The Fibonacci Retracement and its relevance in FX trading, does it offer more than simply ‘mapping’ the market?
There are many aspects of FX trading that elevate us beyond our base level understanding of the usual mathematics involved. These aspects can spark the curious and creative elements which exist in all of us. The use of Fibonacci is one such creative phenomenon that, when you begin to examine and research it in more detail, offers up an exciting and different perspective on our trading.
For every ‘fan’ of ‘Fibonacci trading’ there are as many critics of using the Fibonacci retracement to attempt to plot future price. The main criticism being that what exists in nature doesn’t necessarily convert to the often random world of trading. With Fibonacci we’re suggesting that there is something; organic, natural and universal with regards to trading, of which there is little evidence of, other than curve fitting the data to match these assumptions. However, there is one unique aspect regarding Fibonacci which many new traders overlook; the relationship Fibonacci has to support and resistance and its pivot levels, arguably the cornerstone of all effective day trading strategies.
The Fib mathematical retracement levels correspond very effectively with the support and resistance areas we plot on our charts daily. And whilst we’re on the subject of which time frame we’d politely suggest that Fib, if it is to be effective, should only be plotted on the daily time frame and naturally traders should look to recalibrate the Fib every day if necessary.
Ultimately Fib is simply another tool to help us map price in any given market. In some ways it’s wrong to think in terms of “does Fibonacci work or not?” as that definition depends on how we use Fib in our overall trading strategy. Whichever Fib tool or level of retracement we use, can be made to curve fit previous results. But Fib can also offer up a fascinating prediction as to where markets may be headed after a significant move and there are precious little tools available that may (and we stress “may”) be leading indicators as opposed to lagging, therefore it’s best to use Fib in conjunction with other tools and indicators we may have become familiar and proficient with.
Fib is to a degree self-fulfilling and many traders using it at institutional level help to propagate the self-fulfilling prophesy aspect. Therefore it can be looked upon as a psychological measurement of the market – hence the significance of the 50% level which actually has no direct relevance to the Fibonacci sequence in nature. When the 50% retracement of a swing is reached the majority of traders might start to flip’ their polarity and their view of where price might be headed.
Before we go any further it’s as well that we offer up a simple explanation with regards to what Fib is and where it ‘fits in’ in relation to trading.
What is Fibonacci Retracement?
Fibonacci retracement is a method of technical analysis for determining support and resistance levels. Fibonacci retracement is based on the idea that price retraces a predictable proportion of a move, after which price will continue to move in the original direction. Fibonacci retracement is created by taking two extreme points on a chart and dividing the vertical distance by the key Fibonacci ratios. 0.0% is considered to be the start of the retracement, while 100.0% is a complete reversal to the original part of the move. Once these levels are identified, horizontal lines are then drawn and used to identify possible support and resistance levels.
Fibonacci as a concept was discovered by Leonardo Fibonacci in the 12th century. He postulated that Fib represented a proportion in the building blocks of nature. The Golden rule is the proportion of objects in a larger picture. In terms of trading Fibonacci says that out of a larger movement the price will eventually retrace a certain percentage of that larger move before then continuing in the original direction. The mean for those percentages is 61.8%, often described as the Golden Rule.
Leonardo made some fascinating discoveries with regards to the human body, for example 61.8% of the distance between your head and your feet and your belly button. An elbow rests at the 61% proportion of our total arm distance. He also made incredible discoveries regarding ferns and their growth out of the original stem fern and noted that this pattern is repeated in the petals of certain plants and fruits such as pineapples. In hives bees consist of 61% males to females.
So the important issue is if this sequence does exist in trading and it really is a big if, how can we use this information and sequence in order to trade more effectively and therefore profitably?
Can we use Fib in trading because these same proportions might exist there also?
Trading using Fibonacci
The goal is to find a large movement. Large meaning a definite high and low point because the larger the time frame the more reliable most signals and strategies are. Once we have found our high and low point draw the Fibonacci line in the direction of the movement. The indicator on our charts will automatically draw the percentages of that movement. It will draw a 50% retracement meaning that if the price retraces back to that line it has retraced 50%. There are the other purer mathematical lines and proportions which are also drawn automatically; 38.2%, 61.8%, 78.6%, retracements.
Example one
When the pair retraces to one of the percentage support lines you trade back in the original direction. If price retraces back to 38.2% retracement our bias would is to sell. We could use the retracement line as a support line.
Example two
If the retracement line breaks then it turns into a support line holding price to continue to retrace. The next retracement line is the 50% retracement. If the pair breaks through the retracement line we trade in the direction of the next retracement line. In this instance we would buy at 38.2% retracement, perhaps with a target to the 50% retracement line.
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