacci levels in all time frames. When you use them on the bigger time frames like daily, the result will be applicable for the next several days, weeks and even months and when you use them on smaller time frames like 5 minutes, the result can be applicable only for few hours because the price will leave the Fibonacci levels area very soon (it is not recommended to trade the shorter time frames, because they are not that stable and reliable and you will make a lot of mistakes because you don&8217;t have enough time when trading the shorter time frames.)
You Plotted the Fibonacci Levels on Your Chart. What Next?
Fibonacci trading is using the Fibonacci levels as support and resistance levels and taking proper positions based on them. As I already explained, Fibonacci levels act as support and resistance levels.
So when the price is going up and you have already taken a long position (you have bought), you should be careful when the price becomes close to one of the Fibonacci levels. It is possible that it goes down and you lose the profit you have already made. So you have to move your stop loss to the open price of the first candlestick that is touching the Fibonacci level or a little higher. It depends on the length of the candlestick.
If you&8217;ve made enough profit, you can close your position and wait for the price to break the Fibonacci levels or fail and go down. You can take a new position then.
It is the same as when the price is going down, but in this case Fibonacci levels act as support.
Also keep in mind that when one of the Fibonacci levels is broken, the price usually pullback to retest. If you get ready for all these possibilities, you will not be trapped.
You have to treat the Fibonacci levels as the real support and resistance levels. They really have no difference and sometimes the price reacts to them very strongly.
More About Using Fibonacci in Forex Trading
Fibonacci numbers really work in forex trading because they reflect the psychology of the traders. Trading forex or stocks is all about knowing the psychology of the traders: When most traders sell, the price goes down and when they buy, the price goes up.
How can we know when traders decide to buy or sell? Fibonacci numbers are one of the tools that reflect what traders may have in their minds.
One of the most important problems of the traders is that they really don&8217;t know where to plot the Fibonacci levels. They can not find the start and the stop points for plotting the Fibonacci levels. They choose the wrong points to plot the Fibonacci levels and this causes them to make mistakes.
1. Ranging or Sideways Markets
One of the best places to plot the Fibonacci levels, is the resistance and support of the ranging markets. When the market is slow and in fact is in an indecision situation that means the traders are waiting for each others&8217; action and nobody wants to take risks before the others, the price fluctuation will become very small and the price goes up and down inside a range. We can see the ranging or sideways markets on all different time frames.
A range, long or short, will be broken finally because the market cannot stay in an indecision situation forever. A range can be broken down or up, and this is what we want to know to take our positions and follow the markets.
If you are a Fibonacci trader, all you need is finding a range on one of the time frames and then finding the high and low of the range. Let me show you some examples.
Please follow the notes on the image below as you are reading these explanations. The below chart is the GBP/USD daily chart. GBP/USD started moving sideways almost from 2008.01.22. The distance between high and low of this range was over 1000 pips. It was still tradable but obviously the market was not trending. Almost on January 2008, we could not guess that we are at the beginning of ranging market, but when the price went down on 2008.02.20 and retested the same support line at 1.9329 and then started going up again, we learned that we had a strong support at 1.9329 that could be the low of a range. Then, when the price went up and made a high at 2.0392 on 2008.03.14, and then went down and retested the 1.9329 support for the third time on 2008.05.14, it assured the traders that a ranging market was formed. On a ranging market, chart patterns like triangle, wedge or even head and shoulders can form.
If the price breaks above the range, an uptrend will form, and visa versa. On the below chart, the price tested the 1.9329 support on 2008.05.14, it went up again but couldn&8217;t reach the 2.0392 resistance and made a lower high at 2.0157 on 2008.07.15. When the price makes a lower high it means bulls (buyers) don&8217;t have enough power to take the price up and make it reach the previous high it already reached. So, this can be considered as a signal that the range would be broken down. However, we should always wait for a real breakout:
Almost all of the signs (higher lows) tell us that the range should be broken down. We have to wait until the breakout occurs. We don&8217;t have to guess or predict anything. When the support of the range is broken, we can go short and when the resistance is broken, we can go long.
The signals indicated that the price would break below the range. Therefore, I plotted the Fibonacci levels from the low of the range to the top. So, the 0.0 level was placed at the high of the range and the 100.0 level was placed at the low. Also, all other 161.80, 261.80 and 423.60 levels were placed below the range. These numbers are called the Fibonacci Extensions:
If the price had broken above the range, then we would have to plot the Fibonacci levels from top of the range to the bottom, and so the 161.80, 261.80 and 423.60 levels would be placed above the range.
Now let&8217;s zoom out and analyze the chart in more details. Please follow the below chart.
The 2008.08.08 candlestick tells us that the price has broken below the range because it is closed below the range support. We could go short at the close of this candlestick if we were not already short after the formation of the 2008.07.15 lower high. Our target would be the 161.80 level. The stop loss has to be placed above the open of this candlestick.
