2023-12-12 08:58

Using Fibonacci levels in Forex trading

Learning how to draw and use retracement and extension Fibonacci levels in financial market trading

A famous Italian mathematician named Leonardo Fibonacci invented Fibonacci levels and ratios. This number theorist introduced various mathematical concepts we use nowadays, such as square roots, math word problems, and number ordering.

He found a series of numbers that created ratios. Ratios describe the natural fit of things in the world. Ratios are derived from the following number series: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144. This number series always starts at 0 and the second number is 1. You can obtain the third number by adding the first and second numbers (0+1). Then, you get the number 2 by adding the second and third numbers, which is the fourth number, and you can obtain the following numbers correspondingly.

We will discuss the following topics in this article:

Introduction and how to calculate Fibonacci levels

Using Fibonacci levels in entering trades

Fibonacci levels limits

Fibonacci levels

Fibonacci ratios are created by dividing one Fibonacci number by the following Fibonacci number. For example, 34 and 55 are consecutive Fibonacci numbers, and when we divide 34 by 55, we get 0.618, which is a Fibonacci ratio. These ratios are also called Fibonacci retracement. If we calculate the ratio between two numbers, one in between, the Fibonacci Extension is obtained. For example, dividing 34 by 89 equals 0.382, which is a Fibonacci extension. Below are some Fibonacci retracements and extensions.

Fibonacci retracement: 0.236, 0.382, 0.500, 0.618, 0.764, etc.

Fibonacci extension: 0, 0.382, 0.618, 1.000, 1.382, 1.618, etc.

Many theories state that when the market makes a big move in one direction, the price corrects before starting to move again. Hence, traders use Fibonacci retracement points as potential support and resistance levels. Many traders monitor these levels and use these points to enter or place a stop-loss order. Traders also use Fibonacci extension levels as take-profit areas.

Using Fibonacci retracement to enter the trade

You can use the strategy we are discussing, in the forex market and various other markets, such as stocks, commodities , and cryptocurrencies. This method is a trading strategy in the trend's direction that uses retracement movement in a trend. Fibonacci levels are vital support and resistance areas that most traders closely monitor. Further, we explain the steps of using this strategy in order:

Step 1: Identify an initial big move. We will enter a trade in price correction.

Trends help traders identify market direction and determine where the market will go. Big price movements usually indicate that the market has found its primary direction and is likely to continue in that direction. In this example, we've identified a big move in the upward direction, and we'll see how to use its correction to enter a trade. Let's use Fibonacci levels to enter the trend at the right time.

Using Fibonacci retracement to enter the trade

Step 2: Use the Fibonacci tool and draw levels on the chart

After placing the Fibonacci levels on the chart, we should wait for a price correction and see which Fibonacci levels the price hits. The most favorable conditions are when the price reverse jumps after hitting the 50% or 8.61% ratios. These ratios are also known as golden Fibonacci ratios. In the chart below, as soon as the red candlestick reaches the 8.61% level, we see the formation of an ascending candlestick.

Always ensure drawing Fib levels from the Swing Low to the Swing High in an uptrend. Likewise, in a downtrend chart, the Fib level is from the Swing High to the Swing Low.

Step 3: Enter only after confirmation

Typically, traders are taught to execute their buy order as soon as the price reaches the 8.61% level, but this is not ideal. Make trades only after candlestick confirmation appears. In the chart below, the formation of a green candle at 8.61% gives us further confirmation that the primary trend will continue after the correction. Traders can also confirm this buy signal using other technical indicators. This chart looks like this when entering the trade.

Step 4: Placing take-profit and stop-loss orders

Placing Stop-Loss and Take-Profit orders is essential to reduce risk and maximize profit. Place the stop-loss order just below the 8.61% level in this strategy. If the price breaks this level, the uptrend is invalidated, and we can expect the start of a downtrend. We can also place the take-profit order at the closest point of the uptrend's ceiling and use the floating stop-loss until reaching it. This trade's minimum risk-to-reward is 1 to 1. But since the trade is in the trend's direction, we can wait for higher risk-to-reward. The following figure shows how to set up the final trade. We can see the price movement concerning the Fibonacci levels, and the trade here went precisely as we predicted.

Why should we never depend entirely on Fibonacci levels?

Every technical level will eventually break at a certain period, and this also applies to Fibonacci levels. We previously learned that Fibonacci levels act as potential support and resistance areas. Therefore, these levels are also broken just like support and resistance levels. Hence, we must keep in mind that these levels are not error-free. In the chart below, we can see a big downward movement. So basically, here we must wait for price correction and hit Fib levels. Let's see what happens next.

Below, we see a price correction, and we put the Fib levels from top to bottom because it is a bearish trend.

Then, we can see that the price correction reaches the 8.61% level. Ideally, at this point, the price correction should stop, and the primary downtrend of the market should continue. Also, we need to make our "Sell" trade as the red confirmation candle is visible.

But, to our surprise, as shown in the chart below, the price did not respect our strategy, and the market went upward and defiled all the Fibonacci levels.

While retracement Fibonacci levels help traders often, they are not 100% like any other technical analysis tool. One can never be sure that the price will react to 50% or 8.61% or any other Fibonacci level.

Combining Fibonacci levels with other technical analysis strategies

For a comprehensive and complete analysis and a greater chance of winning, we should have a broader view of the price chart and use other techniques to confirm the signals generated by the Fibonacci levels. Here, we explained the basic concepts of using Fibonacci levels in Forex market trading. Further, we suggest more advanced combined techniques of these levels, which are:

Trading with support and resistance areas with Fibonacci levels confirmation
Trading with trend lines and candlestick patterns with Fibonacci levels confirmation
Placing accurate stop-loss and take-profit orders using Fibonacci levels

Further, we explain a summary of each strategy.

Trading with Support and Resistance Areas with Fibonacci Levels Confirmation: The general idea of buying at support levels and selling at resistance levels is interesting, but buying and selling at these levels blindly, carries high risk because there is no guarantee that these levels will do their job correctly every time. Therefore, we use Fibonacci levels to confirm the performance of these levels.

Trading with Trendlines and Candlestick Patterns with Fibonacci Levels Confirmation: trend lines and candlestick patterns are an essential and inseparable part of technical analysis. Trendlines are used primarily to identify trends, and we cannot use candlestick patterns alone, but when combined with the Fibonacci indicator, they can create trades that are most likely to win.

Placing accurate stop-loss and take-profit orders using Fibonacci levels: Many traders are confused in choosing take-profit and stop-loss points and use old techniques that weaken the trading strategy. In this strategy, we teach you how to precisely place stop-loss and take-profit orders with the help of the Fibonacci tool.

Summary

Using Fibonacci levels is not limited to those discussed above. There are many situations where these ratios and levels are used for various other reasons. For example, we use Fibonacci levels to confirm Harmonic patterns further, as well as analysis with Elliott waves. Therefore, every technical trader should know and learn how to use these levels to excel in the financial markets.