Trading in general and forex trading in particular can be done from a technical and fundamental point of view. This means that traders are focusing on technical analysis in order to find out future price levels based on various patterns that formed in the past or they look at fundamental economic events in specific economies in order to interpret differences between them and speculate on their currencies.
When it comes to technical analysis, Fibonacci numbers represent a key trading tool for finding out specific levels and it uses are so widespread that there is virtually no possibility to finding important support and resistance levels without considering the Fibonacci ratios.
There are multiple Fibonacci tools offered by a trading platform and the most popular trading platform, the Metatrader, has a special button dedicated to Fibonacci.
After opening the Metatrader, on the top left screen, the third tab is the Insert tab. By clicking on it and scrolling down the Fibonacci tool appears, with no less than five different options; Retracement, TimeZones, Fan, Arcs and Expansion.
While all of them have different characteristics and applications within different trading theories, the most popular one is the Fibonacci Retracement tool.
Fibonacci Retracement is widely used to find out important support and resistance levels when price is making a strong move. In other words, after a trend has started, traders will look to buy any dips in a bullish trend or spikes in a bearish one in order to add to an initial entry or simply to enter at better places with the intention to ride the trend.
The bigger the time frame used, the stronger the support and resistance levels are. The most popular retracement level is the 61.8%, or the so-called golden ratio level as according to Fibonacci, this number has important characteristics. In trading it is the defining level for the Elliott Wave theory for example, as the whole theory is built surrounding the implications of this golden ratio retracement.
Besides the golden ratio, levels like 23.6%, 38.2% and 50% are widely used by traders as depending on the price action prior to these retracement levels and coupled with other factors (like oscillators, moving averages, etc.), each and every level represents something else for different traders.
The chart above shows the EURUSD hourly time frame (so resistance levels are not that important to the bigger picture overall) and the drop market made from around 1.11 to recent 1.10.
If one takes a Fibonacci Retracement tool and drags it from top to bottom, from the highest value to the lowest one, the retracement levels will be automatically plotted on the screen.
It is easy to see that the 61.8% is the most relevant level as market tried multiple times to overcome that area with not much of a success, while 50% and 38.2% also offered important resistance when price struggled to move higher.
As mentioned earlier, perhaps the most important use of Fibonacci retracement levels is in the Elliott Wave theory. The whole theory is built around Fibonacci numbers as for example, a flat pattern needs wave B to retrace more than 61.8% of wave A, a zigzag needs a retracement for wave B less than 61.8% of wave A, an impulsive wave is usually retraced minimum 23.6% and most of the times well into the 38.2%, not to mention the fact that everyone knows the way to look for the third wave in a five wave structure is to wait for a retracement into the 50%-61.8% of the previous move and that retracement will most likely be the end of a second wave prior to an explosive third wave.
For more details regarding Elliott Waves theory just make sure you scroll through our dedicated articles here on ForexGator.com as again, Fibonacci numbers are everywhere.
When it comes to trading, Fibonacci retracement levels are very useful for placing pending orders and it allows a trader to be disciplined and patient. Placing a pending order means one already has a trading plan and patiently waiting for price to come and fill the order requires trading discipline.
This allows for overtrading to be avoided and after all a trader wants to enter a trade where market is supposed to hesitate. These levels are always to be found around the Fibonacci numbers.
Next article here in the learning center, will deal with tips and tricks for trading with the Stochastic oscillator.