When the price breakouts out of a range, the 161.80 level is the guaranteed target level that in 95% of the cases will be reached by the price. If the breakout is strong enough, the 261.80 and even the 423.60 will be reached too. Among the Fibonacci retracement levels or the levels that are placed between zero and 100, the 23.60 and 38.20 are the most important ones and as you can see the 2008.07.15 lower high is formed exactly below the 23.60 level. Before this lower high, we have a smaller lower high which is formed below the 38.20 level (the red arrow). Do you see how exactly and precisely the Fibonacci levels work?
So we could go short at the close of 2008.08.08 candlestick and your target could be the 161.80 level.
Let&8217;s take a look at the next part of the chart. As you see (the below image) when the price reached the 261.60, it went up to retest the 161.80 level (follow the numbers &8211; 1). It is time to emphasize on the importance of 161.80 level. This level works as a very strong support/resistance. When breaks below or above this level, it usually retest the level in 95% of the cases. On the below chart, the price goes up and retests the 161.80 level (2) and then goes down. You could go short again here, set the target at 261.80 and the stop loss above the 161.80 levels.
Again when the price broke down the 261.80, it went up and retested this level, but the 2008.10.20 candle indicated that it would keep on going down again. Why the 2008.10.20 candle? Because it is a bearish candlestick that closed below the low and the close of the last 5 candles. It also has covered the whole bodies and shadows of the last three candles and have formed a bearish pattern which is called Dark Cloud Cover.
This downtrend could be traded differently as well. You could wait for the price to break below the range support. Then you had to wait for the price to start going up and make the first correction, flag or consolidation. Then when it started following the downtrend to go down once again, you could go short. Take a look at the below image and you will know what I mean. I am now talking about the Elliott Waves. What I am trying to say is trading the second Elliott Wave which is the best one.
2. Trading the Second Wave after the Range Breakout
Please follow the numbers on the below chart. The below chart is the same chart above but with a different way of trading.
In many cases, a trend will be started when a range becomes broken (As you saw above). As I said ranging means indecision. When we have a ranging market, it means traders are waiting for each other to take the risk. They want the price to start moving and then take the proper position. They don&8217;t want to take any risk before the others. When the market breaks out of the range (1 in the below image), the traders who have been waiting for the market to move and break the range, follow the newly started trend and take the proper position (short position in this case) and this will provide more fuel for the price to follow the breakout direction (to go down in this case).
Then after a while that the market keeps on moving, some traders decide to close their positions and collect their profit, and so the price starts moving to the other direction (2 in the above image). But there are also a lot of other traders who keep their positions and wait for the price to start moving to the direction of the breakout again. These traders will add to their positions, and at the same time, some other traders who are late, will come and see the trend and take the proper position. So the price starts moving to the direction of the trend again (3 in the above image). This is where most traders take their positions, because they believe that the trend is confirmed only when the price starts following the breakout direction once again.
When the price starts following the breakout direction, it is the beginning of the second Elliott Wave which has the biggest movement and is the best to trade. Some professional traders only trade the second wave. At the above image, the second wave is started at 3 and is finished at 8.
Learn more about the Elliott Waves: Elliott Wave Analysis For Beginners
Fibonacci levels are the best tools to show us the waves and our entry and exit points:
1. Wait for the range breakout (1).
2. Wait for the price to start moving against the breakout (2).
3. Wait for the price to start following the breakout direction again (3) and take the proper position (short position in this case) and set the target to the first low support line (4) and set the stop above the 0.0 level.
4. Wait for the price to break below the first low support line (4).
5. If it doesn&8217;t do that, then close your position and wait for the price to follow the trend direction again.
6. If it breaks below the first low support line (4), but goes up to retest the broken support (5), then close your position and wait for the price to follow the trend direction again.
7. If it doesn&8217;t break above the broken support and starts following the trend direction again (5 and 6), then take the proper position again (short position in this case) and set the 161.80 level as the target.
8. If it breaks below the 161.80 level (7), then hold your position, or if you have already closed it, take it again and set the target to 261.80 level (8).
9. Wait for the price to retest the 161.80 (9) and when it fails to break the 161.80 and starts following the trend direction again, take the position (short position in this case) and set the target to 261.80 again.
10. It is possible that it breaks the 261.80 level but retests it (11, 12 and 13). If you see the trend is strong enough to move toward the 423.60 level, take the proper position (short position in this case) and set the target to 423.60 and place the stop loss above the 261.80 level.
Your main profit could be made by trading the second wave (3 to 8), and some traders do not take any position after that because in most cases the market becomes choppy after the second wave.
