Fibonacci studies are an excellent tool for a forex trader to use because they can act as a leading indicator. If used properly, the can help you to determine when to get into a trade. More importantly, they can help you get out of a trade too.
Fib Studies do not tell you if the market is going to go up or down. You need to use lagging indications, such as moving averages, for that. However, once you have established a bullish or bearish bias, you can use Fibonacci retracements to get into a trade when price is pulling back.
The best thing about a Fibonacci study is that once you have measured a retracement and entered a trade, you will also have an estimate of how far price will extend before the next pull back. This “educated guess” is a measure of the frequency of the market’s harmonics. It’s a lot like sound waves.
Figure 1. Examples of sound waves.
If you could SEE sound, it would look like waves. Some sound waves produce peeks and valleys less frequently, such as the sound wave on the top. Others produce them more often. If you measure them, it’s predictable where the next peak or valley will be.
Here are two differences between forex and sound waves. Forex does not move from peek to valley to peak again as precisely as sound does. Also, forex spends most of its time trending, there fore the peaks and valleys are not usually sideways, but angled. Therefore, we measure the high (peak), higher low (valley) and higher high (peak) in an up trend. The opposite is true in a down trend.
Bottom line? We know forex moves in waves and we can use Fibonacci studies to measure them, however, at the end of the day, like all technical analysis they are an educated guess. Things can change and when they do, you will need to adapt or lose money. Use a stop loss, just in case your trade plan fails and ruins your perfect Fib setup.
Figure 2 lists the most common peak to valley ratios measured by Fibonacci studies. They are called Fib retracements and fib extensions.
Figure 2. Fibonacci Studies
Let’s put these Fibonacci Studies to use.
In figure 3, you can see there was a large pull back of an up trend that found support at the 78.6% line. If you had created a trade plan to go long in this area, you immediately should have been aware that the up trend had weakened significantly and that not much more than a double top was likely. Any signs of exhaustion at the 100% level should be enough for you to consider taking profit on your trade.
Rule of thumb: the greater the pull back, the less the extension.
Figure 3. 78.6 – 100% Fib Extension
Take a look at Figure 4. It is an example of an extremely bullish up trend. This is measured by the small 38.2% pull back. You should read this as a technical indication that traders are quick to buy the dips or add to their existing long position. I doubt many traders are shorting here and you should only consider going long too. Because of the Fibonacci study, you should be confident in going long until you reach the 161.8% Fibonacci extension… it could go higher… just be careful here!
Figure 4. Example of 38.2 – 161.8% Extension
Fibonacci retracements and extension occur on all time frames. I’ve seen weekly trade setups work just as well as 1 min setups. Both are completely valid. In Figure 5 you will see an example of a daily chart. This pair had been falling for months, then over a course of a week or two, it rallied. If you had an established bias to be bearish, this is exactly what you want, as you’d like to sell high, not sell low.
The 38.2% Fibonacci retracement provided a potential short entry that was about 800 pips above the lowest low at the time. Once in the short trade and the Fib retracement, your conservative profit target was 161.8% and your aggressive was 261.8%. Note that these levels were hit. However, also note how the old conservative target flipped from “support” to “resistance” on the next pull back.
Figure 5. Daily chart with a 61.8 to +161.8% extension.
Leonardo Fibonacci’s ratios are an awesome tool to apply to currency trading. I use them all the time Over the years of trading forex, I’ve found them helpful in scalp, spot, swing, position and carry trading. However, before you jump in and Fib… practice this methodology using a demo account and do NOT trade real money until you have established a track record of success.
In the video, I will show you how to apply Fibonacci Studies in the live market.
Best regards,
Wayne McDonell Commodities Trading Advisor Chief Currency Coach http://www.fxbootcamp.com
Wayne McDonell is the Chief Currency Coach at FxBootcamp.com, a live forex training organization. He is a member of the National Futures Association and registered as a Commodities Trading Advisor. His book “Strategic & Tactical FOREX Trading” (Wiley Publishing) is a best seller in the Foreign Exchange category of Amazon.com.