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There are plenty of resources about using Fibonacci ratios on the Internet that are aimed at advanced and professional traders. However, since we will be making an introduction to beginner traders, it is worth taking a look at what Fibonacci ratios are before we move on to the practical application of using Fibonacci ratios in (forex) trading.
Fibonacci ratios come from the Fibonacci sequence, which is a well-known integer sequence in mathematics. The sequence goes like the following:
1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, ... and so forth.
This particular sequence of numbers has a unique feature. Starting with number 2, each number is the sum of the previous two numbers in the Fibonacci sequence. For example, 21 is the sum of 8 and 13, or 5 is the sum of 2 and 3.
Although an Italian mathematician named Leonardo of Pisa, who was known as Fibonacci, introduced this sequence to the Western mathematics, it was well known to Indian and Arabic people for a long time.
The reason Fibonacci sequence is so important in trading because the ratio is found in mother nature very often. From fruit sprouts of a pineapple to sunflowers, many plants in nature follow the Fibonacci sequence to grow.
When we observe a price chart of almost any assets, often or not, the price patterns also closely follow this natural sequence, which is known as a Fibonacci ratio.
Regardless, it is important to remember that there is no evidence that the price has any correlation to the Fibonacci ratio or the Golden Ratio. Sometimes the price retraces to 68.2% Fibonacci ratio, at times it retraces to 38.2%, or goes all the way to 100%!
Since a lot of professional and institutional traders watch these Fibonacci retracement levels on their charts too, often they place large pending orders around these levels. As a result, when the price comes near Fibonacci retracement levels, it naturally either reverses or accelerates the prevailing trend.
Keep in mind that there is no special power of Fibonacci ratios, these levels just act as glorified self-fulfilling prophecies in trading.
The most popular charting software includes several Fibonacci tools to draw retracement, expansion, and extension levels. In MetaTrader 4, these tools can be found under Menu > Insert > Fibonacci.
Once you accurately draw Fibonacci retracement levels on a price chart, it would look similar to figure 1, and these levels can then be used as potential support and resistance levels.
Figure 1: Fibonacci Retracement Level Acts as Support During an Uptrend
In our example in figure 1, you can see we have dragged the Fibonacci retracement tool from the lowest swing point of the new uptrend to the highest, and it created some of the common Fibonacci levels, the 23.6%, 38.2%, and the 61.8%. Although MetaTrader 4 adds the 50% level, it is not a Fibonacci sequence, but you should keep it on the chart as it also acts as a pivot zone during mild retracements.
As you can see, as soon as the price came near the 61.8% retracement level, it acted as a strong support level. As a result, the EURUSD soon resumed the uptrend.
Drawing a Fibonacci retracement level on a chart is rather easy with the provided tools, as the software will automatically calculate and draw the levels for you. All you need to do is select the Fibonacci retracement tool from the menu, click on the lowest point during an uptrend, drag it up to the highest point, then release your mouse. Similarly, during a downtrend, you should draw the Fibonacci levels from highest swing point to the lowest.
While the process of drawing Fibonacci levels is easy, you would still need to learn to identify where the high and low swing points would be, and which direction you should draw the Fibonacci retracement levels.
Most beginner traders would most probably see an uptrend and draw the levels based on the high and low of the entire chart. However, we would recommend that instead of drawing the retracement levels on the maximum and minimum points of the chart, you learn to identify smaller price swings and try to find retracement levels.
A simple way to find smaller price swing points would be using trendlines. In figure 1, as soon as the EURUSD price broke above the downtrend line, the price shoots up, then started a minor retracement.
When a trendline breaks, you could be confident that the price will soon have a retracement before resuming the original direction, which is opposite of the trendline.
Fibonacci levels allow Forex traders to project a potential support and resistance level in the future. It allows them to be prepared to act and take actions accordingly. Hence, instead of learning complicated tricks using Fibonacci levels, you should first master the concept that why a certain price level based on high and low points of a price swing can suddenly become an area of interest for traders.
Although it is tempting to place a pending buy or sell order near these levels, Fibonacci levels should never be used to trigger a trade. Instead, we strongly suggest that you use price action or other technical analysis indicator confirmation to enter the trade.
If you only place an order around the Fibonacci levels, and the price keeps going against you, all the way to 100% retracement and you have placed the stop-loss order outside it; then your risk to reward ratio for the trade would terribly low.
Instead, if you wait to see which Fibonacci level acts as a support or resistance, wait for a pin bar or outside bar to appear and place the order, then you can set a much tighter stop-loss order. As a result, your risk on the trade would be much lower.
You see, patience is one of those virtues that goes a long way in trading.