Fibonacci Retracement Levels and Daily Candlesticks
Markets really react to the Fibonacci levels, no matter what time frame or currency market it is.
Some of the Fibonacci numbers are more important for Forex traders. Indeed, 0.618, 61.80, 161.80 and 261.80 are the ones that work for us. 23.60 and 38.20 are also important but not as the 0.618 derivatives. I am going to show you some examples this week.
The 2015.02.18 candlestick on GBP/CAD daily chart formed a strong continuation signal above Bollinger Middle Band. Some traders are used to set pending orders above the high price of a candlestick like 2015.02.18 that has formed the setup. It makes sense to go long when the price breaks above the high price of the candlestick that has formed a long trade setup. But the question is where you should set the stop loss and target orders?
It is where you can use the Fibonacci Retracement Levels. Candlestick 1 on the below chart is the one that broke above the high price of 2015.02.18 candlestick. But as you see it was stopped by 161.80% level. A little below this levels is where you set your first target. You can close the first position here and then move the stop loss of the other positions to breakeven when the price reaches this level.
61.80% level is where you should set your stop loss. However, it is a little risky and usually markets retest/test this level. 38.20% level is a safer place for the stop loss. Of course, as I mentioned above, you can move the stop loss to breakeven when price reaches the 161.80% level. In the below examples, you would be out by candlestick 2.
I forgot to tell you how to plot the Fibonacci Levels based on the 2015.02.18 candlestick that has formed the trade setup. You should plot it from the candlestick&8217;s high to low price, from top to bottom, so that the 161.80% and 261.80% levels be placed above. In case of short positions it will be the opposite.
Candlesticks 2014.10.12 and 2014.10.19 formed a too strong long trade setup on GBP/JPY weekly chart. GBP/JPY went up strongly for over 1670 pips:
Now let&8217;s analyze the above movement using the Fibonacci Levels. I have plotted the Fibonacci Levels from the high to the low price of 2014.10.12 candlestick. Of course the long trade setup was reported when the next candlestick (2014.10.19) which is the confirmation candlestick closed. Based on the Fibonacci Levels, the stop loss had to be placed either where the 61.80% level is which is where we set the stop loss when we reported the trade setup on 2014.10.26 (see the above chart). GBP/JPY went up strongly and it didn&8217;t retest the 61.80% level. It strongly broke above 161.80% and 261.80% levels (1 and 2 on the below chart), but was stopped by 423.60% level (3). Then it went as low as 161.80% to retest this level, but it works as a support and made the price bounce up (4). Now it has broken above the 261.80% level again:
Next week can be an important week. AUD/JPY went all the way up to retest the broken support line. This week&8217;s candlestick closed right below the line. Most probably next week&8217;s candlestick will tell whether AUD/JPY will go down, or it will break above the line again and will go up:
Will AUD/JPY reach the 161.80% level?
GBP/CAD has formed a Bearish Engulfing Pattern by 2015.02.24 candlestick. It is a short trade setup, but not a too strong and 100 score one. There are some negative points with it:
- The uptrend is too strong on the daily chart. This is the most important negative point. It is risky to go short against such a bullish market.
- 2015.02.24 candlestick Bollinger Upper Band breakout is not bad, but the engulfing is not that strong itself.
It is possible that this signal takes the price down to the middle band or the 161.80% level, but I don&8217;t take it, because it looks like a high risk trade setup.
2015.02.24 candlestick has formed a too strong Bearish Engulfing Pattern on the daily chart. Although the engulfing is too strong itself, but there is a weak Bollinger Upper Band breakout, and bulls still look strong. Therefore, this is a 90-95 score short trade setup.
USD/CAD is forming a Bollinger Bands Squeeze on the daily chart. It is just the beginning. It can become much longer than this, but it can be broken very soon too:
AUD/USD has been going down strongly during the past several months. It has formed a too strong downtrend. It has already formed a small Bollinger Bands Squeeze that was broken by yesterday&8217;s candlestick. However, today&8217;s candlestick has formed a too strong bearish body and so a too strong Bearish Engulfing Pattern:
Now the question is whether this is a too strong short trade setup or not?
It is a too strong Bearish Engulfing Pattern formed on a downtrend. So, it is a good continuation trade setup. The problem is it has already touched Bollinger Middle Band and it seems it is reacting to it as a support. I prefer not to take it. If it goes down after this candlestick, then I miss the movement. If it goes up, chances are it forms another too strong short trade setup with a better conditions.
We were right about the negative points of NZD/CAD short trade setup formed by 2015.02.24 daily candlestick. However, from today&8217;s candlestick, you can say that it is possible that if forms another short trade setup soon. It is strongly possible that the next candlestick becomes bearish. You can say this from today&8217;s candlestick upper shadow. Let&8217;s see.
I will have to adjust the Fibonacci levels later.