Lesson 3: Fibonacci ratios in FX trading
Fibonacci refers to a sequence of numbers. It has a wide number of Mathematical applications and can also be observed in natural phenomenon. In the financial markets, a set of fibonacci ratios are used widely to anticipate retracement (entry) and extension (exit). Fibonacci levels themselves are used as clues for support and resistance.
Fibonacci Retracement Levels
0.236, 0.382, 0.500, 0.618, 0.764
Fibonacci Extension Levels
1.382, 1.618. 2.000, 261.8
Concept of wave
In the market, price travels in a zigzag motion. This motion is caused by the action of buying and selling (including profit taking and cutting losses). Price therefore travels in a wave like motion. This wave motion can be exploited by traders to buy dips.
Lets look at the illustation:
Price moves in wave-like motion
In this example of an up trend, the wave-like motion of price can be broken down into 3 stages:
1. An intial movement
2. A retracement
3. An extension
The fibonacci rations can be used effectively by traders to anticipat:
A. How deep a retracement will dip
B. How far the extension will go
Therefore, traders driven by profit maximisation have a means to trade by buying retracement and selling extension. In a downtrend, the opposite is true. Traders will sell retracement and buy extension.
Application
Charting software are now programmed with tools to define the Fibonacci levels for both retracement and extension as long as the user is able to define the initial movement.
A typical strategy is to anticpate how far price will retrace and enter at this retracement. The profit taking exit is determined by anticipating how far price will extend beyond the initial movement.
The fibonacci levels are used only as a guide by expert traders. Thats because entry and exit signals must still be observed from price action such as detecting candlestick patterns. In addition, the fibonacci levels are only good support and resistance level when other confluence factors exist, such as the presence of other trendlines, pivot points etc.
The fibonacci levels and their application is a cornerstone of the FX Tflow® System.