Interests often go to rather bizarre places. Some people get excited over weather forecasts, some love the craft of taxidermy and others still, a rather fond of applying the Fibonacci Principle – forex traders in particular. Those who use it seem to love it a little too much. Beginner traders feel like they have achieved something by dragging out the indicator and making a perfectly symmetrical swirl, but Fibonacci is a lot more than a pretty indicator.
A brief history of Fibonacci
Fibonacci was the moniker of Leonardo Pisano, of Pisa, where towers lean just a bit too much. In the 13th century, he wrote about a sequence of numbers that involved adding the previous two numbers in the sequence. The sequence therefore goes 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610… ad infinitum. Dividing these number by the previous numbers gives an average result of 1.618, which became known as the golden ratio. The ratio and the sequence has been found to have a surprising number of examples in nature, including the relative hand to arm size, the finger bone size ratio, tree branches, human faces and even the size of DNA. The Fibonacci spiral is effective at measuring the outgrowth of a mollusk shells and the spiral of the milky way… so pretty mysterious stuff.
Basically, this sequence of numbers seems to have an almost metaphysical quality and applicability in nature. Which might explain the almost spiritual reverence in which it is held by certain traders.
In trading, the Fibonacci retracement uses the number preceding it to create a percentage, with the golden ratio effectively becoming 61.8%. 38.2% and 23.6% are a result of dividing numbers two and three places away in the sequence from the selected number. These lines produce a grid, which is the pretty graph mentioned at before and primarily used to determine reversals.
The basic idea is that the different percentage points on the grid define the value by which the reversal is to occur. The underlying expectation of the Fibonacci retracement is the follows – just as in nature where this ratio is found with frequency, so to in the market. Whilst this sounds particularly unscientific, the proof can be easily seen by putting the retracement over the trend and seeing how often the reversal occurs at the grid levels, particularly the 61.8% level.
How to use it
Based on the discussion above, the use of Fibonacci is pretty simple. Obviously, it relies on a trend strategy.
One method is based on the retracements providing you a low risk place to buy in the general trend direction. This method involves taking a trend and applying the retracement pattern over it. The graph will represent the place where short term reversals are expected, giving you a chance to identify an entry level where the position will bounce back to the original trend. This is most effective with a longer term trend and best with larger pip trends. For risk purposes, it is best to also have other indicators that support this position.
Another method is to use the targets to identify where to exit a trade. Since the Fibonacci measures reversals, selling at the 61.8% or 38.2% levels will allow you to take a profit off the position where the market is expected to bounce backwards in the opposite direction.
The Fibonacci sequence and reversals occur in trading charts with surprising frequency, providing the key to identifying many trading opportunities. The trick is to train yourself to understand how to use it properly, so time should be taken to develop your strategy skills that also utilizes other indicators to provide support for your trade.
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